Oct 03, 2000 Global: First Cuts to Global Growth

Global: First Cuts to Global Growth Stephen Roach (New York)

For the past 21 months, we have led the upside charge in the global growth sweepstakes. Courtesy of our emphasis on global healing, we have consistently had the strongest worldwide growth estimates of virtually anyone in the forecasting community. Now its time to send a very different signal. While we are leaving our above-consensus estimate for 2000 unchanged at 4.9%, were cutting our forecast of world GDP growth in 2001 to 3.9% (from 4.2%). This is the first significant cut we have made to our global growth forecast since the dark days of the world currency crisis in late 1998. And the key risk is, in my view, that there will be more cuts to come.

Our forecast adjustments are driven by higher energy prices. Consistent with the view of our energy analysts around the world, we do not think that the recent policy-induced fallback in crude oil prices neutralizes the coming impacts of an energy shock. In fact, now that the policy card has been played -- especially Americas possibly politically-inspired injection of its Strategic Petroleum Reserves -- the endgame looks all the more apparent: It now seems reasonably certain there will be a good deal more upside pressure to energy prices through mid-2001 than we had previously been assuming.

Specifically, our global forecast is now conditional on a path of Brent crude oil prices that fluctuates in a $30 to $35 range over the next six months before receding to around $25 by year-end 2001. (Note: The US, or West Texas Intermediate, counterpart is about $1.50 per barrel higher.) For the year as a whole, this pushes our 2001 assumption for crude oil prices up by a little more than 5% above the trajectory built into our previous forecast. In Q400 and Q101 -- the period of maximum pressure -- the overshoot is closer to 15% before tapering off later in the year. But more important than our views on crude oil, is our belief that the days of higher prices for refined products -- gasoline, home heating oil, and natural gas -- will last a lot longer than we had thought. Our 2001 product price assumptions are, on average, about 10% higher than those previously embedded in our global forecast. Our commodity traders concur with those fears, as does our team of equity analysts focusing on the energy business. Product prices, not those for crude, drive the macro impacts that influence the energy-consuming public. And despite seemingly politically-inspired efforts of the authorities to manage these prices, we believe that theres little that can be done to alter the fundamentals of supply and demand, which we judge will remain tilted toward higher product prices for some time to come.

The cuts we are making to our global growth forecast are relatively small at this point in time. They are largely concentrated in the industrial world. A few months ago, our Euro team took on board most -- but not all -- of the energy price adjustments we are now embracing. As a result, they are cutting their 2001 GDP forecast by just 0.1 percentage point to 2.8% (from 2.9%); an important offset, in their view, is the likelihood of larger-than-expected tax cuts in the region in early 2001. In the United States, we are trimming our 2001 growth estimates by 0.3 percentage point to 3.4% (from 3.7%). This would mark a 35% deceleration from the boom-like surge of 5.3% in 2000E -- a slowdown that Dick Berner believes will have significant implications for earnings, especially relative to the optimistic expectations that are still being discounted in the US equity market. For both Europe and the United States, near-term growth risks are especially worrisome; annualized growth could well slip below the 3% threshold at any point in the next 6-9 months, hardly shocking for Europe but a very weak outcome for a once booming US economy. We are also taking our 2001 forecast of Japanese GDP growth down by 0.2 percentage point; this takes our previous below-consensus estimate of +0.2% down to a "zero-growth" prognosis, underscoring the downside risks that Robert Feldman has long stressed for an economy in the midst of a wrenching restructuring.

In the developing world, our forecast reductions are surprisingly small at this point in time. Our 2001 growth prognosis for Latin America remains unchanged at 4.3%; we judge the region to be a net beneficiary of higher energy prices, largely due to the roles of Venezuela and Mexico as large oil exporters. In non-Japan Asia, a region that has nearly three times the weight of Latin America in the global GDP, we are cutting our 2001 growth estimate by 0.3 percentage point to 6.5% (from 6.8%). Relative to our previous expectations, we are making the largest cuts in Korea, Taiwan, and India; our reductions to growth in China and Singapore are more modest. In Emerging Europe, we are actually nudging up our 2001 growth estimate to 4.7% (from 4.6%), as an upward revision to the oil-exporting Russian economy more than offsets downward revisions to other countries in the region.

