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

This is the time of year when folks young and old look forward to receiving a pleasant surprise or two—and not necessarily something that can fit inside a single stocking. We in the International Division have found ourselves pleasantly surprised by the strength of global economic activity during the third quarter, which is now evident in the data, and the indications that some of that strength is continuing. Accordingly, we have revised up our estimate of foreign real GDP growth for 2005 to near 3½ percent, about the pace we were projecting early last year. The baseline forecast this time calls for economic activity abroad to continue expanding at about that pace through the end of 2007.

The greater-than-expected buoyancy of the global economy was widespread and does not appear to be explained by one or two special developments that have limited implications for future growth. Among the industrial countries, the strong performers such as Canada had another good quarter, with Canadian Q3 real GDP growth at 3.6 percent. But more sluggish regions, for example the euro area, also did moderately well, at 2.6 percent real growth. Labor markets have either continued to improve or remained solid. And German and Canadian orders data portend continued solid expansion. Among the Asian emerging-market economies, China, Taiwan, Hong Kong, Korea, the ASEAN countries, and India all performed well in the third quarter. In Latin America, a sharp rebound in Mexican GDP growth raised the average for the region despite a very weak quarter in Brazil.

Some elements of recent foreign activity do raise questions about whether strength is transitory or will prove more persistent. In the United Kingdom and some smaller economies such as New Zealand, further increases in housing prices appear to be contributing to sustained or accelerating consumption. However, an end to the inflation of housing prices could trigger a sharp slowing of consumption. Euro-area growth remains dependent on export demand and lacks support from domestic consumption. And the rebound in Mexico was primarily in the agricultural sector and did not include a significant bounceback in manufacturing. These factors suggest a transitory element in the recent data. In contrast, in the major regions of the global economy, inventories do not appear excessive and in need of reduction. Private fixed investment has shown vitality in Japan, the euro area, the United Kingdom, Canada, China, and Mexico. These elements suggest the expansion will prove durable.

In most foreign economies, financial conditions remain very favorable for growth. Equity prices, in particular, have risen substantially over the year, providing support for both private investment and consumption. Since the end of last year, equity prices have recorded double-digit increases in the foreign G-7 countries, with the more than 30 percent gain in Japan being particularly noteworthy. Among the emerging Asian countries, stock prices in Korea have surged over the year. In Latin America, Mexican and Brazilian stock prices have risen very sharply. Except for Canada, the major foreign industrial countries have all experienced expansionary depreciations of their currencies on balance over the year. For these countries, long-term interest rates remain low, ranging from about 1½ percent in Japan to 4¼ percent in the United Kingdom.

We interpret the positive surprise in the pace of third-quarter activity as indicating somewhat greater fundamental economic momentum abroad than we recognized in the previous Greenbook. That momentum, in combination with the generally supportive foreign financial conditions, should sustain foreign real GDP growth, and we have accordingly raised our forecast for 2006 slightly. We expect that this continued moderate real output growth will be accompanied by little change, on average, in inflation abroad as the flat path projected for global crude oil prices over the forecast interval should result in some shifts down in headline inflation. Of course, risks of an acceleration in consumer prices abroad, owing to second-round effects from previous oil price rises, remain. Both the Bank of Canada and the ECB raised policy rates during the intermeeting period to counter any upward drift in inflation pressures or in inflation expectations. We expect further policy tightening in Canada in the next few quarters, more limited additional action by the ECB, and an end of the Bank of Japan=s policy of quantitative easing some time in 2006.

By itself, somewhat stronger activity abroad should work to narrow our external deficits in 2006 and 2007. But we have also slightly raised the forecast path for the dollar in this forecast from that in the October Greenbook, and the level of U.S. real GDP has been revised up as well. Together, these last two factors outweigh the effects of stronger activity abroad and, as a result, we expect a greater U.S. current account deficit during the next two years, with the upward revision reaching about $50 billion at an annual rate in the fourth quarter of 2007. About $30 billion of the increased deficit is expected to be accounted for by a wider trade deficit, with the remaining $20 billion arising from a downward revision to net investment income. Our outlook incorporates a deterioration of more than $100 billion in U.S. net investment income from the second quarter of this year to the final quarter of 2007, with negative net income expected for the current quarter. With the current account deficit soon to reach $900 billion and projected to cross the $1 trillion mark in 2007 and with net investment income significantly negative, market attention to the burden of the U.S. external

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deficits could increase. This feature of the December forecast is not such a pleasant surprise. Given today=s prices for energy, perhaps we would be better off with a lump of coal.

David and I would be happy to answer any questions.

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