The Outlook for the World Economy in 2006

The resilience of the U.S. and world economies in the face of record-high oil prices in 2005 has been remarkable. Global Insight predicts that growth in 2006 will remain strong - at (or slightly above) trend. The United States and China will continue to be the main locomotives of global growth. Furthermore, without the convergence of two or more big shocks, the risk of a recession in the next couple of years will remain small.

Strong growth momentum in the United States and Asia has been both the underlying cause of record-high energy prices and the reason why the global economy has managed to shrug them off. Global Insight expects both the U.S. and global economies to grow at a rate of some 3.5% next year (compared with 3.7% and 3.5%, respectively, in 2005). In the case of the United States, an expected slowdown in consumer spending and housing will be offset by strength in capital spending, helped by a fiscal boost from hurricane-related reconstruction.

Not every region of the world will enjoy strong growth in 2006. Japan's growth spurt over the past two years is likely to peter out, with the economy expanding by only 1.9% next year, compared with 2.5% this year. Although the pace of growth in Western Europe will accelerate a little to 2.0% (from 1.5% this year), the fundamentals remain weak. Consumer spending is virtually flat, and more than half the growth is export-led. Meanwhile, the European Central Bank (ECB) raised interest rates at the beginning of December 2005 and will probably tighten them again during 2006, and fiscal policy is about to become more restrictive in Germany.

The Asia-Pacific region, excluding Japan, will be able to sustain growth near to 2005's 6.3% pace. Although the Chinese economy is expected to cool off a little, Global Insight predicts that growth in 2006 will be at least 8.4% (compared with 9.3% this year). Other key economies will also be expanding rapidly (e.g., India at 6.8% and South Korea at 6.0%). Although exports continue to drive growth in these economies, domestic demand has also been robust (capital spending in the case of China and consumer spending in other economies, such as South Korea).

The Global Insight baseline forecast assumes that energy prices will fall very slowly in 2005, with the risks remaining predominantly on the upside. This means that inflation will continue to be a low-level threat, even in the United States. At the same time, interest rates will rise gradually in most of the G-7 economies. The net result is likely to be a deceleration in house price inflation without a crash.

The U.S. and global economies were able to withstand a number of major shocks in 2005 - one of the worst tsunamis on record (which occurred at the very end of 2004), one of the worst hurricanes on record, and the highest energy prices ever - without missing a beat. This remarkable resilience indicates that growth will be sustained over the next couple of years despite most shocks. Only if two or more severe shocks were to happen simultaneously would a recession become inevitable. Using its proprietary Global Scenario Model, Global Insight recently addressed the question: 'What would it take to trigger a global recession?'. The answer is a combination of oil prices above US$100 per barrel, inflation and interest rates running three percentage points above current levels, and a 10% drop in house prices across many industrial countries' markets. This is all possible, but unlikely in either 2006 or 2007.

Raul Dary

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raul.dary@globalinsight.com

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