Chart 10 presents recent developments in selected global financial markets. The decline in the exchange value of the dollar in terms of the major foreign currencies has been a feature of these markets since early 2002. The top left panel shows the movements of the dollar in terms of its index of other major currencies (the black line) and in terms of the yen (the red line) and the euro (the blue line). The data are plotted so that the lines coincide at the point about one year ago when the major currencies index reached its peak. The depreciation of the dollar against the euro has exceeded that against most other currencies in the index, with a significant further move down coming since your previous chart show in mid-2002. At its peak last year, this index of the dollar was 40 percent above its low point in April 1995. Currently, it is a little more than 20 percent above that low. Recent market commentary has pointed to the heightened tensions concerning Iraq as a factor in the latest downward pressure on the dollar. These political risks are apparently affecting the terms on which market participants are willing to finance the large and growing U.S. net international indebtedness.
Yields on ten-year sovereign bonds, shown in the panel to the right, have moved down since the spring of last year. On balance, German and U.S. rates have moved about the same amount, but a small differential unfavorable to the dollar opened during the second half of last year, and some differential remains. Despite their low absolute level, Japanese rates have moved down as well. The ten-year rate crossed below 1 percent late in 2002 and has since moved down further as demand for JGBs continues to be strong. The middle panels show the change in market expectations over the past year for euro (on the left) and yen (on the right) three-month rates as captured in futures contracts. Disappointing macroeconomic performances during 2002 in these two economies and more generally globally contributed to shifts down in futures rates. For euro rates, almost all of that shifting has occurred since the June chart show as real output growth slowed in the second half of the year and expectations of monetary easing became established. The ECB did lower its minimum repo rate 50 basis points, to 2.75 percent, in December; and markets now appear to be pricing in additional easing by mid-2003. Futures rates in Japan have shifted down as well; and the curve has become noticeably flatter, suggesting that markets have postponed further any expected move back up in rates. Stock indexes are shown in the bottom left panel, with the lines scaled to coincide at the time of your last chart show. Stock prices are generally down over the full period shown, falling further since mid-2002. U.S. stock prices have compared favorably with European and Japanese stock prices since the June chart show.
Overall, these financial developments reflect the generally weaker tone to economic activity that has emerged, especially during the second half of last year. Interest rates have moved lower, partly in response to some additional monetary easing. But stock prices have fallen, reflecting investor caution. Market conditions are generally supportive of a recovery in economic activity and, for the most part, do not by themselves pose additional risks. There are some exceptions, however. For example, the United Kingdom appears to be experiencing a housing price bubble, illustrated in the bottom right panel, with prices up 40 percent over the past two years. The circumstances under which this rise will come to an end and the consequences for the U.K. economy are a source of uncertainty to the foreign outlook, which is the subject of your next chart.
The top left panel of chart 11 illustrates the deceleration of real GDP in the second half of last year both here and abroad. U.S. and average foreign growth have been roughly comparable and are expected to remain so through midyear. Over the remainder of the forecast period, activity abroad is expected to accelerate but less vigorously than is U.S. output. Past and some prospective monetary easing should boost growth abroad, but there is very limited scope for fiscal stimulus. Recovery of the U.S. economy, along with resolution of some of the geopolitical uncertainties currently impeding growth everywhere, should also support the return to higher growth abroad.
Consumption spending has been a key factor in maintaining output growth in many industrial countries. However, employment growth (shown in the top right panel) has been strong only in Canada, raising questions about the prospects for future consumption elsewhere. We look for household spending in most industrial countries to continue to expand, but we do not see consumption as sparking a rise in output growth in the euro area or Japan. Rather, we think improvement in investment spending is essential if growth in those countries is to rebound. Orders data (shown in the middle left panel) appear consistent with our view that, at least in the near term, activity in Japan will remain sluggish, with investment spending falling further. German manufacturing orders picked up in November, but that move was entirely because of stronger foreign, rather than domestic, orders. We remain fairly pessimistic about the prospects for investment in Germany but expect that, for the euro area as a whole, investment spending will switch from contributing negatively to growth to being a small net positive. Such an outcome is far from certain, however. As can be seen to the right, survey responses gathered by I/B/E/S imply that expectations of long-term earnings growth of companies in the euro area have come down sharply since early 2001, with the second half of 2002 showing a particularly steep drop. These reduced expectations likely reflect not just changes in the circumstances of individual firms but also market perceptions of greater uncertainty and heightened downside risk that are a consequence of global tensions.
As can be seen in the bottom left panel, for this year we anticipate that growth in the euro area and in Canada will result entirely from expansion of total domestic demand. Exports from both regions should expand but will be offset by rising imports. Robust domestic demand should underpin output growth at near its potential rate in Canada, whereas weak growth of domestic demand in the euro area will leave that region with a lackluster performance for the year. In Japan, we look for net exports to be the major positive component of very weak growth. The table to the right presents our real output forecast through 2004. We do expect some further strengthening in 2004, with Canada and the United Kingdom continuing to outperform the other foreign industrial countries.
The economic performance of the emerging-market countries, the subject of chart 12, has continued to be uneven. The emerging Asian economies led the global economy into recovery and continued to outperform in 2002 but cooled somewhat in the second half as global demand, particularly for high-tech products, slipped. The value of the dollar in terms of the Korean won (the black line in the top left panel) moved down in mid-2002 and, on balance, has remained about unchanged since then. The Singapore dollar also gained somewhat against the U.S. dollar during the second half of 2002. Its limited move reflects the fact that high-tech industries were particularly hard hit by the slowdown during the second half of the year. Stock prices, in the right panel, rose in Korea and, to a lesser extent, in Singapore during the first half of last year, as these economies grew vigorously, but then retreated as the global slowdown made itself felt.
