International Economic Update
August 11, 2008
Global economic activity continues to expand, but at a slower pace (Chart 1). Sluggish growth in the advanced economies is expected to continue at least until the first half of 2009. The rapid growth in the emerging markets is likely to soften.
According to advance estimates released by the Bureau of Economic Analysis, U.S. real GDP growth was 1.9 percent in the second quarter of 2008. The contribution of net exports to U.S. growth was a robust 2.4 percent. In fact, net exports have partially offset the negative drag from private residential investment especially since 2007 (Chart 2), although this positive contribution could diminish as global growth slows.
For much of the past two decades, the U.S. has imported more than it has exported. After the 2001 recession, the widening trade deficit coincided with a period of low interest rates and a reallocation of expenditures toward residential investment (Chart 3). A misallocation of expenditures into residential investment might have contributed to excessive capital accumulation in the U.S. housing sector. The willingness of foreign investors to partly finance this spending may be the counterpart for the continued increase in the trade deficit, even after the dollar peaked around 2002.
U.S. residential investment growth declined modestly in early 2004, but tumbled along with housing-price growth in late 2005 (Chart 4). The housing market correction has left a fraction of the U.S. installed capital underutilized, and now the country faces the prospect of a costly adjustment of its stock to other productive activities. The way we expect a hit to the domestic stock of capital to be propagated is not inconsistent (at least in theory) with a depreciation of the real exchange rate and a reversal of the trade deficit, as we have seen in the U.S., particularly since 2005. The U.S. trade deficit's reversal might have somewhat cushioned the unwinding of expenditures out of the residential investment sector over the past 4–6 quarters.
Among developed nations, the U.S., U.K. and Spain are experiencing the sharpest housing corrections. Although housing-price growth peaked in the two European countries earlier than in the U.S., the crisis did not fully begin until after the first signs of strain in the U.S. housing market during 2005–06. Nonetheless, the experiences of the U.K. and Spain are quite different.
Similar to in the U.S., in Spain the deterioration of the trade deficit coincided with a period of low interest rates and a reallocation of expenditures toward residential investment (Chart 5). After the adoption of the euro in 1999, the trade deficit grew gradually as a share of GDP. When housing-price growth peaked in late 2003, residential investment growth became more stable and the trade deficit ballooned. The housing boom was then prolonged for too long, evidenced by the fact that residential investment did not respond to the signal of decelerating housing prices until late in 2006. Lacking the cushion of a trade deficit reversal, the decline in residential investment growth ended up leading the overall GDP growth decline by four quarters (Chart 6).
Unlike in the U.S., the current phase of the business cycle in the U.K. is not characterized by a sizeable change in expenditures on residential investment (Chart 7). Hence, the recent housing slump in the U.K. is likely different in nature from that of the U.S. What we observe is that residential investment growth is quite responsive to housing-price growth, often anticipating it. Housing-price growth has remained elevated in the U.K. for quite a while but has been more volatile recently. In fact, while it reached its 10-year high in early 2003, its latest rebound peaked as late as 2007 (Chart 8). Residential investment growth, housing-price growth and overall GDP growth have been declining since then.
Rising Inflationary Pressures
Inflation rates keep rising around the world, and emerging economies are suffering the most (Map 1). Energy and food prices remain elevated, despite the recent drop in the price of oil. Emerging markets are particularly exposed to these price increases because food and energy expenditures make up a greater share of their consumption basket.
The gap between headline and core CPI has been increasing in the developed economies, with rising headline inflation rates and relatively subdued core rates (Chart 9).
The expectation that the global slowdown will bring inflation under control has yet to materialize. Several developments have contributed to the buildup of inflationary pressures. Among them:
- The prevalence of an implicit dollar-zone in parts of Asia and among commodity exporters may contribute to rising global inflation. Maintaining the zone has required monetary policy accommodation in the face of a commodity price shock and a weakening of the dollar.
- Wage indexation schemes around the world, even among countries with a free-floating exchange rate (the euro zone, for example), may contribute to second-round effects on wages from the commodity shocks and to rising labor costs.
- Signs suggest that the secular trend of decline in transportation costs may have stopped over the past years. The recent collapse of the Doha trade negotiations is also a missed opportunity to boost trade and reduce trade costs through lower tariffs.
A growing number of countries have tightened monetary policy, but capital controls, sterilization and manipulation of the reserve requirements (even price freezes, subsidies, tariffs and wage indexation) have been widely used as complementary tools to fight inflation. They are never foolproof; hence, some countries may be simply trading higher inflation for temporary exchange rate stability and/or growth.
Pressures on the exchange rate against the dollar and some signs of wage spirals in emerging markets are the consequences of growing inflation, which raises the risk of imported inflation for the U.S. Trade costs worsen the inflation outlook because they reduce foreign competition and give cover for domestic companies to raise their prices. If persistent enough, they may alter long-run production plans, reduce the benefits of offshoring and add to U.S. wage pressures. Second-round effects on U.S. wages cannot be discounted either.
In fact, the low levels of pass-through observed during the past 10–15 years are not a guarantee because it is likely that firms will pass cost increases (whether domestic or foreign) more aggressively to U.S. consumers if there is a shift toward a regime with higher inflation.
The dollar has stabilized or appreciated in recent months against the euro and other major currencies, and oil prices have abruptly retreated from record highs in recent weeks. Still, lingering signs point to a more protracted upside risk to the U.S. inflation outlook.
—Enrique Martinez-Garcia and Janet Koech
About the Authors
Martinez-Garcia is an economist and Koech is a research analyst in the Research Department at the Federal Reserve Bank of Dallas.