The NIME Economic Outlook for the World Economy

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1 The NIME Economic Outlook for the World Economy A Medium-Term Outlook for the World Economy 5 - Focus Monetary Policy, Asset Prices and Economic Growth August 5 Federal Planning Bureau Economic analyses and forecasts

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3 The NIME Economic Outlook for the World Economy Editors: Eric Meyermans Patrick Van Brusselen Advisor: Igor Lebrun DTP & Web Publishing: Adinda De Saeger Geert Bryon Dominique van der Wal... A Medium-Term Outlook for the World Economy: 5- This NIME Economic Outlook for the World Economy presents a 5- macroeconomic outlook for the major areas of the world. The outlook was produced using NIME, the Belgian Federal Planning Bureau s macroeconometric world model. This issue also features an assessment of the response of the us and euro area monetary policy to the asset price developments of the last ten years. The major technical assumptions of this outlook as well as a description of the NIME model are presented in the appendix. The euro area economy is expected to grow by no more than.5 per cent in 5, as growth in domestic demand weakens in the face of rising oil prices and net exports contribute. percentage-point to the area s overall growth following the depreciation of the euro. Consumer price inflation should come out at per cent in 5, despite the reduction in total domestic demand growth. In 6, real GDP in the euro area registers a. per cent increase, while consumer price inflation drops to.5 per cent. The higher growth in 6 is largely based on a rebound in employment, which boosts growth in private consumption and business sector investment. The area s net exports make a. percentage-point contribution to GDP growth in 6. Over the remaining 7- period, the area s net exports fail to make any significant contribution to overall GDP growth, which rises on average by.9 per cent per annum. Consumer price inflation averages.8 per cent over 7-, but edges up towards the end of the period. The short-term interest rates are raised gradually from. per cent in 5 to. per cent in. Assuming no further policy slippages, the area s public sector net borrowing requirement is expected to fall from.5 per cent of GDP in 5 to. per cent of GDP in. Over the 5- period, GDP growth averages.9 per cent per annum for the group of countries comprising the United Kingdom, Sweden and Denmark and.6 per cent for the New EU Member States. The US economy expands at an annual average rate of.9 per cent over the period, while prices rise at an average rate of per cent per annum and fiscal and external imbalances persist. GDP growth in Japan comes out on average at. per cent per annum and the Japanese economy is expected to move out of deflation in 6. This issue also assesses whether the economies of the United States and the euro area would have experienced a more balanced growth path over the 995- period, had the monetary authorities of these areas not only targeted contemporaneous consumer price inflation but also changes in asset prices. The simulation results present evidence that such a broader-based interest rate rule would have pushed the euro area s GDP above its historical level by about. per cent by the end of the 995- period and would have reduced US GDP by about.6 per cent by the end of the same period.... The Federal Planning Bureau (FPB) is a public agency under the authority of the Prime Minister and the Minister of Economic Affairs. The FPB has a legal status that gives it an autonomy and intellectual independence within the Belgian Federal public sector. Comments and questions regarding this publication should be addressed to the editors by sending an to

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5 Table of Contents... Executive Summary... The 5- NIME World Economic Outlook... The Euro Area The Western Non-Euro EU Member States The New EU Member States The United States Japan The Rest of the World Risks and uncertainties surrounding the NIME World Economic Outlook Detailed World Area Tables... Focus on Monetary Policy, Asset Prices and Economic Growth... 7 Technical Assumptions... The NIME Model... NIME Studies and Publications...

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7 Foreword For many years now, the Belgian Federal Planning Bureau has developed an expertise in preparing short-term forecasts and medium-term macroeconomic projections for the Belgian economy. All the while, the very open nature of the Belgian economy has put the constant monitoring and analysis of developments in the world economy at the heart of the Bureau s concerns. The wish to improve our understanding of the sometimes intricate functioning of the international economy and of its impact on small open economies such as Belgium has led the Federal Planning Bureau to develop the NIME model, a global macroeconometric model. NIME is now used to carry out both policy-oriented economic analyses and medium-term projections for the world economy. It is with great pleasure that I present to you the first issue of The NIME Economic Outlook for the World Economy. This publication, which is scheduled to come out in January and August of each year, will provide its readers with a timely and concise insight into the medium-term prospects for the world economy. This first issue of our new publication presents an outlook for the 5- period. It also contains a special Focus, providing an analysis of recent interactions between monetary policy, asset prices and economic growth in the United States and the euro area. Henri J. Bogaert Commissioner of the Belgian Federal Planning Bureau

