The most important risks to the outlook for the world economy are:
To my mind, the most likely scenario for the US economy continues to be economic growth of between 2 and 2.5% and a gradually falling inflation rate.
The housing market will probably remain a drag on the economy for some time to come, mainly because inventories are quite high and also because of relatively low housing construction. Housing activity will also be hampered by the financial distress in the subprime segment of the housing market.
At the moment it seems unlikely that the problems in this segment of the housing market will have a major impact on the financial markets more generally. A credit crunch seems rather far away.
Given this outlook, the Fed can be expected to remain on hold for a number of months to come and then to gradually start to ease monetary policy in the third or fourth quarter of this year (one or two cuts this year). By the end of the year the yield curve willbe rather flat, but no longer be inverted.
The outlook for economic growth and employment in the euro area remains bright. A growth rate of around 2.5% this year should be possible, with unemployment continuing to fall to levels well below those recorded in previous periods of strong economic growth. This welcome development seems to reflect both the impact of aging on the labour supply and the positive impact of cautious labour market reforms of past years.
Inflation has come in at just below 2% the past months. Going forward in the medium term a limited increase to just above 2% may be expected, just above the level that the ECB considers to be consistent with price stability.
Under these circumstances, the ECB interest rate hike to 3.75% of last month has not been the last one. The ECB will probably again increase its policy rate to 4%, before the summer break (August). It is interesting to see whether at that occasion the ECB will still call its policy stance “on the accommodative side.” I do not think so. At the same time, probably the ECB will keep on noting that the risks to price stability are on the upside. Therefore, I assume that the ECB will go on summer holidays with its tightening bias still in place. By the end of the year the policy rate is 4-4.25% and also in the euro area the yield curve will be rather flat.
Economic growth in Japan is likely to be on the order of around 2%. In the meantime the price level is slightly falling again (deflation), mainly due to base effects related to lower oil prices this compared with last year.
The Bank of Japan will probably continue to be more hesitant than wise. In terms of interest rate policy that means that I expect them to hike rates from the current 0.5% to at most 1% by the end of the year, in two steps. This would imply that the policy rate remains far below what could be considered a neutral rate (around 3%). Assuming an expected inflation rate of somewhere between 0 and 1%, I consider the Bank of Japan’s pace of interest rate consolidation as too cautious. A policy rate by the end of this year of 1.5% would be more prudent and still not excessive.
Long term rates will go up more or less in parallel with the policy rate, which would bring the 10-year government bond rate at around 2% by the end of this year. Japan would continue to have a relatively steep yield curve.
The overcautious Japanese monetary policy has contributed to an undervalued yen by stimulating carry trades. Although the interest rate differential with the rest of the world will remain large the coming quarters, the basic assumption of carry trades of a continuation of a weak yen is fragile. The yen has upward potential.
For Euro area-based investors a possible appreciation of the yen may offer an interesting investment opportunity in Japan. If the Japanese consumer also starts to consume more than she has done in the recent past, this could also provide a boost to the stock market.