Chapter 1: general assessment of the macroeconomic situation

OECD Economic Outlook, Dec, 2007

OVERVIEW

Financial turmoil, housing weakness and oil prices are forefront ...

2007 is set to become the fourth year of above-trend growth in the OECD area (Table 1.1), but activity is now moderating. One cause of this moderation is the cooling of housing markets, which will act to slow down growth going forward and involves some downside risk. Adding to downside risk, the financial turmoil that began over the summer has not yet played itself out, with the eventual fallout on the real economy still hard to gauge. At the same time increases in the prices of oil, food and other commodities have led to a pick-up in headline inflation rates in many countries.

... but the main scenario remains relatively benign

In the light of these influences, the main scenario presented here appears relatively benign. Area-wide growth is projected to be fairly slow in the near term but then gradually to pick up speed, with this profile being particularly pronounced for the United States. If such an outcome is achieved, it will be in large part due to the fact that financial turmoil struck after a prolonged global expansion when corporate balance sheets and labour markets were unusually strong, as well as due to the prompt reaction of central banks. Moreover, as argued in previous editions of the OECD Economic Outlook, some re-pricing of risk was overdue, and, to the extent that risk is now better reflected in the cost of capital, this may lead to a more discriminating allocation of capital and so enhance longer-term growth prospects.

Housing slowdowns will impact severely in only a few countries

While the slowdown in housing markets, which is now evident in most OECD countries, will damp growth prospects, it is expected to act as a severe brake in only a few. In particular, downturns in housing investment already underway in United States, Ireland and, to a lesser extent, Spain are likely to become more pronounced. (1) It is also likely that slowing or falling house prices in some countries where housing wealth effects or mortgage equity withdrawal have previously been an important factor supporting consumption, including the United States and the United Kingdom, will contribute to some further slowdown in demand.

But downside risks predominate

This scenario is representative of a most likely outcome, but the risks surrounding it have a long tail to the downside. This reflects, in particular, the possibility that there could be after-shocks to financial markets. It also reflects uncertainty about how sensitive households and businesses might be to higher cost and lower availability of credit. It is as well possible that a greater number of countries are vulnerable to a pronounced downturn in house prices or housing investment, particularly if financial turmoil were to disrupt mortgage markets more than currently seems the case, or if the experience of other countries leads to a reassessment of house prices by buyers and sellers.

Monetary policy in the three main areas should remain on hold for now

Recently, the threats posed by financial turmoil have required swift and substantial measures on the part of the monetary authorities in the United States, the euro area, the United Kingdom and Canada, aimed at ensuring that financial markets do not flounder for a lack of liquidity. In the United States, growth is likely to have slowed sharply and to stay low in the near term as the housing downturn intensifies and finally leads to some weakening of consumption. However, this would still be consistent with output falling only modestly below its estimated potential level. Headline inflation has recently picked up, mainly due to higher food and energy prices, but core inflation appears to have stabilised near 2%. In these circumstances the current slightly accommodative stance of monetary policy seems appropriate, although policy rates should revert towards neutral once growth recovers. For Japan, the overriding priority remains a durable exit from deflation. The Bank of Japan, therefore, should not raise the short-term policy interest rate further until inflation is firmly positive and the risk of renewed deflation becomes negligible. In the euro area the situation is somewhat more nuanced. Measures of underlying inflation have drifted upwards over the past couple of years, with some now exceeding 2%, and the most recent monthly figures for headline inflation have moved up sharply, with the flash estimate for November reaching 3.0%. Nevertheless, wage settlements remain largely contained despite tight labour markets. Furthermore, exchange rate appreciation and more stringent credit standards have led to an effective tightening of financial conditions.

Partly as a result, growth is likely to have slowed and to remain slightly below trend rates in the near term, which should help to ease underlying inflationary tensions. Against this background, policy rates can be kept on hold without posing a threat to price stability.

Fiscal consolidation remains a priority