These forecast reductions represent a serious effort of MSDWs global economics team to capture the full ramifications of a very different energy price scenario than we had been assuming. Yet I will be the first to concede that we may not have gone far enough in folding the downside risks into our new macro scenario. Our basic message, in that context, is probably far more important than our precise estimates of world GDP growth: Just as we were correct in diagnosing the upside risks to our own above-consensus prognosis of global growth over the past year, we are now sending an equally emphatic warning that the risks remain very much on the downside of our reduced estimates.

I stress these risks because we cannot treat an energy shock in isolation from other forces that are taking global growth to the downside (see my 11 September essay in US and the Americas Investment Perspectives, "Downside Risks"). Three other factors are especially worrisome in that regard: First, there are the lagged impacts of previously implemented Fed and ECB tightening to consider, actions which are only just beginning to show up in the form of slower growth in interest-rate-sensitive sectors such as homebuilding and consumer durables. Second, there is the "payback effect" from this years growth spike; in 2000, global growth will have recorded its strongest increase in fully 17 years -- reflecting a surge in big-ticket items that invariably borrows from gains that might have otherwise occurred in 2001. And third, there are the impacts on world trade to consider; a slower environment of domestic demand growth around the world could well take a bigger toll on those countries and regions that have benefited the most from this years surge in global trade. Asia strikes me as being especially vulnerable in that regard; Americas NAFTA partners -- Canada and Mexico -- also bear special watching for that reason alone.

Nor does the record of history offer much comfort to incrementalism in adjusting growth forecasts in the face of an energy shock. Each of the two OPEC shocks of the 1970s culminated in outright global recession within a year. Yes, we all know that the world is less dependent on energy than it used to be. In the late 1990s, energy intensity, or oil use per unit of output, among OECD member nations was running at just 60% of its 1972 level. This suggests that oil shocks today will do less damage than they did in the past. But such newfound energy efficiencies werent enough to temper the impacts of the brief oil shock that occurred in the aftermath of Iraqs invasion into Kuwait in the summer of 1990. That latter example haunts me the most. World financial markets seemed utterly convinced that a soft landing was at hand. Central banks had just completed a fairly serious monetary tightening campaign, and growth was slowing in response, alleviating a modest cyclical buildup of inflationary pressures. But then Saddam marched into Kuwait, and presto -- global recession commenced just a few months later. The lesson from a decade ago cannot be lost on todays still complacent financial markets: The confluence of an oil shock and the lagged impacts of monetary tightening could well be a lethal combination for the global economy.

Of course, the authorities most likely will make every effort to resist and manage the outcome to a far less disruptive conclusion than that suggested by the past three energy shocks. The first signs of those efforts have been manifested in the form of the "double intervention" of September 21-22 -- Americas drawdown of its Strategic Petroleum Reserves and coordinated G-7 intervention in support of the beleaguered euro. Over the short term, you have to respect these efforts. They may have put a bottom under the euro, as Joachim Fels argues, and they may have created a more palatable perception of oil price gyrations between now and the US presidential election in early November. However, while policy makers may be successful in managing the primary sources of near-term volatility, they are typically less successful at controlling the secondary sources of macro instability. The likelihood of rising prices of energy products, and the lagged impacts of earlier monetary tightening that are still in the pipeline are especially worrisome in that regard. In other words, while the policies of market intervention may well buy some time, they should do little to alter the endgame.

