Latin America in a Global Context - Economic Briefing September 2006

Weaker Growth in United States and Japan Overshadow Global Outlook

The outlook for the global economy remains positive for this year but is showing signs of a slowdown in 2007. While oil prices have declined amid abating tensions in the Middle East, they remain well above last year’s level, indicating a more permanent increase in the price level than anticipated earlier. The U.S. economy is slowing, following on a strong but temporary rebound earlier this year. Moreover, the trend in consumer confidence continues to point downwards and high energy prices as well as the tighter monetary setting could weaken consumption in the months ahead. The Japanese economy also slowed notably but consumer confidence is remaining close to historic highs, which suggests that the domestic economy will fuel the recovery in the months ahead. In addition, the Euro Area is recovering. However, a tighter monetary policy and the potentially weaker U.S. consumption could dent the potential for stronger growth in the Euro Area. Finally, prospects for Latin America remain solid, as the resilient growth in China promises to support demand for key commodities.

U.S. economy slumps in second quarter

According to preliminary estimates released on 30 August, gross domestic product (GDP) increased at an annual rate of 2.9% in the second quarter.  Second quarter growth came in ahead of the 2.5% reported on 28 July but 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 2.6% 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 paltry 0.5% growth 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 in equipment and software dropped 1.6% over the same period last year, the first decline registered in more than three years. 

Fed pauses tightening as it is walking 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.  However, the latest consumer confidence data suggest that consumption could weaken further.  In August, the University of Michigan’s preliminary reading of the consumer sentiment index was 78.7, well below July's final reading of 84.7.  In addition, consumer expectations dropped from 72.5 in July to 64.5 in August.  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 17 consecutive times since June 2004 until June this year.  However, at the 8 August meeting the Federal Open Market Committee (FOMC) voted to keep the benchmark federal funds rate unchanged at 5.25%.  The FOMC said economic growth has moderated, reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.  Furthermore, the Fed stated that even though inflation readings have been elevated in recent months, price pressures seem likely to moderate over time.  However, the Committee judged that some inflation risks remain and claimed that additional firming may be needed to address these inflation risks.  Consequently, policy makers could well opt to hike rates yet another time in the upcoming 20 September meeting.

Japan's economy slows in second quarter but remains poised for ongoing recovery as businesses are increasingly optimistic

In the second quarter, gross domestic product expanded 0.2% over the previous quarter and 0.8% over the same period the year before in seasonally adjusted terms, according to first preliminary national accounts data.  The reading was well below the 2.7% annual growth reported for the first quarter, which was revised downwards from the 3.1% growth reported previously.  Moreover, the second quarter reading fell short of market expectations, which saw the economy growing by 1.9% just prior to the release.  However, preliminary indicators suggest that the economy will again pick up speed in the current 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 2.6% this year, 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 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 Asian growth remains unchanged

Asian growth prospects remain solid but did not improve over last month.  Following on seven upward revisions during the past eight months to regional output growth projected for 2006, the forecast remained at 5.3% for the region including Japan.  The halt in the series of upward revisions reflects the slump in second quarter growth in the United States and a more cautious assessment of the recovery in Japan in the wake of the subdued development of the economy in the second quarter.  In fact, the outlook for Asia ex Japan improved by 0.1 percentage points over last month to 7.6%.  Once more, China is the key reason for the more optimistic prospects for the entire region.  Since China accounts for 44.1% of total regional output ex Japan, any shift in the economic assessment has a notable impact.  In 2006, China’s economy will grow 9.6% according to this month’s Consensus, 0.1percentage point better than expected last month and the twelfth consecutive monthly improvement.  Apparently, even the recently second step in monetary tightening and the government measures to slow the growth of credit and investment are not considered sufficient to slow the underlying momentum of the Chinese economy.  Next to China, Indonesia and Singapore experienced notable upward revisions to their GDP forecast.  In contrast, Consensus Forecast panellists have cut the outlook for Taiwan and Thailand by 0.1 percentage points respectively.

Latin American outlook remains unchanged

The outlook for Latin American output growth this year remained unchanged over the past month, as upward revisions to four 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, the second consecutive month of unchanged forecasts for the region.  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. 

Slower U.S. growth and tighter monetary policy could dent outlook

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 remainder of the year.  However, on a positive note, the geopolitical tensions in the Middle East have meanwhile subsided and the oil price is declining, freeing some purchasing power of consumers worldwide.  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. 

Downward revisions to Brazil and Chile contrast brighter outlook in Argentina, Mexico, Peru and Venezuela

This month, Argentina, Mexico, Peru and Venezuela are seen more optimistically.  Argentina 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 7.4% forecast, which makes Argentina the fastest growing economy in the region.  Mexico, Latin America’s second largest economy, also experienced a 0.1 percentage point upward revision to the 2006 GDP forecast.  Consensus Forecast panellists continuously raised their forecast since April to the current 4.1% forecast, as the country’s manufacturing sector has profited from accelerating U.S. demand.  However, the Mexican economy is likely to loose dynamism in the months ahead amid the anticipated slowdown in the United States.  Peru profits from strong commodity prices and reduced political uncertainty, as the incoming García administration shows little inclination to fundamentally change the course of economic policy.  As a result, Consensus Forecast panellists lifted last month’s 2006 growth projection by 0.2 percentage points to 5.7%.  Finally, Venezuela continues to benefit from the high oil price that remains well above last year’s level.  On the downside, panelists pared their outlook for Brazil and Chile by 0.1 percentage points respectively.  In Brazil, second quarter growth data came in well below expectations, which triggered a 0.1 percentage point downward revision to the current 3.5%.  Chile also experienced a 0.1 percentage point 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 5.4% output growth expected for this year, Chile will experience yet another year of solid growth.