Global Growth: Still on Track

While there's much talk in the U.S. of slowing economic growth, the global economy will clock its third straight year of GDP gains of around 5% in 2006, using the IMF's purchasing power parity (or PPP) estimates to aggregate the GDP figures of individual countries. Growth is accelerating in most of the industrialized countries, and the growing size of the Asian economies is pulling the global growth rate higher as well.

World GDP is oscillating around 5%, while "advance" economy GDP is bouncing around 3%, and "emerging" economy growth is averaging just above 7%. Using the IMF PPP weights, five economies dominate the world economy: the U.S., the Euro area, China, Japan, and India. Growth in China and India continues to sharply outpace that of other large economic areas, while U.S. GDP growth continues to oscillate around rates well in excess of those seen in Europe and Japan.

The combination of China's sizable upward revisions to past GDP growth, as announced around the start of the year, and the PPP estimates of the IMF -- which give a greater weight to China's output than implied if we just apply the managed foreign exchange rate -- has led to projections that the size of China's economy will pass that of the entire Euro area starting in 2005. The size gap here will widen rapidly over the coming years due to the dramatic difference in growth rates, and the size of the Chinese economy should pass that of the U.S. around 2015.


  China's rapid ascent in the world economy is occurring largely at the expense of Europe and Japan, where growth is slow, and only partly at the expense of the higher-growth U.S. economy. India -- the fifth largest economy, should pass Japan in size using PPP measures by 2007, to take the fourth-place slot.

If we look at the contribution of each of the big five economies to world growth rather than to the size of the world economy, we see that China accounts for about 30% of the increase in the world economy each year, while the U.S. accounts for about 15%, and India just under 10%. Though the European and Japanese economies are large, their low growth rates mean economic gains here each account for only about 3% to 8% of the world-growth total. The gap in significance between China and the U.S. widened considerably from the measures taken just last year, due mostly to China's GDP revisions.

As we have previously argued, a powerful three-way trading arrangement is emerging between China, the U.S., and India. These three countries have divergent comparative advantages that imply continued robust expansion of trade between them is likely. They already account for half of the world's output, and a 55% share of world growth. These three economies are notably "energy hungry" oil importers, while they also supply a large quantity of both labor and human capital to the world market. This trio is driving up the price of global energy products, but it's also holding down other prices that are behind the surprising restraint in the world's core inflation figures.


  Meanwhile, world inflation has trended upward slightly through the 2004-06 global GDP surge, with most of the global runup captured by the price of oil. Because of the dollar's downtrend since 2002, the pop in headline inflation has been the most significant in the U.S. Yet the rise in global headline inflation is hardly problematic, as we have seen offsetting restraint in core inflation. We're mostly seeing shifting "relative prices," as energy prices are rising relative to non-energy prices.

U.S. inflation is likely also leading the pack due to the excessive easing of monetary policy in the U.S. during the 2001-04 period. U.S. short-term real (adjusted for inflation) yields fell disproportionately to other major economies, which can probably be attributed to the impact of the September 11 terrorist attacks. The U.S. is only now approaching the end of the process of "right-sizing" its short-term real interest rate levels, despite three years of robust GDP growth.

This is occurring just as the dollar's value is settling in to more appropriate levels from a sizable overshoot in place following the 1997 Asian financial crisis that ballooned into the global market crisis of 1998. Lofty dollar values carried through the immediate aftermath of the 9/11 terrorist attacks, before the dollar finally began to respond to the surging current account deficit and rapidly falling yields.


  Indeed, the U.S. dollar's value has fallen steadily through this expansion, alongside offsetting uptrends in the Euro and the Canadian dollar. We expect this pattern to continue through 2006 and 2007, as the dollar gives back much of the rest of its 1997-2002 premium to the currencies of its major trading partners. As such, the U.S. will "import" a disproportionate share of the world's headline inflation.

The combination of a tightening in global monetary policy, with a disproportionate share in the U.S., and the rise in the price of energy -- also with a disproportionate share in the U.S., due to the effects of a falling dollar -- imply that a rise in global long term yields is also likely. Global yields overall, and in the U.S. in particular, are moving back toward more sensible, though still-low, levels. If the Fed can maintain credibility with its presumed pause in interest-rate tightenings at the June FOMC meeting, we may find that the runup in U.S. yields thus far in 2006 will account for much of the anticipated rise for the entire year.