Despite relatively strong economic performance in the region, price inflation in the Asian developing economies has been low. Attention has focused on the potential for persistent deflation in some of these countries, in addition to the ongoing issue of deflation in Japan. The middle left panel reports consumer price inflation for selected emerging-market Asian economies. Deflation was the case during 2002 in China and Taiwan; in Singapore, deflation early in the year became very low inflation in the second half. In Taiwan and Singapore, prices decelerated in response to exchange rate appreciation as well as to the weakening of activity during the second half of the year. These economies are relatively small and very open and sensitive to the fluctuations in high-tech industries. We expect that the rebound in activity projected for this year will lift inflation in these countries, including China, to a low, positive number. These economies show no signs of being caught in a debt deflation process as a consequence of the deflation to date.
The panel on the right gives the staff growth outlook over the forecast period for developing Asia. We see no signs that growth in China will flag from the 7½ to 8 percent pace that has been reported for recent years. Continued government spending and strength in exports should support output growth. For the remainder of emerging Asia, the projected rebound in U.S. growth and the return to healthy expansion in the global high-tech sector are essential to the return of growth to the 5 to 6 percent range that we have forecast for these countries.
In Argentina and Brazil, financial market developments are both a barometer of how the economy is currently faring and the channel by which stress is propagated through the economy. Spreads on international debt, shown in the bottom left panel, have stabilized and even retraced somewhat their previous spikes, albeit much more in Brazil than in Argentina. Similarly, exchange rates and stock prices in these two countries, not shown, have come back off their extremes. The situation in Argentina is in a kind of suspended animation, awaiting the outcome of the election now planned for April. While the observed stabilization in markets is welcome and we have written down low, positive growth as can be seen to the right, none of the really hard work of fixing the problems in Argentina has been done. Prospects remain very uncertain. In Brazil, markets have been giving President Lula the benefit of the doubt since the election. But the most recent moves on financial markets have been to take back some of the good news of lower spreads and stronger currency. Much depends on whether the politics of his program can succeed in an environment of fiscal and monetary restraint, and uncertainty remains very great. Only in Mexico do we see grounds for optimism. Our outlook for acceleration in Mexican output is closely tied to the projected recovery in U.S. manufacturing production.
Your final international chart (chart 13) addresses the external sector of the U.S. economy. The real exchange value of the dollar as measured by our broad index has depreciated on balance since its peak in early 2002, as the staff projected at the time of the June chart show. The most recent move down reflects significant nominal depreciation in terms of the other major currencies. With the real dollar already substantially lower than one year ago, we project only modest further depreciation through the end of the forecast period. We judge that the ever-present need to attract growing amounts of net financial inflows to finance the widening current account deficit will weigh on the dollar. We estimate that real imports (shown to the right) grew 9 percent last year, with extremely rapid expansion in the first half. Real exports grew 5 percent, held back by past appreciation of the dollar and only moderate growth abroad. For this year and next, we project that real exports and imports will rise at comparable rates. Depreciation of the dollar should boost exports as foreign output growth remains moderate and should restrain imports some as U.S. GDP accelerates more strongly. With imports already substantially greater than exports, similar growth rates over the forecast period imply a small negative contribution to U.S. real GDP growth from the external sector.
Our projection for a widening trade balance largely explains the increase expected in the current account balance, shown in the middle left panel. That deficit should reach about $625 billion by the end of next year, 5¼ percent of GDP. The most recent data available on the financial flows that are the counterpart to that deficit, shown to the right, give some clues as to the factors moving exchange rates in recent months. Our estimate for the fourth quarter implies that, during 2002, the current account balance (line 1 of the table) widened a little more than $100 billion. Increased foreign official holdings of dollars in the United States (line 2) were nearly as large. Private foreign investors (line 3) purchased substantial quantities of U.S. securities, but at a rate slightly below that observed in 2001. Private U.S. investors (line 4) greatly scaled back their acquisition of foreign securities, lessening the total financial inflow needed to achieve balance. With mergers and acquisitions very much reduced, net foreign direct investment into the United States (line 5) is estimated to have been negative last year.
The final two panels present some foreign detail for two of the alternative simulations that we have recently provided to you. The panel on the left reports the change in foreign real GDP growth that our model projects in the case of a six-month war with a limited embargo, one of the four scenarios that Sandy discussed. For these countries, there are no positive impulses from enlarged government spending, only the effects of higher oil prices and the spillovers that occur across countries. For 2003, the consequences for foreign output growth range from negligible to about minus ¾ percentage point. In 2004, as in the United States, the assumption that the oil price falls below baseline by mid-2003 results in a boost to output growth, and our model calls for growth above baseline for these foreign economies. The panel to the right gives detail for the Greenbook scenario of a $20 rise in the price of oil that lasts four quarters and that includes an additional shock to confidence. In this case, the oil price rise is a bit less than assumed for the limited embargo, but it lasts twice as long. As a consequence, the oil-producing countries of Mexico and Canada experience this as a positive shock to output in 2003. For the other countries, the added confidence factors significantly increase the contractionary effect of the higher oil prices. With oil prices back to baseline in 2004 and the effects of the shock to confidence waning, output growth rebounds to varying degrees in most of these countries. Larry will now complete our presentation.