In the end, its the unintended consequences of macro shocks that always seem to do the most damage. The energy shock is hitting the global economy when it is already moving to the downside. It could well reinforce the cumulative forces of slowing growth that were already under way. We have taken but a first step to bring our global forecast in closer alignment with those risks. There is a good chance, in my view, that we may have a good deal more work to do before we have captured the full force of those risks. For financial markets banking yet again on that ever-elusive soft landing, the rudest awakening of all may yet be ahead.

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-- Martin Thompson (mthom1927@aol.com), October 03, 2000

Answers

part 2 Splitting these up for easier reading.

Global: Where Will Petrodollars Go? John Montgomery/Rebecca McCaughrin (New York)

Oil prices have been rising in recent months, and they have become an increasing concern to investors and policymakers. MSDWs global economics team has just raised its global oil price assumptions. As with any price rise, there are losers  consumers  and winners  producers, i.e., oil-exporting nations. The latter group stands to receive greater income. It is important to take a view on what they will do with their increased income. Our analysis leads us to believe that most of their newly acquired revenues will be saved rather than spent, at least in the next 1-2 years. The funds will go (and probably already have gone) to international financial markets rather than to markets for imported goods and services.

If we subtract out their oil revenues, our estimates suggests that the aggregate trade deficit of major oil exporters (OPEC members except Indonesia, which has a more diversified economy) has been rising gradually over the past five years, despite the fluctuations of oil and of the global economy. That implies that oil exporters have been smoothing out their investment and consumption over the cycles engendered by oil prices. That suggests that at least in the next year or two, oil exporters are not likely to make substantial changes in their spending plans, despite their rising oil export revenues.

There are also signs that leading oil producers, whose economic growth is highly dependent on the whims of oil prices, are shifting resources toward non-oil sectors of the economy. The Saudi Arabian government, for instance, released its five-year development plan for the period 2000-2004 earlier this month, emphasizing the importance of achieving growth through greater investment in the non-oil sector - - primarily, in petrochemicals, construction and heavy industry. Already, the government has undertaken efforts to reform the economy through passage of a new, more equitable foreign investment law. Initial steps toward privatization of a Saudi electricity company, telecommunications company and the governments stated intentions to reduce its 100% stake in Saudi Arabian Airlines are further examples of concrete reform efforts.

We estimate that most of rising oil revenues will go toward augmenting national savings of oil exporters. Historical data since 1970 show oil price spikes are strongly, positively correlated with domestic savings growth. For instance, domestic savings closely tracked export earnings in Saudi Arabia and Kuwait during the 1973, 1979, 1990 hikes and 1986 and 1998 collapses. (The correlation coefficients are 0.932455 and 0.875552 for Saudi Arabia and Kuwait, respectively.) To put a number on this, if oil were to average $30 a barrel this year (in line with our new MSDW global economics assumptions), OPEC oil revenues could expand over $100 billion compared with 1999 levels. Those extra earnings should mostly go to paying down debt and accumulating international financial assets.

What are the global macroeconomic effects of rising oil revenues? First, there is more money for those dependent on international financial markets, most notably the United States with its $400 billion plus current account deficit. It contributes to downward pressure on global interest rates and bond and equity yields. And second, it should reduce demand for non-oil goods and services in the global economy. That is a negative for exporters, but a positive for countries that still risk overheating (such as the US, again).

How big are these effects? As we have observed, the current oil price rise seems more a demand than a supply problem. It is induced primarily by rising global GDP. Our colleague Andy Xie has argued that the recovery of demand in non-Japan Asia is an important component of this. Oil price rises should reduce growth in the global economy, but the growth rate should remain healthy.

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-- Martin Thompson (mthom1927@aol.com), October 03, 2000.

part 3

United States: Downside Risks: Energy Shock Still Threatens U.S. Growth Richard Berner and David Greenlaw (New York)

For the past eighteen months, we've stressed the upside risks to our above-consensus call for U.S. economic growth. Favorable financial conditions, the technology boom and a powerful global economic recovery have all underpinned that prognosis. Even the much- discussed soft-landing has so far proven less soft than expected. Despite significant slowing in consumer and housing outlays, the economy's resilience has continued to amaze as leadership quickly shifted to exports and capital spending.

