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Global Developments in the Economic Outlook

Sometimes globalization giveth, but sometimes it taketh away. The dollar's recent depreciation and exceptionally strong economic growth abroad have been a boon to U.S. economic growth, but that may now be changing. Preliminary estimates showed a surprisingly strong, 3.3 percent increase in GDP during the second quarter of 2008, with almost all of this increase attributable to a combined rise in U.S. exports and decline in imports. Real gross domestic purchases - spending less exports - continued to be very weak in the second quarter, so much so that their recent performance resembles that during the 2001 recession. U.S. exports have increased substantially faster than GDP since mid-2003 and have, therefore, been a significant, sustained source of growth. While imports are now a higher percentage of GDP than in 2003, they have flattened out over the past three years. Consequently, our trade deficit has narrowed substantially.

Real Gross Domestic Product and Purchases

Explaining the causal relationship between trade deficits and dollar depreciations is always tricky because other economic events determine both variables. Since at least 2005, however, the passive reluctance of international investors to add dollars to their portfolios seems to have precipitated the dollar's depreciation. Since the end of 2005 through March of this year, the dollar depreciated 14 percent on a real, or inflation-adjusted, basis against a broad array of U.S. trading partners. Such a real depreciation raises the dollar price of foreign goods, lowers foreign-currency prices of U.S. goods, and shifts world demand toward U.S. products.

At roughly the same time as this exchange-rate-induced demand shift started, the world began to exhibit an exceptionally strong streak of economic growth. Between 2004 and 2007, world output expanded at a 4.8 percent average annual rate. While emerging markets, notably China and India, led the way, nearly every nation on earth shared in the expansion. Such rapid, widely shared economic growth seems unprecedented.

Now, however, some of these favorable international factors may be dissipating and signaling slower economic growth ahead. The dollar seems to have stabilized since March and, while it certainly could move lower, the dollar now seems a tad soft on a purchasing-power-parity basis. More importantly, however, global economic activity is likely to slow substantially in the second half of 2008 and return gradually to a more normal growth rate by late 2009. The International Monetary Fund, for example, expects global growth to slow from 5.0 percent in 2007 to 4.1 percent this year and 3.9 percent in 2009. Economic growth among the advanced economies is expected to drop from 2.7 percent in 2007 to only 1.7 percent this year and 1.4 percent in 2009, while economic growth among the emerging and developing economies is expected to slow from 8.0 percent in 2007 to 6.9 percent in 2008 and 6.7 percent in 2009. While many forecasters have recently revised their forecasts for foreign growth down, the IMF, which initially had a pessimistic world outlook, has generally revised them up.

World GDP Growth

2006 2007 2008 2009
World 5.1 5.0 4.1 3.9
Advanced economies 3.0 2.7 1.7 1.4
United States 2.9 2.2 1.3 0.8
Euro area 2.8 2.6 1.7 1.2
Japan 2.4 2.1 1.5 1.5
United Kingdom 2.9 3.1 1.8 1.7
Canada 3.1 2.7 1.0 1.9
Emerging and developing economies 7.9 8.0 6.9 6.7
China 11.6 11.9 9.7 9.8
India 9.8 9.3 8.0 8.0
ASEAN-5 5.7 6.3 5.6 5.9
Western Hemisphere 5.5 5.6 4.5 3.6
Note: GDP growth is measured as year-over-year percent change.
Source: International Monetary Fund, World Economic Outlook Update Jully 2008.

Financial turmoil, stemming from U.S. subprime real estate loans, initiated the global slowdown. Despite some improvements, financial strains remain a serious risk to the economic outlook. As banks continue to improve their balance sheets by writing down debts and raising new capital, they will increase the terms and limit the availability of credit. This will impair economic growth, which will, in turn, feed back into credit quality. Downturns in housing prices and construction seem to be spreading among advanced developed countries with little evidence of bottoming out. Many central banks have tempered their response to the downside risks associated with the financial turmoil for fear of igniting inflation.

The exceptionally strong economic growth between 2004 and 2007, particularly among emerging and developing countries, raised commodity prices in recent years. Although the upward pressures on commodity prices have recently eased as global economic activity has softened, higher commodity prices are unlikely to disappear in the near future. Spare oil capacity and inventories are limited, and expanding production and distribution capacity is costly and time consuming. Although agricultural production may be more responsive to higher prices than the oil supply, growing global demand and higher oil prices will keep pressure on food prices. Higher commodity prices mean consumers have less to spend on other goods and services.

In advanced countries, according to the IMF, core price measures have generally stayed below 2 percent, while upward pressure from oil and other commodity prices have pushed headline price measures substantially higher. Central banks in most developed countries have been reluctant to ease policy in the face of strong price pressures. Emerging and developing countries, however, have been more accommodative. They have allowed commodity-price pressures to exert a bigger effect on core prices, which are now rising around 4 percent year over year, according to the IMF. Inflation could remain a problem in these economies through next year.

Headline Inflation and Oil Prices

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