In its OECD Economic Outlook for May 2011, the international economic organization of 34 countries says the global recovery is becoming self-sustained and more broad-based, albeit at different speeds between advanced and emerging economies.
Unemployment remains high across most of the OECD countries. In most, headline inflation has risen strongly, and expectations are also drifting up; however, underlying inflation seems likely to edge up only slowly. Besides, they see in non-OECD economies rising inflationary pressures prompting policy restraint that could slow the recovery.
The Paris-based Organization for Economic Cooperation and Development's economic outlook is surrounded by risks, of which most risks are on the downside that include:
• further increases in oil and other commodity prices which could feed into core inflation;
• a deeper slowdown in China;
• an unsettled fiscal situation in the United States and Japan;
• renewed weakness in housing markets.
Financial vulnerabilities are increasing in the euro area in spite of strong adjustment efforts in peripheral countries.
A concern is that, if downside risks interact, their cumulative impact could weaken the recovery significantly, possibly triggering stagflationary developments in various advanced economies.
Unemployment remains high in many countries. As experience shows, following financial crises there are risks of stagnation as structural adjustment and financial repair are delayed. Stagnation could also emerge, and even if such risk doesn’t materialize, the impact of the crisis in lowering potential output is becoming clearer that, eventually, will lower realized growth rates.
The potential for growth-enhancing structural reforms and policies to unleash new sources of growth is substantial. The OECD thinks governments should intensify their efforts in implementing them.
Lower growth would feed back negatively on fiscal consolidation, while evidence shows that, beyond some thresholds, public debt levels have a negative impact on growth. The United States and Japan have yet to produce credible medium-term plans to bring debt levels back to pre-crisis levels while other countries need to bolster medium-term fiscal targets by specifying the measures that will be implemented to achieve them.
For most countries, further action would be needed as the overall scenario has changed with respect to the pre-crisis situation when a significant contribution to fiscal sustainability came from the fact that interest rates were well below growth rates.
It’s extremely important to take into account this is unlikely to be the case in the years to come as interest rates will rise and growth could be slower than generally expected at this time. Structural reforms, while boosting growth, can also help fiscal consolidation by increasing efficiency in the provision of key services such as health and education.
Finally, it would be dangerous to believe that higher inflation could address debt sustainability. Higher and persistent inflation could damp real growth by raising price and exchange-rate volatility. It could also risk unhinging inflation expectations, with the result that interest rates would soon increase more than inflation.
Last but not least, imbalances have been widening again as the global economy is recovering. Notwithstanding, we see China’s current account surplus well below pre-crisis peaks due to adverse terms–of–trade movements and less buoyant export performance, while in high saving oil-producing economies we see mounting surpluses.
A desirable rebalancing mechanism would require more exchange-rate flexibility, which could also help mitigate inflationary pressures. If that is do-able under the current circumstances is another question.
The post-crisis economy will have to deal with old and new challenges, while pursuing new, green and inclusive sources of growth. The endogenous generation of instability and imbalances out of “apparent” tranquility, a phenomenon common to several if not all crisis episodes, has been dangerously overlooked. This reinforces the need for financial-sector reform and tighter prudential policies, both at the micro and macro levels.
As far as the U.S. is concerned, the OECD report states: “With very large budget deficits and fast-rising federal debt, an agreement on a credible medium-term fiscal consolidation program will become increasingly urgent as the economy continues to recover.”
That said, today, in the U.S., budget positions are poor at all levels of government, because of the recession but also weak positions prior to it and given the lack of political consensus on how to cut the deficit.
Further progress to unwind fiscal imbalances beyond 2012 would require ambitious reforms of the tax system and entitlement spending, along the lines recommended by the President’s Fiscal Commission in late 2010.
It’s a fact the adverse effects of the crisis that caused the considerable reduction from 6 percent of GDP in 2006 to 2.75 percent in 2009 are still being felt, particularly in the form of still-high unemployment that notwithstanding it’s declining this is worrisomely largely driven by lower labor force participation.
Output growth should gain speed and the unemployment rate should continue to decline through 2012 though the pace of expansion will be limited by household deleveraging and initial steps at fiscal consolidation.
The OECD thinks the Fed should continue to support growth, as the economy lingers below capacity and core inflation remains low, but a modest reduction in monetary stimulus starting in the second half of this year would reduce the likelihood of a potentially destabilizing rapid increase in interest rates later.
Macroeconomic policy support in the U.S. remains considerable and the response of the economy to the withdrawal of fiscal stimulus presents a real downside risk over the next couple of years. Further increases in fuel and commodity prices would squeeze household and business budgets, presenting an additional downside risk. On the other hand, ample corporate profits and easy financial conditions could trigger a faster recovery of business investment and hiring than projected.
As the just released OECD economic outlook report doesn’t torpedo the U.S. outlook and besides this world is literally awash with “insecurities” I still feel good favoring the U.S. dollar, gold and the Swiss franc. Yes, I continue favoring “risk off.”
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