Now that only a few weeks remain before we say goodbye to 2006, analysts are beginning to forecast future developments in the world’s most important economies. Many of their predictions will depend on investments that take place in their markets and on the momentum of trends in consumption. However, the landscape is obviously complicated. Until now, the most important focus has been on the road that central bank authorities take in the world’s major powers — a key factor that has a decisive impact on economic development.
According to Altina Sebastián González, professor of finance at the Complutense University in Madrid, economic policies have long used movements in interest rates as an adjustment tool for promoting or restraining economic growth. “But now, you have to take into account that the monetary policy goals of the Federal Reserve (Fed) and the European Central Bank are distinct. The Fed’s priority has been on controlling growth in inflation, while the European Central Bank pursues a goal of guaranteeing price stability of 2% [a year] in the euro zone.”
Doubts about the Fed
Current conditions in the United States and Europe are quite distinct. In the U.S., the world’s largest economy, the Federal Reserve has carried out 17 consecutive increases in interest rates, raising the price of money from 1% in the middle of 2004 to 5.25% today. This is the highest level in five years, and it has remained at the same level since last June. Now people are asking whether this upward cycle has finally ended. Will there be nothing more than a pause in that upward cycle? Or has the moment arrived for lowering rates [in the U.S.]?
In their efforts to answer such questions, economists try to figure out how the economy will change during the next three quarters, and what will happen to inflation. Although these two variables are not the only considerations, they are the factors that count the most when central banks make decisions about monetary policy.
In the United States, the Gross Domestic Product grew by 1.6% during the third quarter of the year, after increasing by 2.5% in the three previous months, and after enjoying a spectacular increase of 5.6% during the first quarter of the year. One of the factors most responsible for this slowdown has been the sudden decline in the real estate sector. Investment in residential construction plunged by 17.4% between July and September, the sharpest such decline since 1991.
Inflation dropped by 0.5% in September, the biggest drop since November 2005, because of petroleum prices were lower. However, core inflation, which does not factor in such volatile factors as energy and fresh food, increased by 2.9% on a year-to-year basis, the largest climb in a decade.
Given this situation, investors are doubly lost. The Federal Reserve insists that the economy is slowing down, although inflation is quite high. Yet the Fed is saying nothing about 2007.
Conflicting positions
Citigroup, Merrill Lynch and Goldman Sachs all agree that interest rates will decline in 2007. However, JP Morgan, Lehman Brothers and Morgan Stanley are predicating that rates will rise. There is no middle ground. Rarely has Wall Street been so divided. The managers of big investment funds are also clashing: Pimco, the mutual fund giant, is counting on a rate cut in the next few months. For its part, Fidelity believes that rates will remain unchanged at 5.25% during the coming year.
Those banks that are forecasting interest rate hikes in the U.S. next year believe that the slowdown in the economy will be a smooth one and that, as a result, it will not be enough to reduce inflation. This school of thought also warns that economic activity is strong, except for the real estate sector. “Expectations for inflation are high and on the upswing again,” says Richard Berner of Morgan Stanley in New York. “[The volume of] surplus production capacity has softened, and costs continue to accelerate.” Morgan Stanley expects higher rates during the second quarter of 2007.
Robert DiClemente of Citigroup disagrees. “There are signs that prospects for inflation are improving, along with economic growth, and that could open the door to a small cut in rates at the beginning of next year,” he says. Citigroup, which expects a cut in rates during the first quarter of 2007, is one of the Wall Street banks that expect the collapse in the real estate sector to lead to a significant slowdown in the economy.
Sergio R. Torassa, finance professor at European University in Madrid, points out that Ben Bernanke, new head of the Fed, “has proposed a change in monetary policy when it comes to setting inflation goals.” At the moment, says Torassa, “Everything seems to indicate that interest rates in the U.S. are not going to start rising again, at least over the short term.” Torassa explains that this forecast “is based on fears that the deceleration of the American economy will be more abrupt than hoped for, and that it will exacerbate the abrupt drop in the housing sector. This would involve obvious dangers for the financial sector and for the American economy, and would spread around the globe.”
The European Awakening
In Europe, the European Central Bank (ECB) has raised interest rates five times beginning in December 2005, up from 2% to the current rate of 3.25%. In its last meeting, the ECB anticipated that the price of money will move higher in December [2006]. In all likelihood, it will rise to 3.5%. The ECB left half-open the possibility of additional increases in 2007. All of these possibilities seem feasible.