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9 Executive Summary Executive Summary of the 5- NIME World Economic Outlook Introduction This document is the first issue of a new publication by the Belgian Federal Planning Bureau (FPB) entitled The NIME Economic Outlook for the World Economy (NEO). The NEO presents a medium-term macroeconomic outlook for the major economic areas of the world. This issue also features an assessment of the responses of the US and euro area monetary authorities to the asset price developments over the last ten years. The NEO concludes with an appendix outlining the main assumptions of the outlook and a brief description of the NIME macroeconometric world model. The economic outlook in this document was prepared using the Belgian Federal Planning Bureau s NIME model and builds on the Spring 5 Economic Forecasts of the European Commission (EC). Indeed, the NIME model is basically medium-term-oriented and is thus calibrated to replicate the business cycle data for 5. However, as explained in the technical appendix of this world economic outlook, the Commission s Spring data for 5 have been revised to take into account more recent growth forecasts for 5, as well as recent developments in financial markets. As of 6 and up to, the NIME model then goes on to provide a coherent model-based outlook for the major economic areas of the world. The publication of this NEO falls well within the FPB s long tradition of using macroeconometric models to study both the Belgian economy and the Belgian international economic environment. Indeed, alongside the MODTRIM and HERMES models, which are used regularly to carry out detailed analyses, forecasts and projections of the Belgian economy, the FPB has also made use of macroeconometric multi-country models, such as NEMESIS and NIME. These models have contributed to broaden the FPB s understanding of international economic linkages and allowed it to assess the risks pertaining to the underlying international economic environments of the FPB s national forecasts and projections. With this new publication, the FPB now aims to share its work and findings with the international community of policy makers and academics.. Readers who wish to receive regular notification of new NIME-related documents are invited to contact the editors by sending an to Finally, the reader should be aware that this NIME Economic Outlook does not necessarily constitute the reference scenario for other work carried out within the FPB. A case in point are the Bureau s short-term forecasts and medium-term projections for the Belgian economy, for which the underlying international economic scenarios are traditionally based on a variety of sources. Summary of the 5- Economic Outlook In, global economic growth turned out to be particularly strong, while inflation remained low across the major economic areas of the world. For the 5- period, overall gross domestic product (GDP) growth is projected to remain robust though increasingly unbalanced, mainly due to persistent external deficits in the United States and emerging Europe. The outlook also indicates that, by the end of the projection period, demographic pressures should begin to weigh on the overall growth performance of Japan and, to a lesser extent, of the euro area. In the euro area, real GDP grew by per cent in, rebounding after three years of tepid growth. In 5, GDP growth is expected to come out at no more than.5 per cent, as growth in domestic demand weakens and net exports contribute. percentage-point to the area s overall growth in the wake of a weakening euro. Without the positive effect of the weakening euro on the area s net exports, GDP growth would have come out about. percentage-point below the forecast. Inflation should remain stuck at the European Central Bank s per cent ceiling, despite a persistent negative output gap. In 6, euro area GDP registers a. per cent rebound, while consumer price inflation drops to.5 per cent. The higher growth is largely based on a rebound in employment, which boosts growth in private consumption and business sector investment. The area s net exports make a. percentage-point contribution to GDP growth in 6. Over the 7- period, the area s net exports fail to make any significant contribution to overall GDP growth, which rises on average by.9 per cent per annum, notwithstanding the declining growth rate of working-age population. Consumer price inflation averages.8 per cent over 7-, but edges up at the end of the period. Short-term interest rates are raised from. per cent in 5 to. per cent in, in order to contain inflation. The euro s nominal EXECUTIVE SUMMARY

