- The world economy continued to grow robustly in the first half of 2007. With leading indicators moderating only slightly at a time of diminishing spare capacity, central banks remain in tightening mode. Food price inflation suggests faster appreciation of the undervalued Chinese yuan and Indian rupee.
- Indicators available at this writing are consistent with an inventory-led rebound of U.S. GDP growth in Q2. Whether the rebound will carry into the second half of the year is uncertain. The retreat of home prices seems to have made U.S. households more reluctant to draw down the value of their real estate. Consumer spending growth is decelerating.
- The Canadian economy has stood up well to U.S. cooling. Favourable terms of trade, fiscal stimulus, strong consumer spending and a pickup in U.S. growth set the stage for another good performance in Q2. We have raised our forecast for Canadian real GDP growth for both 2007 and 2008.
World: Strong growth, less spare capacity
The world economy continued to grow robustly in the first half of 2007. With leading indicators moderating only slightly at a time of diminishing spare capacity, central banks remain in tightening mode.
The indicators of the last month continue to depict a healthy global economy with above-trend growth in many countries. With the current expansion now long in the tooth, spare capacity is running thin in the industrialized countries. We estimate that only four of the 18 industrialized countries for which the IMF calculates output gaps are currently in a position of excess capacity (the U.S., France, Italy and Portugal). As our top chart shows, this is the best diffusion in seven years and it comes at a time when the leading indicator for OECD economies is turning up.
This picture has prompted a number of central banks to tighten in the past month (England, New Zealand, ECB, Switzerland, South Korea). As a result we estimate that the global policy rate – our weighted average of the main central bank policy rates – is now at a six-year high. Since inflationary pressures remain the key concern of most central banks, there is room for further tightening of short-term rates in the coming months. If current market expectations of rate hikes in Canada, the U.K. and the euro zone are borne out between now and year end, our global policy rate will be at a seven-year high (chart). If this scenario unfolds without acceleration of G-7 core CPI inflation, the real policy rate will exceed 2% for the first time since early in this decade. Global monetary policy may be about to turn slightly restrictive.
In China, 12-month CPI inflation rose to a 27-month high of 3.4% in May. The pressure was concentrated in food (33% of the overall index), whose prices were up 8% from a year earlier. As our bottom chart shows, other prices were surprisingly tame – 12-month core CPI inflation is hovering around 1%. Because of this concentration in food – in meat in particular because of an outbreak that has disrupted the pork industry – we do not see the current situation as requiring drastic action by monetary authorities, at least in the short term.
This said, Chinese dietary patterns have in recent years shifted significantly toward meat, whose percapita consumption has increased 50% in the past decade (chart). The change suggests that food is likely to continue pushing up all-items CPI inflation in the coming months. It will be important to monitor this indicator because a long period of high prices for food – which figures prominently in the CPI baskets of emerging economies – could lead to higher cost-push inflation in countries such as China and India. We still think the real near-term significance of rising food inflation is not for interest rates in those countries but for their currencies. Faster appreciation of the undervalued yuan and rupee would improve Chinese and Indian terms of trade by reducing import prices, offsetting part of the rise in their CPIs.