Unlike the United States, the euro zone is undergoing an economic awakening after recent years of lethargy. During the second quarter of 2006, [the euro zone’s GDP] grew by 2.6%, compared with the same period of 2005. This growth rate is half a percentage point above the growth figures registered for January-through-March.
The European Commission is very optimistic that growth in the euro zone will continue. The EC, executive branch of the European Union, recently revised upward its 2006 growth forecast for the zone to 2.6% from its previous forecast of 2.5%. Achieving this prediction would mean that the GDP in the “twelve” [older members of the E.U.] would grow by 1.2% [over previous forecasts]. In 2007 and 2008, Brussels[the E.U.] expects that growth will reach 2.1% in 2007 and 2.2% in 2008.
For her part, Sebastián believes that “the recovery is sustainable because the unemployment rate has dropped and job growth is gaining strength. On the other hand, the euro zone must confront the predictably negative impact of higher added value taxes in Germany beginning on next January 1. They will have some impact on growth in the E.U.”
When it comes to inflation, declining prices for energy that were recorded in mid-August have enabled the Consumer Price Index (CPI) to end September at a year-to-year rate of 1.7%, below the goal set by the ECB’s monetary policy.
Given such conditions, it is logical for the ECB to continue to raise the price of money in 2007. However, analysts are divided in their views. Half of them expect additional rate increases, perhaps up to a 4% rate, while the other half believes that interest rates will wind up peaking in December.
Increases for 2007
Both Jean Claude Trichet, president of the ECB, and Bernanke, chairman of the Fed, have made comments that created doubts. On the one hand, Trichet has downplayed the importance of the recent drop in the CPI to 1.6%. Noting that he expects the decline to be only temporary, Trichet has warned that “inflationary risks in the future are increasing.” On the other hand, Trichet expects that “the European economy will continue to grow in a robust way, nearly meeting its target” in 2007. However, he emphasizes that there is a risk of slower growth in the United States.
In any case, experts believe that any rate hikes in 2007 will be significantly less than the cumulative increases made over the last 12 months. Elena Nieto at BBVA in Madrid expects that rates will be raised on two occasions during the coming year — to 3.75% in February, and to 4% in April.
Both in the United States and Europe, a key factor will be the changing price of petroleum. In recent months, petroleum prices have been the key determinant of inflation. Markets watched crude oil prices register their all time height on August 8, 2006, when the price of a barrel of Brent crude reached $78.49. From that point onward, prices began to decline. On the one hand, political risk has dropped as a result of the cease fire in Lebanon and fewer tensions between Iran and the West. On the other, real demand has been lower than initially anticipated.
For his part, Torassa predicts that 2007 will be a year of fewer tensions and less volatility than 2006, and that prices will drop slightly. “The record high prices of 2006 will probably be the last [such records] in history. The process of technological innovation in alternative energy sources, along with active exploration for new deposits, should saturate the market with petroleum within two or three years. Starting from 2010, supply will clearly exceed demand,” he predicts.
Globalization
Beyond monetary policy, both fiscal policy and public spending policy are also important considerations, says Sebastián, recalling for example, that the solution to the recession of 2001, in which the American economy played a key role, was based on the Bush administration’s tax cuts and on the substantial interest rates cuts pushed through by Alan Greenspan, then head of the Fed.
“The current situation is very different, and traditional remedies will not ‘cure’ the same ills,” notes Sebastián. The difference today stems from the greater globalization of the economy. Over these past few years, economies have opened themselves to the world to such an extent that it is hard to calculate the precise impact of any measures taken by authorities [in various national governments.] For example, cutting taxes provides incentives to consumption as well as to investment. However, this fact does not always wind up benefiting the country that has adopted such a [tax cut] measure, because consumers may prefer not to spend their extra disposable income on purchasing their own country’s goods and services. Instead, they may opt to import cheaper goods and services [from other countries]. In such a case, the [main] beneficiary [of tax cuts] would be a foreign country, not the country that carries out the [tax] reform.”
Torassa agrees. “Regardless of a government’s political ideology or the school of economic thought it belongs to, globalization has completely outpaced the capacity of [authorities in] Washington, Tokyo and Frankfurt to control the course of their own economies,” he says.
