Macroeconomic Outlook

Macroeconomic Outlook

Originally published in the May 2007 issue

Over the past month my macroeconomic outlook did not change significantly. The world economy continues to be in good shape, with overall growth somewhat slower than last year. The slowdown is mainly caused by slower growth in the US, with limited knock-on effects to the rest of the world. Inflation will generally remain relatively contained. Emerging economies are growing briskly, with the need for monetary policy tightening in some countries to avoid or combat overheating (India and China in particular).

The most important risks to the outlook for the world economy are:

  1. A return of risk premiums to more normal levels. Risk premiums continue to be very low. This is partly justified by better macroeconomic policies than in the past, better fundamentals in many emerging economies than in the past and by financial innovations which have increased the efficiency of risk allocation. However, it is also partly the result of the search for yield triggered by the loose monetary policies in past years. A reversal of risk premiums to more normal levels would trigger a correction in financial markets, with the most risky assets affected most. This could easily have a negative impact on the real economy. The correction of end of February was too limited and short lived to affect the real economy and its impact on financial markets has been more than reversed.
  2. A disorderly correction of global imbalances. This would mean a rapid and strong depreciation of the dollar and a sharp increase in interest rates. The implication would be a significant slowdown in world economic growth, including the possibility of a word wide recession.
  3. Inflation could prove to be more resilient than foreseen, as a result of several factors. The most important among these factors are higher oil prices and stronger wage increases than projected. This would force central banks to run tighter monetary policies than expected at this moment. This would come at the cost of slower economic growth, in the worst case with a recession in 2008. It would also be an unfavourable scenario for financial markets.
  4. A harder landing of the US economy than expected, caused by a larger impact of the correction in the housing market on the financial markets in general and the real economy than envisaged.

The United States

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.

“The world economy continues to be in good shape, with overall growth somewhat slower than last year.”

The consumer so far has not really responded to the problems in the housing market. The continued strength of the labour market provides support to consumption. It may well be that consumption growth will weaken going forward. A gradual bottoming out of the reduction in residential housing construction would at least to some extent compensate for this negative effect on economic growth.

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 Euro area

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.

Lex Hoodguin is Chief Economist at Robeco