Just where is the world economy headed?

To see how the Indian economy will grow, take a look at the most influencing factor: US GDP growth

In recent years India8217;s GDP has been riding the high global GDP growth. Would a slowdown in the world economy mean a slowdown of Indian exports? By how much? Unfortunately for economic forecasters this is a tricky question. There are no ready figures for the elasticity of Indian exports with respect to the world economy. Yet, given that the Indian economy is highly globalised, it is important to keep a watch on where the world economy is heading.

Views about the world economy have been changing rapidly. A month ago there was disagreement on which way the global economy was headed. Today, there is increasing consensus that global GDP growth, which had accelerated slightly from 4.75 per cent in 2005 to 5 per cent in 2006, will slow down to 4 per cent in 2007.

The biggest change in outlook is in the US, where growth is expected to fall from 3.5 per cent in 2006 to 2.25 per cent in 2007. The Economist believes a sharp slowdown in the American economy could be offset by increasing consumer demand in Asia. However, there is little doubt US GDP growth still matters.

One reason for this outlook is the change in the US housing market. After a decade over which prices doubled, a drop in prices has taken place for the first time since 1991.

The fall in new construction means lower demand for furnishings and consumer durables. The decline in housing prices is also expected to have a wealth effect leading to lower consumption demand. Besides, higher interest rates mean more money goes out in EMIs. Big question: what will happen to US GDP growth and world GDP growth in the aftermath of this turnaround in conditions on the US housing market?

The answer is not entirely clear. There are many conflicting signals. For example, the drop in crude prices has given US consumers fresh spending power. It could help improve the US current account balance, thus reducing the 8216;global imbalances8217; problem. On the other hand, lower commodity prices could reflect sombre expectations about future growth.

Second, while media is full of bad news on US housing, the stock market index of home construction firms has improved recently. Third, the US also has good news with the government deficit which shrank from 4 per cent of GDP in 2004, to 2 per cent of GDP this year, despite the enormous costs of fighting two wars.

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Another piece of the puzzle is interest rates. The key factor that will shape the Fed8217;s decision on interest rates is US inflation data. For most of 2006, US inflationary expectations have exceeded the 2 per cent that Ben Bernanke and the Fed consider the highest acceptable inflation for the US economy. The Fed can accommodate inflationary expectations of above 2 per cent if it is felt these reflect transitory fluctuations of oil prices. But if inflationary expectations persist above 2 per cent, or accelerate, the Fed will be forced to raise rates.

The question of 8216;global imbalances8217; remains. Chinese reserves crossed a trillion dollars, and there seems to be an acceleration in the rate of RMB appreciation. While economists have been criticised for crying wolf, it remains a difficulty underlying the outlook for the global economy. The 4 per cent world GDP growth is clouded by the possibility of unpleasant events as these imbalances are resolved.

Those who expect a 8216;soft landing8217; expect slowing GDP growth, a consequential easing of inflationary pressures in the US, thus removing the possibility of rate hikes by the Fed. Interestingly, while the US bond market appears to believe future growth will be poor 8212; the long interest rate is low 8212; the US equity market appears to believe it will be strong stock market valuations are high. In coming months, this contradiction will undoubtedly be resolved in one direction or the other.