“World economic growth has been broadening over the past few months,” the Organization for Economic Cooperation and Development (OECD) approvingly reported last week in its semiannual economic outlook. Citing a “powerful impetus” from Asian and U.S. economies, and noting that “global growth has been exceptionally vigorous,” the OECD said that “the case for a prolonged world expansion, finally extending to convalescent European economies, looks plausible” — though by no means certain or perhaps even likely.
Indeed, the Paris-based group of 30 market-based industrialized democracies pointedly warned that “[w]orsening fiscal and current-account imbalances present policymakers with clear challenges” that would “require substantial policy adjustments” if those challenges are to be addressed successfully. Especially worrisome is the fact that those policy adjustments do not appear likely to be undertaken in the near term.
On the monetary-policy front, the OECD report recommended that the Federal Reserve continue raising short-term interest rates in the United States. Since June 2004, when the Fed’s target short-term rate stood at an historically low 1 percent, the U.S. central bank has raised it 12 times by a quarter-point, lifting it to today’s 4 percent. By the OECD’s reckoning, another three-quarters of a point would be in order. Given the current status of energy-induced inflationary pressures and the absolute necessity of keeping long-term inflation expectations “well anchored,” that seems about right. Raising short-term interest rates by a quarter of a percentage point at each of the next three Fed meetings would have an added benefit: It would allow Ben Bernanke, who will almost certainly replace Alan Greenspan as Fed chairman at the end of January, to establish — at least symbolically — his anti-inflation credentials at the Fed’s March 28 confab, when the third-quarter point increase would be implemented.
The OECD rightly recommended against tightening monetary policy in the euro area, arguing that “underlying inflation has been steadily declining and economic slack remains entrenched.” Unfortunately, the European Central Bank (ECB) ill-advisedly raised its target short-term interest rate two days later. Economic growth in the euro area — 0.8 percent in 2003, 1.8 percent in 2004 and a projected 1.4 percent for 2005 — has consistently failed to meet very modest projections in recent years. Tightening monetary policy at this stage in the business cycle threatens to choke the eurozone’s nascent recovery (projected growth is 2.1 percent next year), which, by U.S. and Asian standards, is quite tepid.
Even before the ECB’s ill-timed rate increase, the OECD legitimately warned that “substantial” risks surrounded its otherwise-upbeat forecast. These risks included a “renewed surge in oil prices, ever-worsening current-account imbalances and abrupt exchange-rate realignments, as well as long-term interest-rate [increases] and asset-price reversals.” Unfortunately, there seem to be no conceivable policy actions on the horizon that would prevent either the U.S. current-account deficit from exceeding an astonishing 7 percent of GDP by 2007 or the Chinese and Japanese current-account surpluses from becoming “extremely large.” The OECD rightly criticizes American policy-makers for tolerating such huge budget deficits at this stage of the U.S. economic expansion and for the growing domestic imbalance between personal saving and business investment. Asian leaders were deservedly chastised for pursuing ” ‘mercantilist’ exchange-rate management geared toward market-share maximization.”
Asserting that “strong and sustained world growth should not be taken for granted,” the OECD once again warned that the unsound policy configurations being pursued in both America and Asia “increas[e] the probability of a disorderly unwinding of current-account imbalances, coupled with an evaporating appetite for dollar-denominated assets.” The latter development would be especially scary. Regarding the consequences for America of “a disorderly unwinding,” well, they include an unacceptably high jump in long-term interest rates and potentially plunging U.S. asset prices (including U.S. house values), to say nothing of a weakening global economy.