10 EXECUTIVE SUMMARY effective exchange rate appreciates on average by. per cent, chiefly because inflation in the rest of the world remains stronger than in the euro area. The current account surplus barely moves over the projection period, coming out at.7 per cent of GDP in 5 and.8 per cent of GDP in, as the area s real effective exchange rate remains almost unchanged and growth in the other major areas of the world proves to be somewhat more resilient than in the euro area. Assuming no further policy slippages, the area s public sector net borrowing requirement is expected to fall from.5 per cent of GDP in 5 to. per cent of GDP in. Real GDP growth of the Western non-euro EU Member States rose by.8 per cent in and should not exceed per cent in 5. Despite its recent weakening, domestic demand is expected to remain the main engine of growth in 5, while net exports should reduce growth prospects by a more limited. percentage-point, compared with a.8 percentage-point negative contribution in. Over the 6- period, the area s real GDP growth averages.9 per cent per annum, with domestic demand contributing almost all of the economic stimulus. Inflation remains subdued over the entire projection period, with consumer price inflation levelling off at about.9 per cent as of 7, allowing interest rates to be kept around.5 per cent throughout most of the projection period. Real GDP of the New EU Member States is expected to grow by. per cent in 5, just a notch below the area s growth performance of the year before. This vigorous growth is solely supported by sturdy growth in domestic demand, especially in investment, while the area s net exports weaken significantly in 5. Over the 6- period, real GDP growth in the area averages.6 per cent per annum. The area s real effective exchange rate is expected to depreciate on average by.8 per cent per annum. However, this real depreciation proves insufficient to curb the area s widening consolidated current account deficit, which reaches. per cent of GDP in. In the United States, real GDP is expected to rise by.8 per cent in 5, after recording a strong.5 per cent increase in. This lower growth primarily reflects a.9 percentage-point slowdown in domestic demand growth, while the negative. Western non-euro EU Member States comprises Denmark, Sweden and the United Kingdom.. New EU Member States comprises Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia, plus Bulgaria and Romania. contribution of net exports to overall GDP growth declines from.8 percentage-point in to.6 percentage-point in 5. Short-term interest rates are raised from.6 per cent in to. per cent in 5, as inflationary pressures intensify. In 6, US real GDP growth is projected to decline further to. per cent, as the short-term interest rates are raised by an additional.9 percentage-point. Under current US laws and policies, a number of significant tax cut provisions are set to expire as of 7. This leads GDP growth to slip to just. per cent in 7, as private consumption stumbles. GDP growth then rebounds, coming out just above per cent up to, but then declining to per cent in as taxes are raised sharply once again. Inflation remains slightly below per cent per annum throughout most of the projection period. Furthermore, in the absence of any major exchange rate realignment, the contribution of net exports to GDP growth remains generally negative over the projection period and the current account deficit widens to 6.6 per cent of GDP in. Notwithstanding the gradual expiration of tax cut provisions, the US fiscal deficit shrinks only slowly, from.9 per cent of GDP in 5 to. per cent in, as fiscal adjustment is hindered by a rise in public outlays on unemployment benefits and debt interest payments. Japanese real GDP is expected to rise by. per cent in 5, after having posted a strong.7 per cent increase in. This lower output growth is caused by a strong deceleration in domestic demand, as well as a noteworthy deterioration of net exports. In 6, real GDP growth is expected to remain weak, but consumer price deflation comes to an end with the deflator of private consumption increasing by. per cent on the year. Over the 7- period, Japan s GDP grows on average by. per cent per year. During this period, economic growth is driven by private consumption and investment in residential buildings, while the positive contribution of net exports declines due to a gradual loss of competitiveness. The declining competitiveness is linked to the re-emergence of inflation in 6 and a strengthening of the country s nominal exchange rate in the wake of rising interest rates. Long-term interest rates rise from. per cent in 5 to. per cent in. The deflator of private consumption increases on average by. per cent per annum. Japanese government fiscal imbalances persist over the horizon of this outlook, as no further corrective measures are assumed to be taken.

11 Summary World Area Table - Main results Average 5- I. Euro area. Gross domestic product GDP deflator Unemployment rate (level, % of civilian labour force) Long-term interest rate (level) Nominal effective exchange rate (+: depreciation) Government net lending (level, % of GDP) Current account (level, % of GDP) II. Western non-euro EU Member States. Gross domestic product GDP deflator Unemployment rate (level, % of civilian labour force) Long-term interest rate (level) Nominal effective exchange rate (+: depreciation) Government net lending (level, % of GDP) Current account (level, % of GDP) EXECUTIVE SUMMARY III. New EU Member States. Gross domestic product GDP deflator Long-term interest rate (level) Nominal effective exchange rate (+: depreciation) Current account (level, % of GDP) IV. Unites States. Gross domestic product GDP deflator Unemployment rate (level, % of civilian labour force) Long-term interest rate (level) Nominal effective exchange rate (+: depreciation) Government net lending (level, % of GDP) Current account (level, % of GDP) V. Japan. Gross domestic product GDP deflator Unemployment rate (level, % of civilian labour force) Long-term interest rate (level) Nominal effective exchange rate (+: depreciation) Government net lending (level, % of GDP) Current account (level, % of GDP) VI. Rest of the World. Gross output Output deflator Nominal effective exchange rate (+: depreciation) All figures are year-on-year growth rates, unless specified otherwise. Consolidated import and export flows for the euro area, the Western non-euro EU Member States and the New EU Member States. The Western non-euro EU Member States comprises Denmark, Sweden and the United Kingdom. The New EU Member States comprises Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia, plus Bulgaria and Romania.