That was then. We now think that risks for growth are shifting to the downside. Higher energy prices still threaten U.S. growth, despite the U.S. use of the Strategic Petroleum Reserve (SPR) to cap them. We assume that crude prices (WTI) will average $30.70/barrel this year and $29.25/bbl next year, on average about $1.50 higher than previously. More important, petroleum product and natural gas prices seem likely to average as much as 10% higher than we previously thought. That's where the rubber meets the road for the macroeconomic outlook as the higher prices act like a tax hike on both consumer income and corporate profits.

Our assumed higher price path for energy products reflects supply crosscurrents. The MSDW energy team believes that a shortage of refining and shipping capacity will keep a floor under energy prices, especially for products, while repeated intervention will cap them. But relief may be limited. Heating oil inventories and natural gas fills remain subpar, and just the threat of a "normal" winter would push them higher. Moreover, product and crude prices may not fall much next year because the intervention amounts to a repo or a loan rather than a permanent addition to supply. Unless it removes the "backwardation" from the oil market -- with futures prices well below current spot quotes -- producers have little incentive to increase supply.

This apparently modest forecast revision thus hides near-term downside risks. We now see U.S. growth in 2000 at 5.3% and in 2001 at 3.4%. Previously we expected 5.3% and 3.7%, respectively. While this new oil price path is only a bit higher than before, it has tipped near-term risks to the downside. That's partly because most of the upward risks to energy product prices lie immediately ahead.

Two factors are critical to our judgment that downside risks to growth now prevail. First, the SPR and other interventions may have capped crude prices for now, but uncertainty clouds the outlook. That is likely to weigh on business confidence and thus investment outlays, especially abroad. Thus, regardless of what energy producers do with their windfall, the oil shock would be a negative for global growth and, in turn, U.S. exports. As my colleague Eric Chaney notes, tax cuts in Europe should mute but not offset this risk. And Robert Feldman believes that Japanese policymakers have little scope or desire for either fiscal or monetary stimulus.

The second factor creating downside risks is Corporate America's likely response to the looming pressure on profit margins and earnings growth. Booming productivity gains and an accelerating global economy fostered a strong profit rebound over the past year. But productivity growth will likely cool as U.S. and global growth slow. And rising energy and accelerating compensation costs, despite the new flexibility in compensation practices, will hurt margins. A strong dollar, especially against the euro, is also crimping margins. Consequently, corporate earnings growth likely will bear the brunt of this slowdown, slipping to only 3% (measured in the GDP accounts) or so next year. This near stalling in earnings growth may well reinforce the downside risks to growth if defending margins prompts caution in hiring or in capital spending.

That's not all. The depressing influence of the energy shock on exports and profits must not be considered in isolation. The new energy burden comes at a time when the lagged effects of Fed tightening are still working their way through the economy. Together, higher interest rates and the impact of higher energy quotes will further curb housing and purchases of big-ticket durables. And it comes after an unprecedented durables spending spree. History shows that the normal payback from such a spike in growth when fundamentals turn less favorable often is more dramatic than anticipated.

Along with this forecast change, we are changing our call on the Fed. Previously we believed that the Fed would want to take out a bit more inflation insurance later this year and early next year by raising rates another 50 basis points. Core inflation has risen only gradually, as the twin headwinds of a strong dollar and hearty productivity gains have checked the rise in inflation expectations. Inflation risks haven't evaporated, however. Higher energy quotes mean higher headline inflation -- it will likely flirt with 4% late this year or early in 2001. And core inflation, in our view, has yet to peak. Yet, with growth and inflation risks now more evenly balanced, officials are likely now on hold for the foreseeable future.

