Forecasts and risks

Under our central forecast (scenario 1), the global economy will grow by 5.1% in 2007 (calculated using purchasing power parity exchange rates) and by 4.8% in 2008. If our main risk scenario (scenario 2) comes to pass, world GDP growth will slow to 4.8% in 2007 and 3.7% in 2008.

The growth rate next year would still surpass the 2.4% and
2.9% rates in 2001 and 2002 respectively, and would still be above the threshold that most economists set for a global recession (around 3%).
Why is this only a risk and not our central forecast? We believe central banks have learned important lessons from past asset price bubbles, and will not hesitate to pump funds into the economy to cushion a slowdown in growth. In our main risk scenario, we expect the Federal Reserve to look past inflationary pressures (which would evaporate quickly in a slowdown) and cut its benchmark lending rate from 5.25% to 3.75% by the end of 2008.

The European Central Bank will also cut its reference rate, and the Bank of Japan will slow the pace at which it raises rates (from an extremely low level).

At the same time, our main risk scenario is by no means the worst case. There is a possibility that monetary policy stimulus may have less traction than it did during previous downturns (possibly because of financial innovation itself).

There is also a risk that central banks will withhold interest rate cuts for fear of creating a “moral hazard” that would encourage another round of overinvestment and another asset bubble.

Many policymakers, including the IMF, play down the risk of a severe global slowdown, emphasising the economy’s “strong fundamentals.” This is true only in the narrow sense that global growth has been very strong in recent years. But the global expansion stands on a fragile base, driven by unsustainable consumer demand in the US. Many commentators, including the Economist Intelligence Unit, believe that the repricing of risk is a good thing because it will put the global economy on a sounder footing. But this is true only in the longer term. For the next 12 to 18 months, a significant reassessment of risk could lead to huge capital flows into and out of economies, volatile currency swings, big fluctuations in stock and bond prices, and rising alarm among investors. This is a recipe for slower growth in much of the world, and brings the risk of a recession that much closer.