12 THE 5- NIME WORLD ECONOMIC OUTLOOK The 5- NIME World Economic Outlook The Euro Area Diminished expectations for growth in 5 In, real GDP of the euro area grew by per cent, rebounding after three years of tepid growth during which GDP rose on average by just per cent per annum. In the wake of high and rising oil prices, the softening of business and consumer confidence, and despite the recent strong depreciation of the euro, the area s GDP growth is currently expected to come out at no more than.5 per cent in 5. Moreover, without the positive effect of the weakening euro on the area s net exports, GDP growth would have come out about. percentage-point below the forecast. Domestically, business sector investment, which grew by. per cent in, is expected to grow by.9 per cent in 5, thanks to low real interest rates and a further effort to catch up from previous years low investment levels. While private consumption grew by only. per cent in, it is expected to rise by. per cent in 5, mainly due to low interest rates. Residential investment should rise by.6 per cent over 5, after having risen by.5 per cent in. Inventory demand, which added.5 percentage-point to domestic demand growth in, is forecast to grind to a halt in 5 due to flagging business sentiment. Net exports made no contribution to real GDP growth in but are expected to add. percentage-point to overall growth in 5. Indeed, the euro area s consolidated exports are forecast to rise by 5.9 per cent in 5, compared with 5.5 per cent in. Demand for euro exports should increase as the recent significant nominal depreciation of the area s exchange rate reverses part of the loss in price-competitiveness incurred over recent years. At the same time, import growth remains almost unchanged, slightly down from 6 per cent in to 5.9 per cent in 5. Total employment increased by only.6 per cent in, despite the relatively strong.8 per cent increase in gross private sector output. A similar outcome is forecast for 5, as employment is expected to rise by.7 per cent, while gross private sector output should increase by. per cent. However, steadily declining real unit labour costs. See the technical appendix and the section on risks for details regarding the baseline assumptions and risks to the scenario. in and 5 set the conditions for stronger future growth in labour demand. The labour force increased by.8 per cent in and is expected to rise by another.7 per cent in 5, leaving the unemployment rate at 8.8 per cent of the civilian labour force in both and 5. In, consumer price inflation reached per cent. Rising oil prices and a depreciating euro should leave inflation unchanged at per cent in 5, notwithstanding a further fall in real unit labour costs and a persistent negative output gap. As inflation remains stuck in 5 at the European Central Bank s per cent ceiling, nominal short-term interest rates are expected to be kept on hold at an average rate of. per cent this year, despite the flagging growth prospects for the year. Long-term interest rates reflect these limited expectations and fall from per cent in to. per cent in 5. Higher interest rates in the euro area than in the United States, together with a more balanced current account outlook for the euro area, have led to a significant strengthening of the euro s external value in recent years. However, the area s nominal effective exchange rate is expected to depreciate by.5 per cent in 5, largely due to the recent reversal of the interest rate differential and increased uncertainty in the foreign exchange markets linked to the current political turmoil surrounding the future of the European Union. After having reached a fiscal deficit of.8 per cent of GDP in, the euro area s fiscal stance improves only gradually. Indeed, the area s public sector net borrowing requirement fell to.7 per cent of GDP in and, assuming no further policy slippages, it is expected to decline to.5 per cent of GDP in 5. As direct and indirect tax rates stay almost unchanged in the euro area, the slight improvement in the area s fiscal position is almost entirely due to the relative upswing in economic activity in and 5. Employment picks up and raises domestic demand growth in 6 In 6, euro area real GDP growth improves markedly as it jumps from.5 per cent in 5 to. per cent. This higher growth is largely borne by a further rebound in private consumption, robust growth in business sector investment and a

13 slightly higher contribution to overall GDP growth from net exports. Private consumption growth increases by per cent in 6, as it continues to pick up from the particularly low levels of the previous years, and benefits from favourable financing conditions and continued income growth. Household real disposable income increases by. per cent, largely due to a. per cent increase in total employment, combined with a mild. per cent rise in real take-home wages. Despite rising real interest rates, business sector investment grows by. per cent in 6, up from the.9 per cent increase expected in 5 due to rising private sector output. The more vigorous growth in business sector investment is accompanied by higher public investment, which rises towards its trend growth rate, while growth in residential investment remains subdued. The euro area s export growth edges downwards from 5.9 per cent in 5 to 5.5 per cent in 6, primarily reflecting a fall in foreign demand and an appreciation of the area s real effective exchange rate. Indeed, after depreciating by.5 per cent in 5, the area s nominal effective exchange rate rebounds and appreciates by.9 per cent in 6, though the real effective exchange rate indicates a continued depreciation of.6 per cent. In 6, import growth falls back to. per cent as it adjusts with a lag to the sharp increase in import prices of the previous year. On balance, the area s net exports contribute. percentage-point to overall GDP growth in 6, despite high oil prices. slight increase in taxes. Real wage growth remains modest as the unemployment rate remains high. In 6, labour productivity growth once again outpaces the rise in wage costs, leading to a further decline in real unit labour costs. Graph - Gross domestic product in the euro area Graph - Selected components of demand in the euro area Graph - Contributions to real GDP growth in the euro area (percentage-points) GDP (% change) Private consumption (% change) Enterprise sector GFCF (% change) Imports (% change) Exports (% change) THE 5- NIME WORLD ECONOMIC OUTLOOK After an expected rise of.7 per cent in 5, total employment increases by. per cent in 6, as labour demand begins to respond to the area s improving economic performance, the favourable evolution of real unit labour costs since and the relatively low employment growth of the previous years. As employment expands more rapidly than the labour force, the unemployment rate falls from 8.8 per cent of the civilian labour force in 5 to 8. per cent in 6. - Graph - Price deflators in the euro area.5..5 Private consumption Enterprise sector GFCF Total domestic expenditure Real net exports Nominal wages grow by.9 per cent in 6, down slightly from the. per cent of the previous year. Real take-home wages increase by only. per cent, while the real private sector wage costs increase by.9 per cent, reflecting a higher increase in consumer prices than in producer prices and a..5. Deflator of private consumption (% change) Deflator of GDP (% change) 5

