Global Soft Patch Not a Recession at Year End

I. GLOBAL ASSESSMENT AND OUTLOOK A slowing in global economic activity is underway, driven by a high degree of uncertainty in the global political environment and a worldwide tightening of monetary policies. There are several areas where geopolitical concerns remain unusually high and cloud the global business outlook. The conflict in Iraq has not produced calm in the country, which was expected to bring substantial additions to oil supplies and intensify trade from reconstruction activities. Terrorism has expanded to several areas in a synchronized pattern, even reaching India's fast growing economy. The latest turmoil in the Middle East has substantially increased political instability, which adds to global uncertainty in the energy and financial markets and, consequently, contributes to a higher risk premium on prices. Increased geopolitical uncertainties result in higher oil prices and falling worldwide stock prices, which are expected to lead to a softening in business investment and moderation in consumer spending. For any $10 per barrel increase in the price of oil, the next-year effect for the global economy is a 0.3-percent point reduction in output growth, followed by a 0.4-percent point reduction in the third year. More important for monetary policy, fast increasing energy costs have begun to contribute to accelerated overall inflation rates, which build up inflationary expectations. In addition, elevated commodity prices and a tightening in labor markets in the industrial countries have pushed core inflation higher. The second contributing factor to the current global slowdown is the impact of rising interest rates as central banks are fighting inflationary expectations. The Federal Reserve has led the current cycle of interest rate hikes by raising the federal funds rate 17 consecutive times from 1 percent in the summer of 2004 to 5.25 percent in the summer of 2006. The Federal Reserve also made clear that although the economy is moderating, the focus is on core inflation, which has accelerated. At the end of July, the Federal Reserve's beige book report-based on business surveys from around the country-found that economic growth slowed while price pressures for the most part remained in check. We do not expect U.S. interest rates to be raised again as the economy is forecast to temporarily stall in the fourth quarter. We do not forecast the U.S. economy to tip to a full-fledged recession; rather, we project a fourth quarter mini-hard landing with full recovery in 2007. For the whole year of 2006, U.S. economic growth will average 2.8 percent. The United States has been the engine of growth in the global economy over the past several years. The booms and busts of global economic activity have started in the United States and then spread to the rest of the world. Historical analysis of worldwide economic fluctuations suggests that the United States, which accounts for one-third of the world's output, generally leads other industrial economies in the global business cycle. In addition, research indicates that the economic and financial performance of the U.S. economy has a very significant influence on growth in emerging economies via trade and interest rates. In the Euro Area, growth is estimated to have accelerated beyond its 2-percent trend rate, driven by exports and private investment. We expect growth to stay slightly above trend throughout 2006 and settle back to slightly below trend in 2007. This is due to the lagged impact of interest rate hikes by the European Central Bank, which follow with a year lag the Federal Reserve as well as the German increase in Value Added Tax (VAT), which is scheduled to begin in January 2007. Despite the central bank's lifting of the five-year-old policy of zero interest rates in July, Japanese economic growth will accelerate to 3 percent in 2006 and to 2.5 percent in 2007. The Bank of Japan probably will continue its gradual monetary policy tightening by raising the interest rate 0. …