June 09, 2008	Monday	Jamadi-us-Sani 04, 1429

M.Ziauddin

According to the OECD’s latest Economic Outlook report, GDP growth in the UK slowed gradually from an above-trend pace throughout 2007 to an annualised rate of 1.5 per cent in the first quarter of 2008.

A further slowing is expected over coming quarters, as both investment and consumer demand are damped by tight credit conditions and housing market weakness. Consumer price inflation has accelerated in recent months and is expected to rise further to above 3.5 per cent later this year before falling back to close to the inflation target during 2009.

Given the extent to which inflation is expected to exceed the target, the Bank of England should leave policy interest rates on hold in the short-term, in order to ensure that high inflation expectations do not become embedded.

However, some further easing in policy rates is likely to be required further ahead, to avoid a significant undershooting of the target in the medium-term as the economy slows. The slowing economy is also likely to limit tax revenues, and the government deficit now seems likely to move significantly above three per cent of GDP, putting the fiscal rules at risk.

Overall, OECD economies, the Outlook said, have been hit by strong gales over the recent past and it will take time and well-judged policies to get back on course. Nonetheless, because of the effects of past structural reform and well-honed macro-policy frameworks, the effects of this near-perfect storm, it said, have not been worse. This, it added, underlines the need to persevere with such policies.

The Report predicted several quarters of weak growth ahead for most OECD economies. At the same time, headline inflation is expected to remain high for some time to come. This scenario is said to be the combined outcome of financial market turmoil, cooling housing markets and sharply higher commodity prices.

The projections in the Outlook carry both upside and down side risks and embody the following main features:

* US activity is predicted to be essentially flat through 2008 and then it is expected to pick up thereafter as housing adjustment ends, credit conditions normalise and the effects of past monetary ease are felt. With substantial capacity slack and under the assumption of unchanged commodity prices, inflation is expected to moderate significantly. Robust export growth, on the back of recent dollar depreciation, would help to narrow the external deficit to around 4.5 per cent of GDP next year.

* Euro area activity is expected to be restrained through the current year by tighter credit, squeezed real incomes, lower export market growth and market share losses. Growth is likely to recover gradually as these factors fade, though falling housing investment is expected to remain a drag throughout. Despite currency appreciation, inflationary pressures are likely to remain strong and, with capacity use moving just slightly below its normal level, it is only towards the end of the projection period that inflation would revert to two per cent.

* Japan has been less directly affected by financial turmoil but growth is expected to be held back in the near term by slower export growth, weak household incomes and some hesitancy on the part of firms to invest. As growth regains momentum, inflation also gradually moves up to reach a rate around half per cent.

“The current economic situation is particularly unsettled and the distribution of risk around the projections is wide. In this environment, economic policy in OECD countries, needs to take into account the growing importance of developments in non-OECD economies; the influences of higher energy and credit costs on the supply side of OECD economies; the possibility of upward drift in inflation expectations; and the uncertainty as to the effects of financial market developments on growth and inflation, “the Outlook cautioned.

The Outlook said globalisation was an important driver of the economic cycle on the way up as non-OECD economies exported both cheap manufactured products and surplus saving, helping to keep OECD interest rates low and thereby boosting asset demand and prices. Currently, robust non-OECD growth is considered an important factor behind high commodity prices. And, going forward, continued rapid import growth in non-OECD countries will help to cushion activity in the OECD area. At the same time, buoyant non-OECD demand is said to be leading to inflationary pressure in these countries and sustains tensions in commodity markets.

Macroeconomic policy setting, and in particular monetary policy, in OECD countries is said to need to take into account that non-OECD countries are likely to be an important source of demand at the same time as they are likely to be a less important source of disinflation than previously.

Macroeconomic policy, the Report said is also faced with a more hazy picture of OECD economies’ supply capacity than previously. Both globalisation and structural reform have boosted potential growth rates in the past and will hopefully continue to do so.

But sharply higher energy prices and higher costs of capital as a result of financial market developments could sap potential growth. The chapter on supply side uncertainties in the Outlook provides some illustrative calculations of these effects. While such quantifications are inherently uncertain, macroeconomic policy, it is said, needs to be alert to the possibility that capacity limits could be tighter than posited.

Financial market influences on growth remain hard to gauge. The odds have improved that financial market dislocation has passed its peak, but this is far from a foregone conclusion. And even if true, the effects on growth are likely to linger. Uncertainty is compounded by the likely feed-back from a weaker growth environment on financial markets and by the fact that problems at financial institutions can be resolved in different ways. In this regard, it is desirable, according to the Outlook, for capital deficiency to be addressed through the injection of new capital and asset disposal rather than through credit compression.

The Outlook advises avoidance of regulatory overkill. Many recent innovations in financial markets have the capacity to improve welfare, when appropriately harnessed. It also needs to be considered whether and how the tendency for financial markets to generate cycles can best be addressed. This may involve both regulatory initiatives to attempt to damp inherent cyclicality as well as a reconsideration of monetary policy conduct.

Dynamic provisioning and reserve requirements are some of the instruments that may help smooth credit cycles and increase resilience of the financial sector but they are not without drawbacks.