Latin America in a Global Context - Economic Briefing August 2006

Improving Outlook for Latin America

The global economic outlook remains positive. However, the recent tensions in the Middle East have prompted yet another spike in oil prices, which is overshadowing current upbeat prospects. The U.S. economy is slumping, following on a strong but temporary rebound earlier this year. However, in spite of high energy prices and the tighter monetary setting, consumers remain sufficiently confident to support robust economic growth in the months ahead. Simultaneously, Japanese consumer confidence is also remaining close to historic highs, which suggests that the domestic economy will fuel the recovery in the months ahead. Non-Japan Asia will continue to grow at a resilient rate, as the Chinese economy defies government’s attempts to cool investment and is growing at the fastest pace in more than a decade. The Euro Area that has represented a major drag to global economic growth during the past years is showing incipient signs of revival. However, a tighter monetary policy and the potentially weaker U.S. consumption could dent the potential for recovery in the Euro area. Finally, prospects for Latin America remain solid, as the benign outlook of the global economy promises to support demand for key commodities.

U.S. economy slumps in second quarter

According to advance estimates released on 28 July, gross domestic product (GDP) increased at an annual rate of 2.5% in the second quarter.  Second quarter growth came in below expectations, which had the economy growing at a more robust 3.0% pace.  Moreover, the second quarter reading represents a significant slowdown from the resilient 5.6% growth registered in the first quarter and thus continues the erratic growth pattern observed during the past quarters.  The first quarter had marked the fastest growth in more than two years and represented a strong rebound from the anaemic 1.7% growth registered in the final quarter last year, when the economy grew at the slowest pace since 2002.  The second quarter slowdown was broad-based and reflected a deceleration in consumption as well as in investment.  Private consumption slowed to almost half the 4.8% pace observed in the first quarter and increased 2.5% annually in seasonally adjusted terms.  The slump in private consumption mainly reflects a pronounced dip in durable goods, where a 19.8% expansion in the first quarter turned into a 0.5% contraction in the second.  Consumption expenditures of services, in contrast, accelerated notably but were not sufficient to compensate for the slowdown in durable consumer goods.  Investment on equipment and software dropped 1.0% over the same period last year, the first decline registered in more than three years. 

Fed walks fine line between economic slowdown and accelerating inflation

While a deceleration from the vigorous first quarter pace was generally expected, the size of the slowdown surprised to the downside.  Nevertheless, the economy is unlikely to head for a further nose-dive.  In fact, Consensus Forecast panellists see the economy picking up speed in the coming months, expanding 3.2% in the second half of the year and 3.4% for the full year.  The mildly optimistic outlook is supported by consumer confidence, which holds up relatively well in spite of high gas prices and rising interest rates.  In July, the University of Michigan’s consumer sentiment index was 84.7, up from the initial reading of 83.0 but slightly lower than June's final reading of 84.9.  In addition, consumer expectations rose from 72.0 in June to 72.5 in July, the second consecutive increase.  Consumer confidence continues to hinge largely on the development of gasoline prices, which once more pierced the threshold of US$ 3.0 a gallon by the end of July.  However, while consumers no longer view high energy prices as temporary, they are convinced that inflation will revert to lower levels over the longer term, which constitutes a central element of consumers’ newfound resilience, according to the survey.  This view, however, is not supported by the latest data.  In the second quarter, the core price index for personal consumer expenditures, which measures the price of consumer goods and services excluding food and energy, jumped 2.9% annually, well ahead of the first quarter's 2.1% and the fastest rate in nearly a dozen years.  Moreover, the employment cost index, which covers wages, salaries and benefits, increased by 0.9% in the second quarter, which represented the largest increase since the first quarter of 2005.  The data suggests that inflation could continue to spread beyond energy through the rest of the economy, even as economic growth slows.  The diverging developments of the slowing economy on the one hand and accelerating inflation on the other hand, highlight the dilemma of monetary policy makers.  So far, the Federal Reserve has put the emphasis on fighting inflation, raising interest rates for the17th consecutive time since June 2004 to 5.25% on 29 June this year.  While financial markets heralded the economic slump as an indication that the Fed will end the current tightening cycle, policy makers could well opt to hike rates yet another time in the upcoming 8 August meeting. 

