There was good news and bad news on the economic front from the International Monetary Fund on Monday. The good news: The fund made only a slight downward revision to its global growth forecast. The bad news: That projection assumes that policymakers will do the right things in the months to come.
Based on past performance, the fund’s assumptions can best be described as optimistic.
The IMF now forecasts that the world economy will grow by 3.5 percent this year, a statistically insignificant drop of 0.1 percentage point from its previous forecast in April, and expand by 3.9 percent in 2013, down from 4.1 percent previously. Both rates are on a par with 2011’s sluggish growth of 3.9 percent and well below the 5.3 percent recorded in 2010.
The fund trimmed its 2012 growth forecast for the U.S. by 0.1 percentage point, to 2.0 percent; left its outlook for the euro area unchanged at -0.3 percent this year; and reduced its forecasts for a number of key emerging markets countries. It lowered its 2012 growth forecast for Brazil by 0.6 point, to 2.5 percent; for China by 0.2 point, to 8.0 percent; and for India by 0.7 point, to 6.1 percent.
Although the revisions were minor, the downside risks to growth have increased appreciably, said Olivier Blanchard, the fund’s chief economist.
Europe continues to pose the biggest risk. The IMF forecast assumes that European Union leaders will follow through on their June agreement to establish a euro area banking union with a centralized banking supervisor, a common deposit insurance system and financial support for weak banks from the European Stability Mechanism. Those measures are needed to break the vicious circle between weak banks and weak sovereigns that threatens to sink countries like Spain, officials said.
“The monetary union really needs to be accompanied by a very close degree of financial integration,” said José Viñals, director of the fund’s Monetary and Capital Markets Department.
Unfortunately, EU leaders show signs of backtracking since their late-June summit meeting, with Chancellor Angela Merkel saying Germany hadn’t decided whether to allow the ESM to bail out banks. With Germany’s Constitutional Court announcing Monday that it would take two months to decide on the constitutionality of the ESM itself, doubts about European policy are likely to increase in the near term.
IMF officials also urged the European Central Bank to intervene actively to contain bond yields in peripheral countries, with Viñals suggesting the ECB revive direct bond purchases under its Securities Markets Program, something central bank officials have expressed great reluctance to do. Spain and Italy have taken important measures to bring their deficits under control, “but they will only succeed if they can finance themselves at reasonable rates,” said Blanchard. Bond spreads widened on Monday, with yields on Spanish 10-year bonds rising 14 basis points to 6.80 percent.
One hopeful sign for Europe is that the amount of fiscal tightening — tax increases and spending cuts — should begin to diminish rapidly. Euro area countries have tightened their fiscal stance by 2.5 percent of GDP a year in 2011 and 2012, with crisis-hit countries like Greece, Ireland, Portugal and Spain making especially severe cutbacks. That tightening should ease to just 0.75 percent a year in 2013 and 2014, said Carlo Cottarelli, head of the IMF’s Fiscal Affairs Department.
For the U.S., the IMF assumes that President Obama and Congress will take steps to avoid the so-called fiscal cliff, which would hit at the end of this year with the scheduled expiration of the Bush-era tax cuts. Barring a fresh agreement, the expiration of tax cuts would hit the economy to the tune of more than 4 percent of GDP, “which would not be a good idea for the U.S. economy,” said Cottarelli. Such a budgetary tightening would be unprecedented in the post-World War II era and would almost certainly tip the U.S. into recession, said Blanchard.
The IMF forecast assumes that the U.S. will avoid the cliff and adopt measures to reduce the deficit by 1.5 percent of GDP next year. But with the presidential election campaign heating up, both Obama and his rival, Republican Mitt Romney, are hardening their stances on taxes, making it hard to see where the grounds for compromise might be.
Emerging markets have driven the global economy in recent years, but momentum has slowed significantly over the past year, partly because of measures taken by countries like Brazil and China to slow domestic credit growth. With problems in the West now hitting those countries’ exports, policymakers have shifted gears to stimulate their economies, with both China and Brazil cutting interest rates recently.
“We think easing will gain traction,” said Thomas Helbling, a deputy to Blanchard. That may be the best hope that the global economy has right now.