Could the Fed ease monetary policy to head off the deceleration? Like it or not, neither investors nor CEOs should expect relief from the Fed any time soon. To be sure, the Fed eased in the summer of 1995 when core inflation also was moving higher, but then, more convincing forces were in train to bring it down again. At his February 1995 congressional testimony, Fed Chairman Greenspan noted that "there may come a time" when policy would turn neutral as inflation indicators cooled. The economy slowed dramatically, from a 3.6% rate in the second half of 1994 to a 1.1% pace in the first half of 1995. Even then, the Fed was in no hurry to ease: in the 10 months ended in December of 1995, officials merely unwound the last 50 basis points of tightening.

To prompt Fed ease now would thus take dramatic evidence that "the risks were tilted mainly toward slower growth" instead of higher inflation -- or perhaps a shock such that suggested financial conditions were far more restrictive than realized. And there's the rub for equity investors. This combination of sharply decelerating earnings and a static Fed isn't good news for richly-valued equity markets. Yet the circumstances that could prompt Fed ease and lower rates are precisely those implying further pressure on earnings growth.

At the same time, we cannot rule out other policy actions. First, we assume that the Administration won't hesitate to intervene further in oil markets if needed. Second, Congress seems now to be engaged in an even bigger-than-normal pre-election Federal spending spree. And slower growth late this year or early next year might stir a new Administration and Congress to agree on accelerated tax cuts. As has happened so often in the past, however, tax cuts might click on just as the economy regained its footing. With growth slowing and energy prices still on an uncertain path, the chances of a policy mistake are rising.

Finally, how oil producers recycle their windfall gains will also influence the outcome. If they step up imports of goods and services from oil consumers, that would mute the hit to growth. So far, that seems unlikely. U.S. exports to OPEC countries have fallen steady over the past fifteen months despite the rise in oil revenues. More likely, producers will recycle the gains into financial assets. Flows into U.S. financial markets would continue to help the dollar and U.S. Treasuries. Rates may test the lower end of our 5 1/2% to 6 1/4% range for 10-year yields. Either way, however, the oil shock would still depress global growth.

Important Disclosure Information at the end of this Forum

-- Martin Thompson (mthom1927@aol.com), October 03, 2000.

part 4

Europe: Capex Hit by Oil Shock More Than Consumer Spending Eric Chaney (London)

We are revising our GDP growth forecast for Europe from 2.9% to 2.8% for 2001 Also on the back of the new and more aggressive oil price scenario our global economic team has recently adopted, we are reducing our GDP growth estimate for this year, from 3.3% to 3.2% for 2000. Back in May, before we started to revise our GDP growth prognosis because of creeping oil prices, we were betting confidently into an acceleration of economic growth in Europe, especially in continental Europe, as a consequence of strong fundamentals and of a secular acceleration of investment in technology.

Since then, we have not changed our long-term views, but we acknowledge that short-term prospects are darker than we thought. In comparison with our May forecasts, we have now cut our pan-European GDP growth forecast by 0.5 percentage point and our Euroland one by 0.6 pp. Our rules of thumb linking the oil prices and the real economy would suggest an even worse outcome, a reduction of at least 1% of GDP, mostly in 2001. Fortunately for the European business cycle, the magnitude of the fiscal policy response has increased dramatically with the French and the Italian governments joining the tax cut fray initiated by Germany. The income tax cuts should amount to around 0.7% of GDP next year, and we consider that it should add at least 0.5 p.p. to GDP growth. As a result, the effect of the oil shock should be partially offset by bold counterattacks from fiscal policies. Note that the tax cuts are to start in November in Italy, December in France and January in Germany.

Within domestic demand, corporate demand should suffer more than consumer one While massive tax cuts should help the consumer sector to sail safely through the headwinds of the oil shock, the alteration of the global business cycle and the difficulty to pass higher input prices to final ones should have a significantly negative (but ultimately relatively short-lived, we think) effect on corporate spending (fixed investment and inventories). Although it is more a guess than a scientific statement, we think that strategic investment such as information and communication technology is likely to suffer less than more traditional capex items.