14 THE 5- NIME WORLD ECONOMIC OUTLOOK Graph 5 - Interest and exchange rates in the euro area Graph 6 - Employment in the euro area Nominal short-term interest rate (levels) Nominal long-term interest rate (levels) Nominal effective exchange rate (% change, +: depreciation). Graph 7 - The unemployment rate in the euro area Employment (% change). Graph 8 - Real wages and productivity in the euro area.5 Unemployment rate (levels, % of civilian labour force) the consumer price deflator trails the sustained declines in real unit labour costs and a potential output growth that has consistently outpaced effective demand for several years in a row. Despite the fall in inflation, nominal short-term interest rates are raised from. per cent in 5 to. per cent in 6, as the monetary authorities gradually move to a more neutral monetary stance. This relative monetary tightening leads to a rise in the real interest rate, which jumps from. per cent in 5 to.9 per cent in 6 (deflated by the consumer price deflator). Simultaneously, yields on long-term bonds edge up, from. per cent in 5 to.6 per cent in 6. With government outlays growing somewhat less quickly than government revenue in 6, the public sector net borrowing requirement is contained at. per cent of the area s GDP. As nominal GDP rises by.5 per cent in 6, the overall government gross debt-to-gdp ratio declines to 7.5 per cent of GDP, compared with 7.6 per cent of GDP the year before. Balanced domestic-led growth up to Over the 7- period, GDP growth in the euro area averages.9 per cent per annum. This rise in output is achieved in the context of a decline in working-age population growth. Indeed, the growth rate of the working-age population falls to zero towards the end of the projection period, but this decline is partly offset by an increase in the labour participation rate. During this period, domestic demand is driven mainly by private consumption and business sector investment. External trade fails to make any significant net contribution to the area s overall GDP growth rate over the 7- period Real take home wage rate (private sector, % change) Productivity (GDP per worker, % change) After hitting a high of. per cent in and then remaining stuck around per cent over the following years, consumer price inflation finally decelerates to.5 per cent in 6. This decline in Private consumption growth remains strong over the 7- period, coming out at an average rate of. per cent per annum. This robust rise in consumption is mainly due to the steady.8 per cent average growth rate of total employment and an average. per cent growth in real take-home wages. This relatively high wage growth is itself underpinned by a steady per cent average rise in labour productivity. Total gross fixed capital investment increases by.7 per cent over the 7- period. Business investment growth comes out at a robust average 6

15 rate of per cent per annum, chiefly due to sustained private sector output growth and moderate interest rates. Euro area imports grow on average by 5 per cent over the 7- period, as they respond to the steady rise in domestic output, as well as to the limited rise in import prices. The rise in euro-denominated import prices is kept in check by the. per cent average appreciation of the area s nominal effective exchange rate and by contained oil prices. At the same time, in an attempt to remain competitive in world markets, euro area exporters keep export price growth limited to an average of just. per cent per annum over the 7- period. Moreover, as foreign effective demand increases on average by.9 per cent over the period, the area s exports post a robust.7 per cent annual growth rate between 7 and. Private sector employment grows by more than per cent in both 7 and 8, partly as a result of robust private sector output growth and limited increases in real unit labour costs. However, as consumer prices rise more rapidly than producer prices, real producer wage costs come under pressure as households seek compensation for their rising cost-of-living; this leads overall real unit labour costs to rise on average by.5 per cent over the 7- period. This rise in labour costs cuts into labour demand growth, which subsequently rises on average by a more modest.7 per cent a year between 9 and. The unemployment rate declines from 8. per cent in 6 and settles around 7.7 per cent between 8 and the end of the projection period. deficit falls from. per cent of GDP in 7 to. per cent of GDP in. Furthermore, robust nominal GDP growth allows for a fall in the euro area s public debt-to-gdp ratio, which declines from 7. per cent in 7 to 68. per cent in. Graph 9 - Current account of the euro area Graph - Net borrowing of government in the euro area Current account (% of GDP). Net borrowing of government (% of GDP) The Western Non-Euro EU Member States THE 5- NIME WORLD ECONOMIC OUTLOOK As potential private sector output growth starts to trail behind growth in effective demand - partly reflecting a rising number of pensioners and constant labour force growth - inflationnary pressures begin to build up and consumer price inflation increases from.6 per cent in 7 to.9 per cent in. Consequently, nominal short-term interest rates are raised from.7 per cent in 7 to. per cent in, while nominal long-term interest rates rise from.8 per cent in 7 to.5 per cent at the end of the period. In a context of rising employment, stable output growth, and assuming no further policy slippages, government revenue rises slightly more quickly than public outlays over the 7- period. As a consequence, the euro area s consolidated fiscal Domestic demand prospects weaken but continue to drive GDP growth in 5 Real GDP growth of the Western non-euro European Union Member States rose by.8 per cent in and is expected to grow by a maximum of per cent in 5. In, GDP was underpinned by a robust domestic demand, while net exports reduced overall GDP growth by.8 percentagepoint. Domestic demand is expected to remain the main engine of growth in 5, while net exports should reduce this year s growth prospects by a more limited. percentage-point.. Western Non-Euro EU Member States comprises Denmark, Sweden and the United Kingdom. 7

