Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Constructing our outlook for the rest of the global economy this time entailed assessing the information in and implications of varying indicators of activity from different regions, the somewhat weaker prospects for U.S. output growth, and the backup in global oil prices. In addition, we struggled to understand the likely consequences of the episode of financial market volatility that emerged in global equity and credit markets at the end of February as well as the risks to our forecast that this episode might foreshadow. In the end, our baseline forecast for real GDP growth abroad is just slightly stronger over this year and about the same next year as in the January Greenbook. Our projection for foreign inflation has been revised up just a little in response to the higher level of our path for oil prices. The resulting contribution for U.S. real GDP growth this year from the external sector is about neutral and that for next year is a small negative; we now see exports, relative to the January forecast, as contributing slightly more positively to U.S. GDP growth over the forecast period and are projecting an arithmetic negative contribution from imports that is a bit smaller in magnitude, especially this year.

The favorable news for activity abroad was mostly from the major foreign industrial countries. We were particularly surprised by Japanese real GDP growth in the fourth quarter, which in the latest data was an annual rate of 5.5 percent, 2 percentage points above our expectation in January. Household consumption showed some signs of strength—a development that has been lacking in Japanese economic activity for a long time. In addition, private investment spending increased at a double-digit rate. Available indicators for activity in January, such as machinery orders and household expenditures, support the view that solid expansion is continuing, and we have revised up our near-term forecast such that our projected growth rate for 2007 is ½ percentage point stronger. The economic expansion in the euro area continues to firm, and we were surprised by the fourth-quarter growth rate there, as well. The 3.6 percent annual rate of growth recorded for last quarter was 1 percentage point higher than we had expected in January. That strength was due particularly to investment and to export demand. We have revised up our outlook for growth over the forecast period about ¼ percentage point as a result.

Within emerging Asia, real GDP continues to expand vigorously in China and in India, sustaining expansion in the region at an average annual rate of about 6 percent. We see average growth in Latin America this quarter as having been slowed by weakness in Mexico that is related to softness in U.S. manufacturing production. Mexican growth should rebound in line with the projected improvement in U.S. industrial production, resulting in average growth in the region of about 3½ percent over the forecast period. We have revised down slightly our forecasts for growth in Mexico and emerging Asia relative to the January outlook.

On balance, we do not see the negative implications of the slightly weaker U.S. projection this time as outweighing the indications of robust domestic demand in Europe and Asia. Accordingly, our baseline forecast continues to be for vigorous growth on average abroad. A weaker U.S. outcome than projected is clearly a downside risk for the global economy, however. The rise in oil prices over the intermeeting period erased some of the inflation restraint that the low January level of global crude prices provided. We have added a couple of tenths to our inflation projection as a result, with most of the upward revision projected for the Asian emerging-market economies that are very dependent on imported crude oil.

The heightened financial market volatility that appeared in late February was a global event, with stock prices in several major foreign countries declining 2 to 6 percent through the date of the Greenbook and then retracing somewhat over the past week. Credit spreads widened for risky credit abroad, including emerging- market sovereign risk spreads, and yields on long-term governments bonds moved down in the euro area, the United Kingdom, and Canada as investors shifted to higher quality securities. But in many instances, these moves just brought the particular price or yield back to its level toward the end of last year. Although the drop in Chinese stock prices on February 27 was seen on that day as a contributing factor, market developments on subsequent days support the view that much of the concern of global investors is directed toward the U.S. expansion and, in particular, the U.S. subprime mortgage market. We do not see the market correction to date as a source of significant restraint on spending abroad. In addition, the evident weakness in the U.S. housing sector has limited potential for spillover to economic activity abroad. Accordingly, we have strengthened a little our forecast for foreign real output growth and reduced the magnitude of the net subtraction from U.S. GDP growth implied by the projections for exports and imports. Clearly, global financial market participants are ready to react strongly to any news suggesting less-favorable outcomes on investments. This poses a negative risk to the global outlook as the financial market response to a negative shock may intensify the consequences of that shock for credit extension, spending, and ultimately global growth. On the upside, we have been surprised by the strength of domestic demand in some foreign industrial countries, and we could be underestimating its momentum. In addition, a more buoyant outcome for China is always a possibility.

Last week we received data on the U.S. balance of payments for the fourth quarter, completing our picture for the year as whole. Although the annual total for the current account deficit rose in 2006, the balance for the fourth quarter narrowed quite a bit. That narrowing is due to a reduced trade deficit and a swing to positive in the figure for net investment income. A decrease in our nominal oil bill largely accounts for the improvement in the trade deficit, but the non-oil trade balance also narrowed somewhat. The smaller bill for imported oil in the fourth quarter resulted mainly from lower prices, although the quantity imported declined as well. The balance on the portfolio portion of U.S. net investment income was a sizable deficit that widened about $4 billion at an annual rate from the previous quarter. However, the positive balance on direct investment income jumped nearly $40 billion at an annual rate as receipts continued to be robust and payments fell sharply. The decline in payments was widespread across sectors and countries. The net result was a positive figure for total investment income of nearly $19 billion.

Going forward, we expect that the current account deficit will resume widening from its reduced, fourth-quarter level and will reach about $950 billion, or 6½ percent of GDP, by the end of 2008. We project that a widening of the trade deficit will continue, with the oil and the non-oil components of the merchandise balance both becoming larger deficits. However, a positive change in the balance on services will partially offset the deterioration in the deficit on traded goods. The net investment income balance should account for a larger portion of the current account widening. The positive balance of direct investment income should drop back in the near term but then rise slowly to record a small, positive net change over the forecast period. However, the negative balance for portfolio income is expected to increase in magnitude significantly, as our net international investment position records yet greater net indebtedness. This increasing net indebtedness and wider current account deficit will continue as long as the trade deficit remains sizable. David and I will be happy to answer any questions.

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