Global Economic Outlook and Strategy - Kadin Indonesia

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February 28, 2008 Global Economic Outlook and Strategy Lewis Alexander (212) 816-9882 lewis.alexander @citi.com Financial conditions are weighing on the U.S. economy. Most countries show few signs of distress... ...but that may change. Emerging economies are well positioned for the slowdown. Overview: The United States and World Economic Outlook The recent deterioration in financial conditions is having its biggest impact on the U.S. economy. Europe is also slowing, but the spillover to most emerging economies remains modest so far. Looking ahead, we expect a variety of factors — including the waning of the drag from residential construction, fiscal stimulus, and improving financial conditions driven by a more assertive Fed — to contribute to a modest recovery in U.S. growth starting in the second half of the year. The forces restraining the pace of U.S. economic activity have shown few signs of easing in recent weeks. Incoming data from the housing sector point to ongoing contraction. The prevailing mix of credit, equity, and other asset prices continues to be a significant headwind for aggregate demand (see Figure 4). Consumption indicators suggest that household spending has slowed markedly. The U.S. slowdown is a drag on the Canadian and Mexican economies, and economic activity in the United Kingdom and the euro area is also slowing, but less sharply than in the United States. However, most other countries still show few signs of being adversely affected by the U.S.-led slowdown. Recent data for China point to a strong start to 2008, while resilient demand for commodities is supporting many emerging economies and smaller highincome countries with a comparative advantage in commodity production. The underperformance of the U.S. economy relative to most other major economies is contributing to downward pressure on the U.S. dollar (see Figure 5). This pattern may change in coming quarters. The U.S. slowdown is spreading beyond residential construction. A broader and deeper slowdown in U.S. consumption and investment should generate a more significant slowdown in imports that will serve to moderate growth in the rest of the world (see Figure 6). Policy flexibility around the world is likely to play an important role in containing the global slowdown. Unlike the past, many emerging economies (such as Brazil, Mexico, and Korea) have strong public and private balance sheets, and they have established Figure 4. United States — Citi Financial Conditions Index (Standard Deviations) and the Output Gap (Percent of GDP), 1988-Jan 08 3σ 3 6% 6 Figure 5. United States and Other Major Industrial Countries — Economic Surprises (100=1 Standard Deviation), Jan 07-27 Feb 08 100 100 2 4 75 75 1 2 50 50 0 -1 -2 -3 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 FCI (Left) GDP Gap (Right) 0 -2 -4 -6 25 0 -25 -50 United States Other Major Economies -75 -75 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 25 0 -25 -50 Note: Shaded regions denote recession. Sources: Bureau of Economic Analysis, Congressional Budget Office and Citi. Note: Citi Economic Surprise Indexes are weighted averages of the difference between individual data releases and the consensus forecast. “Other Industrial Countries” includes the euro area, Japan, Great Britain, Australia, and Canada. Source: Citi. 4
February 28, 2008 Global Economic Outlook and Strategy Slow growth should contain inflation. The course of global growth depends on financial conditions. The Citi FCI has tightened despite Fed easing. The fiscal package will provide a temporary boost. Inflation likely will cool in the second half. strong records of pursuing stable macroeconomic policies. This should make it possible for these countries to ease policy, if needed, even in the midst of substantial turmoil in global financial markets. Strong commodity prices and declining output gaps in some countries are putting upward pressure on inflation. Nonetheless, we expect the slowdown in the United States and Western Europe to contain inflation in those countries (see Figure 7), and slowing export growth should help to contain inflationary pressures in other key countries such as China. The evolution of financial conditions remains a key source of uncertainty. In recent days, credit, equity, and other financial markets seem to have found a footing in response to the significant shift in Federal Reserve policy in late January, the U.S. fiscal stimulus package, and other policy measures intended to address some of the stress points in the financial system. However, even if financial markets stabilize and improve from here, the cumulative impact of the financial turmoil of the last six months is likely to be a drag on the U.S. and global economy for many months. Moreover, given the still considerable uncertainty about the magnitude and distribution of losses in the financial system, we cannot be confident that we have seen the worst in financial markets. U.S. Financial Conditions Critical to the Outlook Our composite measure of U.S. financial conditions has tightened since our last forecast round (see Figure 4). Currently, the Citi financial conditions index (FCI) is about two standard deviations tighter than normal, a reading consistent with anemic economic growth. Recent data, particularly the deceleration of consumption since November, appear consistent with the deterioration in financial conditions since last summer. The Federal Reserve seems likely to lower policy rates further in an attempt to offset the adverse dynamic starting to take hold. Importantly, forecasts of a sustained improvement in the pace of activity later this year depend on a recovery in financial conditions. The recently enacted fiscal stimulus package will boost economic growth later this year — most likely in the third quarter — but its impact on activity will be temporary. The lift in household disposable income from the rebate checks could underpin consumer spending growth that is about 2½ percentage points faster than otherwise would be the case. But because this is a one-time boost to household income, the step up in spending will be largely reversed out in ensuing quarters. An additional 100-basis-point decline in the funds rate is likely despite the continued stickiness in inflation. Consumer and wholesale inflation readings in January were disappointing, and our latest forecast anticipates slightly higher core inflation this year. As long as inflation expectations remain anchored near current levels, however, the combination of soft demand, tight financial conditions, and falling home prices should produce a cooling in price pressures. The timetable for such a cooling probably will be deeper into the year than we previously envisioned. As key Fed officials continue to remind market participants, an unmooring of pricing attitudes could upend expectations of an easing in inflation. So, we will continue to monitor developments on this front closely. 5
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