16 THE 5- NIME WORLD ECONOMIC OUTLOOK Graph - Gross domestic product in the Western non-euro EU Member States 5 - Graph - Selected components of demand in the Western non-euro EU Member States GDP (% change) Graph - Contributions to real GDP growth in the Western non-euro EU Member States (percentage-points) - Private consumption (% change) Enterprise sector GFCF (% change) Imports (% change) Exports (% change) - Graph - Price deflators in the Western non-euro EU Member States Private consumption Enterprise sector GFCF Total domestic expenditure Real net exports In 5, private consumption in the Western non-euro EU Member States is expected to grow by.6 per cent, down from. per cent the year before. Consumption growth is reduced somewhat by the weaker rise in household real disposable income, which is limited by the moderate.5 per cent rise in total employment and by fairly tight monetary conditions. Consumer spending is also expected to wane on the back of the recent stabilisation of house prices in the area. After posting a.5 per cent rate of growth in, business investment is expected to rise by 5.6 per cent in 5, reflecting relatively level private sector output growth combined with declining real interest rates (deflated by the price of private sector output). At the same time, investment in residential buildings and government investment are expected to pursue their rise, coming out at 5. and 9.5 per cent respectively in 5. Investment in residential buildings should continue to benefit from a still buoyant housing market, while high public sector investments are aimed at a further improvement of public sector services. Notwithstanding the strong appreciation of the area s real effective exchange rate in recent years, exports jumped by per cent in, thanks to a more robust global demand. Imports rebounded by an even more vigorous 5.5 per cent, in response to rising private sector output and falling import prices. On balance, net exports reduced overall GDP growth by.8 percentage-point in. This drag on GDP growth from net exports is expected to persist in 5, as exports and imports are forecast to rise by 6. and 6. per cent respectively. Import growth should be sustained by a. per cent rise in private sector gross output, while exports should benefit from firm growth in global demand and a tempered depreciation of the area s real effective exchange rate. After a.7 per cent rise in, total employment is expected to grow by a more limited.5 per cent in 5. This more measured rise in employment stems from lower private sector hiring, as private sector employment is faced with a tight labour market, characterised by an unemployment rate of just.9 per cent of the civilian labour force and a labour supply that is expected to increase by a modest. per cent in 5.. Deflator of private consumption (% change) Deflator of GDP (% change) The area s consumer price deflator came out at.5 per cent in and should edge up to.6 per cent in 5. The GDP deflator, which is a broader meas- 8

