Economic activity has become somewhat weaker than we had projected in the United States and somewhat stronger in the euro area and Japan. While rising oil prices have exerted upward pressure on headline inflation, core inflation in OECD countries has been stable. Until now, there have been no visible “knock-on” effects in the form of higher wage claims , not least because inflation expectations remain well anchored, in a context where central bank commitments to price stability are rightly seen as robust and credible. As a result, the negative impact of oil market turbulence has been limited to date.
With policy stimulus beginning to fade, US expansion increasingly hinges on employment creation and business investment. Household confidence has been affected by the slow pace of job creation recorded so far, but remains around its long-run historical average, and this bodes well for resilience in consumption. Firms are much more upbeat than consumers. They have taken advantage of the prolonged spell of historically low interest rates to strengthen their balance sheets and enjoy ample profits. This should allow for robust business spending and greater hiring.
In the euro area as well, businesses are in a somewhat better mood than households. Real GDP, which was surprisingly strong earlier in 2004, is expanding at around its potential rate, albeit still over-reliant on external demand. Moreover, compared with the US, economic activity in Europe remains slack.. Meanwhile, stark differences persist within the euro area, with domestic demand buoyant in France, but still lackluster in Germany. Italy lags behind, due to both competitiveness problems and weak domestic demand.
The resilience so far shown by OECD economies in an environment of geopolitical uncertainties and turbulence in oil and commodity markets suggests that, looking further ahead, growth should remain solid. Nonetheless, further increases in oil prices or a sharper, more prolonged slowdown in China than currently forecast could pose a risk to this outlook.
Growth in Japan and China has slowed from the very rapid pace of early 2004, but in both cases sustained expansion remains the most likely scenario. In Japan, domestic demand growth continues to rely heavily on business fixed investment, against the backdrop of strong profits. Firms are hiring, but overwhelmingly in the form of non-permanent contracts and in a context where wages are not yet recovering. Household confidence is improving, but needs to strengthen further. Japan is nonetheless finally in a position to lift itself out of its deflation trap, provided macroeconomic policy stays the course and structural reforms, including in the financial sector, are pursued.
Against the background of a continuing recovery, several central banks, including the US Federal Reserve, have started to rein in the exceptionally vigorous stimulus they had injected to foster the recovery. With the global recovery spreading more widely, monetary tightening should be progressively extended to other parts of the OECD. However, the pace of tightening will depend on the speed with which spare capacity is shrinking and the extent to which core inflation remains under control. Under the present circumstances of weak domestic demand in the euro area and mild deflation in Japan, the current “wait and see” stance of their monetary policies seems warranted.
Fiscal consolidation should begin in earnest though, not just to avoid pro-cyclical impulses as business slack is worked off, but also to deal with the mounting pressures faced by all OECD countries as their populations age, in combination with further reforms of pension and health systems. At this point, governments have much to do. Deeds speak louder than good intentions, and permanent adjustment measures are now called for to restore overall sustainability to public finances.
This article is based on a Please press briefing given by Mr Cotis at the OECD in Paris on 21 September, 2004.
©OECD Observer No 244, September 2004