thanos

•

•

some capacity has been destroyed, and the position of

Emerging Asia and commodity countries differs from the

G-3. However, in the aggregate, the world remains

awash with slack and inflation is moving lower. Core

inflation in the G-3 is dangerously low—it is flat over the

past six months.

While the uncertainties surrounding where private sector

behavior is heading have increased, the path of developed

market (DM) policy has become clearer. Fiscal tightening

is taking hold broadly in the aftermath of the European

financial crisis. On the heels of recent announcements

across the Euro area, the new UK government presented

an emergency budget that adds to substantial tightening

already in place. The US Congress also failed to extend

Emergency Unemployment Compensation (EUC), signaling

shifting sentiment in the US as well. Although the

EUC extender is likely to be passed soon, other initiatives

anticipated to dampen next year’s fiscal drag now look less

likely to materialize. We also are learning that the new

Japanese government under Prime Minister Kan intends to

be more aggressive on fiscal consolidation. Accordingly,

we have raised estimates of the aggregate fiscal tightening

in recent months by 0.4%-pt to about 1% of DM GDP next

year. This adjustment would be the most aggressive DM

tightening in more than four decades.

As fiscal policy consolidates, monetary policy is shifting

toward a “low for longer” stance. Our long-held view that

the developed world policy normalization would not start

this year has been extended until late 2011. As a result, our

expectation of mid-2011 DM policy rates now stands 45bp

lower than three months ago. With central bank balance

sheets expected to remain bloated and real rates set to stay

in negative territory for at least two full years, monetary

policy stances will remain far more accommodative than at

any point since the mid-1970s.

Standard macroeconomic models mark these moves as having

offsetting effects on growth, a point that reflects the

policy objective of achieving early progress on fiscal consolidation

while using monetary policy to sustain abovetrend

growth. Low inflation will allow central banks to

hold up their part of the agreement. But it also underscores

the significant risk of fiscal tightening in the current environment.

A significant shortfall in growth or a slide in inflationary

expectations would require a quick and decisive

monetary policy response. But policy rates are at the zero

bound—and already anticipated to remain there. To be

sure, asset purchases and other unconventional measures

are available tools. But evidence that these tools can lift

activity or anchor inflation expectations is sorely lacking.

For this extreme policy mix to achieve its aim, it must produce

lower DM borrowing rates and currency values. It is

thus encouraging that DM 10-year government bond yields

have moved lower, alongside stable medium-term inflation

expectations. The real effective DM exchange rate is also

sliding and stands 7% below its level a year ago.

The private sector response to these financial incentives

and improving economic conditions holds the key to the outlook.

As the chart above shows, a significant improvement in

underlying private demand—both directly and in response to

easier money—will be needed to offset fiscal tightening and

a fading of the inventory cycle. In this regard, the establishment

of a hiring and capital spending upturn across the globe

sends a positive signal that a shift in business behavior away

is under way. However, the damage to consumer confidence

from developments in Europe and the recent decline in equity

prices remains to be assessed.

Although the trajectory of our global economic forecast has

not changed much, we recognize that growth momentum

probably was cresting into midyear. Incoming data confirm

that global IP is set for another blockbuster gain in the current

quarter. This strength reflects an important rotation

from Asia—which led the global recovery—to the US and

Europe.

Looking ahead, policy tightening is producing a downshift

in China, which will reverberate through Asia and more

broadly. At the same time, as mentioned earlier, we have

scaled back expectations for growth across Europe to reflect

likely damage done by the debt crisis. The global economy

also is going to lose support from the industry cycle. The

recovery in global demand has been heavily focused in the

goods sector, including capex, autos, and other consumer

durables. In addition, the robust growth of final demand has

been leveraged by the inventory cycle, as companies gradually

shifted from cutting to accumulating stocks. This onetwo

punch will lose strength in coming months as the growth

of final demand moderates somewhat alongside the maturation

of the inventory cycle. Thus, the pace of global IP

growth is forecast to slow to a 6% annual rate in this year’s

second half—a pace that is still strong, but just half of what

was seen in 1H10.

The anticipated moderation in IP will be one of the most striking

features of the macro landscape. Ignoring the influence of

the inventory cycle would incorrectly attribute the moderation

in output to a slowing in final demand growth. At the same

time, the global economy is becoming less dependent on

goods demand as the expansion broadens to the services sector.

This sectoral rebalancing means that GDP growth can remain

relatively strong even against the backdrop of a significant

slowing in the pace of manufacturing activity.

[....]