17 ure of prices, rose by. per cent in and is expected to come out at per cent in 5. As demand growth started to outpace potential output growth, the anticipation of heightened inflationary pressures led the monetary authorities to raise nominal short-term interest rates from an average of.5 per cent in to. per cent in. Weaker labour market conditions and a recent slowdown in the reduction of the area s output gap should leave nominal short-term interest rates at an annual average rate of. per cent in 5. Long-term interest rates, which came out at.8 per cent in, should settle at an average rate of. per cent in 5. In, nominal government revenue grew at a faster pace than total government outlays, reducing the government net borrowing requirement to. per cent of GDP. As a result of the continued strength in GDP growth, this evolution is expected to continue over the course of 5, during which the government net borrowing requirement should come out at no more than per cent of GDP. Positive net exports boost GDP growth in 6 In 6, GDP in the Western non-euro EU Member States rises by per cent, driven by a somewhat less buoyant domestic demand and a positive contribution to growth from the area s net exports. Graph 5 - Interest and exchange rates in the Western non-euro EU Member States Graph 6 - Employment in the Western non-euro EU Member States Nominal short-term interest rate (levels) Nominal long-term interest rate (levels) Nominal effective exchange rate (% change, +: depreciation). Graph 7 - The unemployment rate in the Western non-euro EU Member States 8 7 Employment (% change) THE 5- NIME WORLD ECONOMIC OUTLOOK Private consumption growth progresses by. per cent in 6, compared with.6 per cent in 5. Strong growth in private consumption is supported by a. per cent rise in real take-home wages and a.6 per cent rise in total employment. Consumer spending is resilient, despite smaller capital gains from financial assets and real estate. Total gross fixed capital formation continues to provide a vigorous contribution to the area s overall GDP growth. Business sector capital investment grows by.7 per cent in 6. Government investment grows by 6 per cent in 6, reflecting continued strong government spending on public services. Conversely, growth in residential investment falls back from 5. per cent in 5 to a more modest.8 per cent rise in 6. The contribution of the area s net exports to the overall GDP growth rate jumps from a. percentage-point negative contribution in 5, to a. percentage-point positive contribution in Graph 8 - Real wages and productivity in the Western non-euro EU Member States Unemployment rate (levels, % of civilian labour force) Real take home wage rate (private sector, % change) Productivity (GDP per worker, % change) 9

18 THE 5- NIME WORLD ECONOMIC OUTLOOK This turn-around in net exports is mainly linked to the sharp downward correction in import growth, which rises by no more than.7 per cent in 6, compared with a rise of 6. per cent the year before. The weaker import growth is due to both a smaller rise in private sector gross output in 6, and the previous year s strong. per cent rise in the area s import prices. Graph 9 - Current account of the Western non-euro EU Member States Graph - Net borrowing of government in the Western non-euro EU Member States Current account (% of GDP). Net borrowing of government (% of GDP) Export growth also stumbles in 6, coming out at.8 per cent, compared with a 6. per cent rise in 5. The area s reduced export growth performance reflects a more subdued rise in foreign effective demand, as well as the strong real effective appreciation of the area s currencies in 6. Labour demand rises by.6 per cent in 6, bolstered by continued strong output growth and the decline in real unit labour costs over the course of the previous years. At the same time, relatively favourable employment prospects lead to a surge in the labour supply, which jumps by.8 per cent in 6, compared with just. per cent the year before. With the labour supply rising somewhat faster than labour demand, the unemployment rate edges slightly up, from.9 per cent of the civilian labour force in 5 to 5 per cent in 6. However, conditions in the area s labour market remain tight and labour productivity growth remains strong, pushing up real private sector producer wages by. per cent. As a result, overall real unit labour costs rise by. per cent in 6. Consumer price inflation accelerates in 6, jumping from.6 per cent in 5 to per cent, as private sector potential output growth continues to lag behind growth in domestic demand. This leads the monetary authorities to adjust short-term interest rates, nudging them up from. per cent in 5 to. per cent in 6. Long-term interest rates increase from. per cent in 5 to.5 per cent in 6. In 6, as government income once again increases more briskly than government expenditures, the area s net borrowing of government declines from per cent of GDP in 5, to just.6 per cent of GDP. Stable expansion of domestic demand as of 7 The Western non-euro EU countries GDP growth averages.9 per cent per annum over the 7- period, with domestic demand contributing the totality of the growth over the period. Private consumption rises on average by. per cent over the 7- period, reflecting a.5 per cent average growth in real disposable income and continued strong increases in expected future income. The rise in real disposable income mainly stems from a.6 per cent average rise in employment and a.8 per cent average rise in real take-home wages. Households heightened expectations regarding their future wage incomes are linked to their more optimistic views as to future labour demand and real wages. Total investment in gross fixed capital increases by. per cent over the 7- period, notwithstanding a decline in public investment growth rates. Continued strong output growth and robust employment growth require a.9 per cent average expansion in the business sector s fixed capital stock. The area s consolidated exports rise on average by.5 per cent over the 7- period, mainly due to the.5 per cent average rise in foreign effective demand. Over the same period, export price growth is contained as exporters attempt to remain competitive in the face of the steady.9 per cent

