We May Have Avoided the Cliffs, But We Still Face High Mountains

IMF Blog, January 23, 2013

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Acute risks have decreased compared to the same time last year: "The United States has avoided the fiscal cliff, and the euro explosion in Europe did not occur."
Uncertainty is lower, but "there remain considerable challenges ahead" and the recovery "continues to be slow, indeed much too slow."
A year ago the two short-term risks were:
- Excess fiscal consolidation in the United States due to gridlock.
- Firewalls in Europe not strong enough to prevent a crisis in Spain or Italy.
Developments noted:
- The agreement at the end of 2012 in the United States does not solve the fiscal problems, but "the extent of fiscal consolidation in 2013 should be roughly appropriate."
- In Europe, measures including the Outright Monetary Transaction program and the start of a banking union have reassured markets that "the firewall was indeed there, and that Europe was committed to the euro."
Remaining global headwinds: ongoing need for fiscal consolidation (reduction of government debt and deficits) and a still weak financial system.

Euro area periphery:
- Forecasted recessions with growth of "-1.0 percent" for Italy and "-1.5 percent" for Spain.
- Adjustment process underway: competitiveness improving, export market shares increasing, sovereign spreads decreased, cross border imbalances stabilized or reversing.
- Persisting problems: interest rates still too high, required fiscal adjustment still large, uncertainty remains — all contributing to low demand and low output.
Core euro area:
- Forecasted growth: "0.6 percent" for Germany and "0.3 percent" for France.
- Low growth drivers: fiscal consolidation, lingering uncertainty, weakness in periphery countries, and low confidence among consumers and firms.
- Financial conditions are improving and a gradual strengthening is expected over the course of the year.

Japan fell into recession in 2012.
Policy response expectations:
- New measures announced by the government (this month) should support positive growth in 2013 at "1.2%".
- Higher inflation target and more ambitious monetary policy goals are viewed as welcome.
- The fiscal package leads to a baseline growth forecast increase of "about 0.5 percent for 2013."
- Warning: given the high level of debt and absence of a medium term fiscal consolidation plan, the package "comes ... with higher risks of a fiscal crisis."

The United States is in better shape than Europe or Japan.
Main outstanding issue: need for a clear medium-term fiscal consolidation plan.
Even without such a plan, "fiscal consolidation is likely to proceed at a reasonable pace in 2013."
Signs of strengthening:
- Housing investment is on the rise.
- Wealth to income ratios have returned to historical levels, suggesting stronger consumption in the future.
- Fixed investment shows some signs of strengthening.
Forecasted growth for 2013: "2 percent", with a gradual strengthening over the course of the year.

Group forecast for 2013: "5.5 percent" growth, up from "5.1 percent" in 2012.
Country forecasts for 2013:
- China: "8.2 percent"
- India: "5.9 percent"
- Brazil: "3.5 percent"
Risks and observations:
- Weak investment in India and in Brazil is a source of concern.
- Many countries have offset slower external demand with higher internal demand and managed capital flow volatility.

World growth forecast for 2013: "3.5 percent", compared to "3.2 percent" in 2012.
Despite improvement, growth is "not enough to make a significant dent in the unemployment rate," which for advanced countries is forecast to remain at "roughly 8 percent."

Main message: "Financial market optimism should not lead to policy complacency."
Specific priorities:
- Europe: implementation of laid-out plans remains key for the euro area (after clearer plans were set out).
- Japan and the United States: both "still very much need medium term fiscal consolidation plans."
- Financial sector: "financial reform still has a long way to go."
Conclusion: With progress on these fronts, "cautious optimism may indeed be justified."

Olivier Blanchard, January 23, 2013.