Bank of Japan raises interest rates as businesses are increasingly optimistic

Second quarter growth data have not yet been published for Japan.  However, preliminary indicators suggest that, although the 3.1% growth pace registered in the first quarter cannot be fully sustained, the economy will only experience a marginal slowdown in the second quarter.  According to the government’s consumer confidence survey of households with two or more people, the confidence index declined from 48.2 in March to 46.2 in June in seasonally adjusted terms.  Thus, confidence fell even further below the critical 50 level, where pessimists outnumber optimists.  However, the March reading had represented the highest value registered in 15 years and the level observed in June still marks one of the strongest confidence levels observed in the past decade.  In fact, since 1982, the index has been only four times above 50.  Moreover, the consumer confidence survey contrasts a recent business confidence report that showed companies are increasingly confident.  The Central Bank’s so-called Tankan survey showed companies plan to spend 11.6% more this fiscal year, well ahead of market expectations and the fastest pace in the past 16 years.  The confidence index for large manufacturers rose to 21 in June from 20 in March where a positive number means optimists outnumber pessimists.  Consequently, Consensus Forecast panellists remain upbeat that the current recovery will continue and expect the economy to grow 2.9% in the second quarter.  With growth slowing to 2.5% in the second half of the year, the full-year growth forecast stands at 2.6%, which is a notch below last month’s 2.7% forecast.  Moreover, the panel is optimistic that the recovery will continue into next year, with the economy expanding at a more moderate but still positive pace of 2.0%.  The rekindling of the economy is also likely to overcome deflation, which has held a grip of the economy for most of the past decade.  In June, annual core consumer price inflation, which excludes fresh food, remained at May’s 0.6% level, the highest rate in eight years.  As a result of the moderate but sustained price increases, the Central Bank has ended over five years of zero interest rates.  Four months after the announcement to end its ultra-loose monetary policy, the Bank of Japan (BoJ) raised the key overnight call rate target by 25 basis points to 0.25% on 14 July.  While the BoJ indicated that it would continue to raise interest rates gradually in light of economic developments, monetary authorities pledged that they would probably keep rate hikes very low for some time.  Next to political pressures to keep interest rates low, the Bank is likely to act cautiously after its rate hike in August 2000 allegedly contributed to squash an incipient recovery of the economy.  The BoJ expects consumer prices to rise 0.6% this fiscal year, which ends next March, and to increase 0.8% in the coming fiscal year, ending March 2008.  Consensus Forecast panellists mainly share the Central Bank’s assessment and see inflation reaching 0.5% in 2006 and 0.6% in 2007.   

Outlook for Asia improving as better outlook for China compensates for lower forecasts in Japan and India

Asian growth prospects continue to improve.  Following on seven upward revisions during the past eight months, Consensus Forecast panellists beefed up this year’s economic growth forecast for the region including Japan another 0.1 percentage points this month to 5.3%.  This month, upward revisions to economic growth in four of the twelve economies surveyed are mitigated by four downward revisions and unchanged outlooks in the remaining four countries.  Once more, China is the key reason for the more optimistic prospects for the entire region.  Since China accounts for almost one quarter of total regional output, any shift in the economic assessment has a notable impact. Consequently, this month’s 0.3 percentage point upward revision to the 2006 GDP forecast to 9.8% was sufficient to compensate for weaker projections for the other two regional behemoths, Japan and India.  In China, apparently even the recently introduced measures to slow the growth of credit and investment are considered insufficient to slow the underlying momentum of the economy.  In India, a small adjustment just tipped the outlook from 7.7% expected last month to the current 7.6% forecast  Next to China, Hong Kong, Malaysia and Singapore experienced notable upward revisions to their GDP forecast, as the countries benefit from the solid global consumer electronics demand.  Thailand and Vietnam, in contrast, are join Japan and India with weaker forecasts compared to last month.

Latin American outlook remains unchanged

The outlook for Latin American output growth this year remained unchanged over the past month, as upward revisions to three major economies were insufficient to compensate for a downward revision to two countries and unchanged prospects for one country.  As a result, the Consensus Forecast for GDP growth in 2006 for Latin America remained at the 4.4% expected last month, following on last month’s 0.2 percentage point upward revision.  Last year, Latin America expanded 4.0%, continuing a strong recovery initiated in 2004.  Apart from 2004, this year’s expansion would represent the strongest expansion since 1997.  The regional average growth forecast for 2006 remains robust in spite of the ongoing wave of monetary tightening around the globe and concerns that U.S. consumption – one of the key drivers of the export-led expansion - could weaken in the months ahead.  In addition, the geopolitical tensions in the Middle East sustain the oil price at high levels, eroding purchasing power of consumers worldwide and fuelling headline inflation.  So far, the real side of the economy is unlikely to suffer a major setback from tighter monetary policy, as evidenced by the stable outlook for the region.  However, if the tightening continues and reduces excess liquidity that has fuelled the current business cycle, the global economy could experience a slowdown that would also seize Latin America.  This month, Argentina, Brazil and Peru are seen more optimistically.  Argentina, Latin America’s third largest economy, experienced a 0.1 percentage point upward revision to the 2006 GDP forecast.  Consensus Forecast panellists raised their forecast eleven times during the past twelve months, culminating in the current 7.3% forecast, which makes Argentina the fastest growing economy in the region.  The GDP growth forecast for Brazil also inched up a notch this month to 3.6%, as the monetary easing is fuelling domestic demand.  Meanwhile, Peru benefits from a more peaceful political arena following the inauguration of President Alan García.  In contrast, Chile experienced a downward revision this month, following signs that the economy is loosing some of the momentum that has been fuelling the current business cycle.  Nevertheless, with 5.6% output growth expected for this year, Chile remains one of the fastest growing economies in the region.