A DANGEROUS combination of mounting inflation and weakening growth now pose a double threat to US economic prospects, the International Monetary Fund said yesterday.
In a warning to the US over growing price pressures, Raghuram Rajan, the IMF’s chief economist, said that with inflation on the rise, even as the American economy slows, the Federal Reserve could soon face a quandary over its interest rate response.
“The Fed may soon be on the horns of a dilemma, and monetary policy will need to be skillfully managed if the economy is not to be gored,” Mr Rajan said as he unveiled the IMF’s twice-yearly World Economic Outlook.
The Fed has been right to pause last month in its relentless, two-year long campaign of rate increases, Mr Rajan said. But he sounded a warning that, with increasing signs that inflation was still escalating, “pausing too long carries its own risks”.
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The IMF chief economist pointed to persistent pressures from past increases in the cost of commodities, a lack of slack in a US jobs market with strong employment levels, falling productivity, and a recent marked surge in wage pressures as worrying indication of inflation risks.
If these higher inflation began to fuel expectations of still further price increases among American companies and household, the Fed “will have to raise interest rates even higher and for longer”, he cautioned.
But Mr Rajan emphasised the potential dilemma for the Fed and its chairman, Ben Bernanke, which also confronts a slowdown in US growth driven by the sharp downturn in the American housing market.
With US house price increases now having stalled completely, an expected housing slowdown was “well and truly here” and it was likely that “things will get worse before they get better”, he said.
The IMF’s analysis highlighted the threat that the US housing market could cool more rapidly than anticipated, “triggering a more abrupt slowdown” of the US economy, as one of the key risks for the American and global outlook.
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It also pointed to big uncertainties over how deep the impact of the continued US slowdown would be on other leading world economies.
Yet despite all of these concerns, the IMF’s central view of US and world economic prospects remains relatively upbeat.
Yesterday’s forecasts projected robust US growth of 3.1 per cent this year, slowing to a still respectable 2.7 per cent in 2007.
That is expected to allow the world economy as a whole to expand by 5.1 per cent this year, and 4.9 per cent in 2007, both higher than the IMF’s view in April, and marking the best four-year run since the early Seventies.
There is a one-in-six chance, however, that global growth could drop far more sharply next year to 3.25 per cent or less, the IMF report concluded.
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The Fund said that there was more uncertainty than usual surrounding its bi-annual forecasts, with a series of hazards clouding prospects.
Inflation worldwide, as well as in the US, was a central worry, with the report noting that prices in many leading economies have been rising at a pace faster than central banks’ usual “comfort level”.
These concerns were now all the more pressing with so-called “core” prices, excluding those for food and energy, having accelerated.
Other key risks included fears that near-record oil prices would be driven to new heights by a lack of spare capacity in the crude market and geopolitical tensions.
The IMF also repeated past warnings over the persistent danger that global economic imbalances, symptomised by the vast US current account deficit, could unwind abruptly.
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While this was seen by the Fund as unlikely, the impact of the sharp falls in the dollar, shares and bonds that would result “could impose heay costs on the global economy”, it said.
For now, the Fund was able, though, to raise its forecast for eurozone growth this year to 2.4 per cent, from the 2 per cent it saw in April, with only a modest slowdown to 2 per cent expected in 2007.
But Mr Rajan said that consumer spending in Europe needed to pick-up if its improved pace of expansion was to last.
He renewed IMF calls for more to be done by European governments to deliver structural reforms.
“Europe’s leaders need to find the will to take on vested interests in both labour and in the corporate sector at the same time,” he said. “This necessary but difficult domestic battle is constantly postponed ‘til after the next election _ but the next election never comes.”
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The IMF also upgraded its projections for Britain’s growth this year, to 2.7 per cent, from the 2.5 per cent it expected in April. The UK economy is now seen expanding at the same pace in 2007 _ broadly in line with its long-term average performance.
In Japan, the IMF now expects buoyant growth this year of 2.7 per cent, dropping back to 2 per cent next year, with business “on a solid growth path”.
China is tipped to remain a key motor for world growth, with a booming expansion of 10 per cent forecast for 2006. But Mr Rajan said that Beijing needed to move faster to deliver market-based reforms to allow it to steer the Chinese economy more effectively.
He compared China’s present efforts to use government rules to curb runaway investment as “akin to using Band Aids to staunch a gaping wound”.
“Moving all prices to market levels may cause pain, but is ultimately the only way to go, and it is best to do it when growth is strong,” he said.