Soft Landing to Long-Term Trend

I. GLOBAL ASSESSMENT AND OUTLOOK Led by the United States and China, the world economy enters its sixth year of expansion in the global business cycle. The latest evidence from quarterly national accounts and forward-looking economic data suggests that global economic growth is broad based, above trend, and sustainable. On a year-to-year basis, in the first quarter of 2006 the U.S. economy expanded at an annual growth rate of 3.5 percent and China's economic growth soared by 10.2 percent. Leading indicators of the global business cycle compiled in 35 countries are signaling even stronger growth in the second quarter of 2006. Despite the largest sustained increase in oil prices since the oil shocks of the midand late 1970s, both of which were followed by global recessions, world economic and financial conditions remain generally good supporting the continuation of the global economic expansion at a satisfactory pace during 2006-07. The strength of economic activity is particularly impressive in emerging economies with an increasing number of them reaping the benefits of globalization and higher commodity prices. We have slightly revised our baseline forecast scenario upwards on growth and inflation for the world economy in both 2006 and 2007. Worldwide output is now expected to increase 3.6 percent this year and 3.4 percent next year, revised from our growth forecasts last March (2006) of 3.4 percent and 3.3 percent, respectively. In 2007, the world economy would enter a soft landing path towards its long-term trend. The central forecast projects growth in the United States and Japan to outpace the Euro Area, which is growing well below its potential because of structural rigidities and the appreciation of the euro. Output growth in the Emerging Asia countries-led by China and India-will be two times higher than the combined output growth rate of the industrial countries in Europe and North America (see Figure 1). Inflation forecasts are the result of interplay between cost-push and demandpull pressures. We expect to see a moderate acceleration in global inflation as we contemplate these two factors. Cost-push pressures from the labor market and energy prices will continue to place an upward pressure on inflation. However, growth in wages is partially suppressed by gains in labor productivity; technological advances that improve efficiency and promote alternative resources would contain higher energy costs. Like in 2005, demand-pull inflation is expected to remain the principal dynamic on the inflation front during 2006-07. Excess demand in the world economy during 2005 was the contributor of the acceleration in worldwide inflation to 2.9 percent from 2.6 percent in 2004. We forecast inflation to further accelerate to 3.1 this year and then plateau in 2007, amid an expected slowdown in economic growth towards its trend rate. In 2006, inflation rates are forecast to slightly increase in NAFTA to 3.4 percent from 3.3 percent last year, to accelerate in emerging Asia to 3.5 percent from 3 percent in 2005, stay the same in the Euro Area at 2.2 percent, and decline in South America to 6.5 percent from 7.3 percent in 2005. According to the quantitative findings of the latest survey of the Ifo Institute (a leading European research institute) of 1100 business executives from around the world, conducted in the second quarter of this year, the worldwide average inflation rate for 2006 is expected to register 3.1 percent. In comparison to the findings of the previous quarter's survey, inflation expectations remain unchanged in Western Europe and Asia, at an average rate of 2.1 percent and 2.8 percent respectively. Inflation expectations for the United States during 2006 increased slightly in the latest survey to 3 percent from 2.9 percent in the previous survey. The continuation of growth in the United States, the transformation of China and India into economic powers, the long-awaited revival of the Japanese economy, and the rapid accumulation of purchasing power in the oil-producing countries will maintain growth in international trade at high levels. …