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A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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Oil Takes Shine Off IMF Upgrades


Getting an economic upgrade from the IMF may turn out to be like landing on the cover of Sports Illustrated: a feather in your cap, but also a sign trouble may lie ahead.

The International Monetary Fund Wednesday upped its forecast of Japan's economy for 2004 to 4.5% from 3.4%. Last week, it offered a sunnier view of the euro zone's economy, upping its 2004 gross domestic product forecast by 0.3 percentage point to 2%.

But just as the IMF conceded what economists have long recognized as a better first half for the global economy, Japan and the euro zone - like the U.S. - face growing headwinds from stubbornly high oil prices. Oil futures hit a new record high Thursday at $45.75 a barrel. Estimates for the economic impact hover from around 0.2 to 0.4 percentage points of GDP depending on the economy for every $10 rise in oil prices.

“It hurts everybody, but probably hurts the U.S. less than it does Europe," with Japan somewhere in between, said Lakshman Achuthan, managing director of the Economic Cycle Research Institute in New York.

Japan imports most of its oil from overseas, while high energy taxes in Europe and greater sensitivity among consumers to inflation than in the U.S. make euro-zone economies particularly sensitive.

Still, Japan is expected to validate some of the IMF's optimism, at least for the second quarter, when it releases GDP figures on Friday. Second quarter GDP is seen growing 4.2% on an annualized basis, down from the first quarter's 6.1% pace but better than the 3% growth pace in the U.S. and the expected pace in the euro zone.

Meanwhile, data Thursday from France and Germany suggest the euro zone expanded at the upper band of its 2% to 2.5% potential during the second quarter. Germany, the euro zone's largest economy, expanded at a 0.5% quarterly rate last quarter, or 2% annualized. France, meanwhile, cemented its status as the region's key growth engine by expanding 0.8%, or more than 3% annualized.

Barclays Capital expects the euro zone expanded at a 0.6% quarterly, or roughly 2.4% annualized, pace in the second quarter. The European Union releases GDP data Friday.

Though Japan's recovery is showing some signs of broadening to the consumer sector - evidenced by a surge in July consumer confidence to 13-year highs - it's still highly dependent on its export sector, particularly to the U.S., where retail sales data signal some slowing in consumption, and China.

China's consumer price index jumped last month to a 5.3% year-on-year rate, the highest in seven years, raising expectations that China's central bank may consider raising interest rates. Meanwhile, money supply there has decelerated in recent months, which Barclays Capital worries could "sap the vitality from investment."

Explaining a drop in its third quarter global economic indicator released Thursday, Hans-Werner Sinn, president of German think tank Ifo, cited "the cooling of the overheated economy in China" which weighed on Asia.

2003 Redux?

Higher oil prices could still turn rosy for the global economy, particularly the U.S. and Japan, to the extent that they damp expectations of higher U.S. interest rates.

The Federal Reserve this week chalked up recent job and economic weakness to higher energy prices. Markets took that to mean the Fed will raise rates again in September. But if oil prices march higher and continue to disrupt the economy, it may have to reconsider its tightening cycle.

If that happens, look for U.S. market rates to fall and the dollar to slump against other major currencies such as the yen. That could lead to a repeat of 2003 and early 2004, when persistent yen strength led to massive currency intervention by the Bank of Japan, which involve purchases of U.S. assets such as Treasury securities, keeping U.S. rates low and its consumer sector strong.

Under that scenario, the euro and euro zone would bear the brunt of the adjustment, as it did last year.

The BOJ also alluded to higher energy prices when it met this week, as did the European Central Bank in its August bulletin released Thursday. But keeping with its inflation-fighting tradition, the ECB added the wrinkle that oil prices "continue to exert upward pressure on the general price level over the short term" and that "upside risks to price stability over the medium term need to be monitored closely."

"They cite the inflationary impact of oil and others cite the deflationary impact" given the damping impact on growth, said Marc Chandler, head of currency strategy at HSBC in New York. That suggests the ECB could be less responsive to any negative growth shock from oil prices than the Fed and BOJ.

Achuthan at ECRI worries that heightened emphasis by central bankers on oil overlooks the fact that the world economy is on a cyclical slowdown even when energy is factored out, due to a less friendly consumer spending environment and monetary policy tightening. Data such as the Organization for Economic Cooperation and Development's leading indicator signal that growth will slow later this year.

So just as slower second-half global growth isn't solely related to oil prices, neither would any softening in prices be a panacea, as global central bankers seem to suggest.

"Once you get a cyclical downturn and it's well defined in leading indicators, it's a done deal," said Achuthan of ECRI. "Removing oil will not reverse the cycle...that is an important point that gets lost in this discussion.”