We are revising our inflation forecast for Europe from 1.8% to 2.3% for 2001 On top of higher retail prices for energy, we believe that some second round effects should contribute to an acceleration of inflation next year. We assume that only 50% of the acceleration of inflation will pass on to wages. But even so, domestically generated inflation should accelerate somewhat next year. We see headline EMU inflation dropping again below 2.0% -- the ECB ceiling -- not before the second half of next year.

The ECB is unlikely to punish the economy to fight imported inflation We haven't changed our views regarding the likely path of interest rates. Fundamentally, we think that the ECB considers that it is not appropriate to fight imported inflation by means of aggressive monetary tightening and that this is why the ECB has intervened in FX markets. Accordingly, our ECB watchers Joachim Fels and Elga Bartsch think that the ECB is unlikely to punish the economy through higher rates, as long as wage inflation remains subdued. That said, we continue to expect a last 25-bp rate hike in the short term, as a message sent to unions and companies "do not change your inflation expectations."

(A more detailed note can be obtained from your MSDW correspondent.)

-- Martin Thompson (mthom1927@aol.com), October 03, 2000.

part 4 Japan: Dangerous Curves Robert Alan Feldman

Details

The Economics team has recently re-calculated our global growth outlook with a new set of oil price forecasts. With crude oil now likely to remain in the mid-US$30/bbl range until mid-2001 and drop only to the mid-US$20/bbl range in the second half of 2001, the outlook for growth is changed. Already our forecasts for Japan had taken into account rather high assumptions for the price of oil (Exhibit 1). Thus, the size of the revisions needed in our new scenario is rather small. However, it is also possible that even our new scenario may reflect crude oil prices that are too low. Hence, it is prudent to consider two scenarios.

Exhibit 1. Effects of Higher Oil Prices on the Japanese Economy

CY2000 CY2001 Old New Very High Old New Very High Oil $/bbl 26 28 28.5 26 26.5 36 Real GDP 1.7 1.6 1.5 0.2 0.0 -0.6 CPI -0.7 -0.7 -0.6 -0.9 -0.7 -0.3

Source: MSDW Estimates.

Why the Scenarios Differ

The two scenarios for oil essentially come down to a relatively rapid decline of oil prices in our main scenario, and little if any decline in the alternative. The main scenario, which brings crude oil prices back down in 6-9 months time, is based on historical experience of the last decade. Recent levels of crude oil prices are about 2 standard deviations above the ten-year average. Even if one believes that a significant supply shock has occurred, it seems imprudent to think that crude oil prices would stay so high. Hence, the new scenario, while recognizing a global oil shock, brings oil back down to only about one standard deviation above the ten-year average.

The economics behind this scenario are simple. In the short run, both demand and supply curves for oil are steep. Since bringing new supply of oil on stream takes time, the supply curve is nearly vertical. And since usage of different types of energy is also tied to current facilities, the ability of users to switch to alternatives is limited in the short run. However, in the longer run, experience shows that both supply and demand respond within relatively short periods. The supply curve shifts outward, and the demand curve shifts inward. When these curves are steep, even small shifts of this sort would cause large changes of price, and rather small changes of quantity. Hence, the high now, low later character of our main scenario. (Note for economic theory buffs: If the supply response is stronger than the demand response, the world will be in an oil cob-web.)

The alternative scenario is that oil prices just stay high. The economics of this would be that supply response is muted, and demand does not fall. Of course the hit to income from higher crude prices would have to be offset somehow, through factors that would keep global aggregate demand high. Such factors might include lower savings rates in the industrial world, high propensities to spend among the recipients of the new oil revenue, or demand-stimulating policy actions by the industrial countries. In our view, the likelihood of the supply response over the medium term is probably underestimated by investors today, that oil revenue recipients will spend heavily is probably low, and that policy response in the industrial nations will be significant is probably low as well. Hence, this scenario is only the alternative. But it is far from impossible.

