Financial turbulence clouds growth prospects

(World Economic Outlook Update an update of the key WEO projections)

Following strong growth through the third quarter of 2007,the global economic expansion has begun to moderate in response to continuingfinancial turbulence. Global growth is projected to decelerate from 4.9 percentin 2007 to 4.1 percent in 2008, a markdown of 0.3 percentage pointrelative to the October 2007 World Economic Outlook. Risks to the outlookremain tilted to the downside.

Recent data suggest that global growth slowed markedly inthe final quarter of 2007 in the face of significant headwinds from thefinancial sector, following a stronger than expected third quarter. Asdiscussed in the accompanying GFSR Financial Market Update, the financialmarket strains originating in the U.S. sub prime sector-and associated losseson bank balance sheets-have intensified, while the recent steep sell-off inglobal equity markets was symptomatic of rising uncertainty.

Economic growth in the United States slowed notably in thefourth quarter, with recent indicators showing weakening of manufacturing andhousing sector activity, employment, and consumption. Growth has also slowed in Western Europe, and confidence indicators have generally deteriorated. In Japan, growth has been dampened by a tightening in building standards, while consumer andbusiness sentiment has weakened. Despite some slowing of export growth,emerging market and developing economies have thus far continued to expandstrongly, led by China and India.

These economies have benefited from the strong momentum ofdomestic demand, more disciplined macroeconomic policy frameworks, and forcommodity exporters, from high food and energy prices as well.

Headline inflation has increased since mid-2007 in bothadvanced and emerging market economies. Core inflation has also drifted upward.In the United States, the Federal Reserve has been cutting interest rates inresponse to increasing downside risks to activity, while policy has been onhold in the euro area and Japan. Meanwhile, central banks have continued totighten monetary policy in many emerging market economies, where food andenergy represent a higher share of consumption baskets and overheating is moreof a concern.

Against this background, global growth is projected at 4.1 percent in 2008, down from 4.9 percent in 2007. The projections for the advanced economies have been reduced significantly. Projected growth in the United States in 2008 has been lowered to 1.5 percent on a year-on-year basis, downfrom 2.2 percent in 2007. The annual growth figure for the U.S. economy in 2008 reflects the carryover from 2007. Projections on a fourth-quarter-on-fourth-quarterbasis thus give a better sense of the slowing growth momentum. On this basis,growth is projected at 0.8 percent in 2008, compared to2.6 percentover the same period in 2007. For the euro area, growth has been lowered to1.3 percent, again on a fourth-quarter-to-fourth-quarter basis, comparedto 2.3 percent during 2007.

Growth in emerging market and developing economies is alsoexpected to ease, moderating from 7.8 percent (on an annual basis) in 2007to 6.9 percent in 2008. In China, growth is projected to decelerate from11.4 percent to 10 percent, which should help alleviate overheatingconcerns.

The overall balance of risks to the global growth outlook isstill tilted to the downside. The main risk to the outlook for global growth isthat the ongoing turmoil in financial markets would further reduce domesticdemand in the advanced economies and create more significant spillovers intoemerging market and developing economies. Growth in emerging market economiesthat are heavily dependent on capital inflows could be particularly affected,while the strong momentum of domestic demand in some emerging market economies provides upside potential.

In addition, a number of other risks also remain elevated.Monetary policy faces the difficult challenge of balancing the risks of higherinflation and slower economic activity, although a possible softening of oil prices could moderate inflation pressures. There are also concerns about continuing large globalimbalances, in the context of heightened financial volatility.

World Economic Outlook update projections

(Annual percent change unless otherwise noted)

Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during December 4, 2007-January 2, 2008.

Source: AEPC newsletter