19 annual average nominal effective appreciation of the area s currencies. Imports grow at an annual average rate of.9 per cent over the same period, as import demand is sustained by strong domestic output growth and the continued exchange rate appreciation. Net exports fail to make any significant contribution to overall GDP growth and the area chalks up a current account deficit that averages. per cent over the 7- period. Employment rises by.6 per cent per annum over the 7- period, while the labour supply grows by.7 per cent on average over the same period. Hence, the unemployment rate settles at an average of 5. per cent of the civilian labour force. After an initial measured acceleration in 6, consumer price inflation stabilises at.9 per cent per annum between 7 and. Moreover, as inflationary pressures tend to subside, short-term interest rates are kept close to their equilibrium level which stands at.5 per cent between 7 and. Nominal long-term interest rates also settle at an average rate of.5 per cent. With public expenditures growing at a slightly faster pace than government income over the 7- period, the area s fiscal deficit rises from.6 per cent of GDP in 7 to.8 per cent of GDP in. only slightly, down from.9 per cent in to.7 per cent in 5. In line with this high domestic demand growth, but also stimulated by the easing of customs formalities after the accession of these countries to the European Union, imports continue to grow rapidly. Indeed, imports progress by a whopping. per cent in 5, though this is still somewhat lower than the exceptional. per cent jump that was noted in. Growth in exports is equally impressive, as exports are expected to grow by.9 per cent in 5 after having posted a formidable. per cent increase in. On balance, in 5 the area s net exports should subtract.8 percentage-points from overall GDP growth, compared with the negative percentage-point contribution to the previous year s growth. Graph - Gross domestic product in the New EU Member States 5 GDP (% change) THE 5- NIME WORLD ECONOMIC OUTLOOK The New EU Member States Graph - Selected components of demand in the New EU Member States Strong domestic demand growth forecast for 5 In 5, real GDP of the New EU Member States is expected to grow by. per cent, slightly down from the. per cent the year before. This continued vigorous output growth is solely supported by sturdy growth in domestic demand, especially in investment, as the area s net exports are forecast to weaken significantly in Private consumption (% change) Total GFCF (% change) Imports (% change) Exports (% change) Growth in gross fixed capital formation accelerates from an already high 8 per cent in to an impressive 9.6 per cent in 5. At the same time, public consumption growth should increase from.7 per cent in to. per cent in 5, while private consumption growth is expected to fall. New EU Member States includes here Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia, plus Bulgaria and Romania. In 5, consumer price inflation is expected to come out at. per cent, down by.5 percentagepoints from the year before. Partly in response to this easing of inflationary pressures, nominal short-term interest rates are forecast to fall by.8 percentage-points to a level of 7. per cent, while long-term interest rates should decline from. per cent in to 7.5 per cent in 5. Simultaneously, the area s nominal effective exchange rate

20 THE 5- NIME WORLD ECONOMIC OUTLOOK should appreciate by 6. per cent, while the real effective exchange rate moves in the opposite direction and depreciates by. per cent, primarily reflecting stronger price increases in the rest of the world than in the New EU Member States. Graph - Interest and exchange rates in the New EU Member States Graph - Price deflators in the New EU Member States 5 Nominal short-term interest rate (levels) Nominal long-term interest rate (levels) Nominal effective exchange rate (% change, +: depreciation) Graph 5 - Current account of the New EU Member States Deflator of private consumption (% change) Deflator of GDP (% change) During the 6- period, growth in the New EU Member States is mainly underpinned by a robust.5 per cent average annual increase in private consumption and a 7 per cent average annual increase in gross fixed capital formation. These high growth rates for investment reflect the efforts that continue to be made to facilitate the further transition of the area to a modern service-oriented, knowledge-based, market economy. Though the area s nominal effective exchange rate appreciates by. per cent per annum on average over the 6- period, the real effective exchange rate depreciates on average by.8 per cent per annum. To a large extent, this reflects the relatively higher rates of inflation that prevail in the rest of the world. However, this real depreciation of the area s currencies is insufficient to curb the widening current account deficit, and the area s consolidated current account deficit reaches. per cent of GDP in. As the nominal effective exchange rate further appreciates and interest rates are only gradually lowered to levels similar to euro area interest rates, consumer price inflation recedes and comes out at an average rate of. per cent per annum over the 6- period, compared with an average rate of.7 per cent in the euro area. The United States Growth slips as interest rates rise sharply in Current account (% of GDP) As of 6, continued strong economic activity accompanied by widening current account deficits Assuming no further policy slippages and a close adherence to growth and stability-oriented macroeconomic policies, real GDP growth of the area averages.6 per cent per annum over the 6- period, compared with just.9 per cent in the euro area over the same period. After the strong.5 per cent rise in real GDP in, real GDP in the United States (US) is expected to progress by a more restrained.8 per cent in 5. This lower growth primarily reflects a slowdown in domestic demand, following the sharp interest rate hike that is forecast over the course of this year. However, as the effective external value of the dollar is expected to continue its slide in 5, and as previous depreciations start to produce their full impact on import demand, the negative contribution of net exports on overall GDP growth is forecast to decline from.8 percentage-point in to.6 percentage-point in 5. Growth in private consumption should come out at.6 per cent in 5, down slightly from its.8 per cent rise in. In, consumer spending was underpinned by low interest rates, a sharp rise in total employment and rising real wages. In 5,

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