Effects of the Two Secnarios on Japan

To analyze the effects of higher oil prices, it is convenient to use the textbook IS-LM-Aggregate Supply curve model. The impact effect of an oil price hike acts like a tax. Then in the IS curve, the effects on sentiment, external demand, and profits kick in, and multipliers go to work. Separately, the LM curve moves because of changed inflation expectations. And the AS curve moves because of higher costs to corporations and the reaction of domestic wages to new economic conditions. Let us trace these effects in both the main scenario and the alternative.

For the new main scenario, the average oil price is up by only US$2/bbl in CY00 and only 0.5/bbl in CY01, relative to our earlier forecast. Most of the effect of the rise this year will be felt in CY01, however, due to adjustment lags in both consumption and investment. So the effect on GDP growth and on CPI is felt primarily in CY01. The magnitudes of change are small, however, because each US$1/bbl on the price of oil means only a US$3 bln reduction of the current surplus. Regarding this as a tax on Japan by oil producers, the overall tax of US$6 bln (less than 0.2% of GDP) would not affect GDP much. Sentiment of both business and consumers would be adversely affected, but not much, in light of the small size of the overall tax. Nor would external growth. These items constitute the extent of the inward shift of the IS curve. The LM curve effect in Japan is virtually nil, because the LM curve is flat (liquidity trap). Ironically, this turns out to be a bad situation for Japan, because an upward sloping LM curve would ease the effect of the tax. That is, if the LM curve were positively sloped, falling real interest rates would offset part of the effective tax increase. The aggregate supply curve effect (inward shift) from the oil price hike is small, because the hike itself is small. Moreover, the inward move of the supply curve would be partly offset by wage cuts, which labor is more likely to validate in light of historical experience. Low or even negative wage settlements would move the AS curve back out somewhat. In short, the aggregate demand curve moves inward slightly, and the aggregate supply curve moves inward slightly, resulting in marginally lower growth and marginally less deflation.

In the very high oil price scenario, the analysis is similar but the effects are much larger. Crude oil prices stay at US$36/bbl (landed price in Japan), and so the tax on Japan is very much larger. In this case, the tax is US$30 bln, or about Y4.5 trl or nearly 1% of GDP. Despite lags, the effects are already felt in CY00 but are felt in CY01 as well. The IS curve shifts inward sharply, not only due to the oil tax but also due to the adverse impact of higher oil prices on business sentiment and consumer sentiment. In addition, echo effects of lower growth around the world would be serious. The LM curve (which is still in a liquidity trap situation) allows the full effect of the inward movement of the IS curve to be felt. As for aggregate supply, the net inward shift is much larger, in light of the larger oil tax and limits to the ability of firms to convince labor to accept large wage cuts. As a result, growth in CY01 is about 0.8% lower than in our Sept 12 forecast, and CPI deflation is much milder, only -0.3% instead of -0.9%. That is, the IS curve moves much further inward, the LM curve is still flat, but the AS curve move inward is much larger.

Policy Response

Would Japanese policymakers respond to these scenarios? In the main scenario, the answer is probably not. Of course, the response would be determined in part by economic factors so long as politics does not interfere. History suggests that a small oil shock will not generate much fiscal response, because the large fiscal reaction to the first oil crisis of 1973-74 was regarded as a failure and because the room for fiscal maneuver is so limited. The same goes for monetary policy. In the scenario with very high oil prices, however, the answer would depend much more on politics. Already in both the US and Europe, the reaction of voters to higher oil prices has dictated some policy changes. If the effects in Japan become severe particularly in the run-up to the July 2001 Upper House election, pressure to postpone fiscal consolidation yet again, and for the Bank of Japan to return to the zero interest rate policy might intensify.

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-- Martin Thompson (mthom1927@aol.com), October 03, 2000.

All of this and practically no emphasis, in fact, hardly a mention, on natural gas. Unbelievable.

-- Wayward (Wayward@webtv.net), October 03, 2000.