Boom or bust? The global economy in 2007

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(CNN) -- In the coming weeks, four leading economists and analysts will be looking ahead to the prospects for the global economy during 2007.

The second of these is Brian Farthing, senior economist for the Economist Intelligence Unit, the highly-respected analysis and forecasting arm of The Economist magazine.

Q. How do you think the global economy will perform in overall terms during 2007?

A. The global economy will slow from the exceptional pace of the past three years but still record another year of strong growth in 2007 as a whole.

In general terms, a slowdown in most OECD economies will be offset by continued strong growth in major emerging markets, particularly in Asia. Softer demand in economies such as the U.S., Japan and Germany will drive the slowdown as the tightening of economic policy begins to bite.

The US in particular will suffer from past interest rate rises and as the consumer boom of the past few years peters out. More subdued US demand will contribute to a trimming of OECD and non-OECD export growth rates. In addition to higher interest rates, Japan and Germany will also suffer from tighter fiscal policy in 2007.

Emerging Asia will continue to be the fastest growing region of the world and help prop up the global economy. Measured using GDP at purchasing power parity weights, we expect the world economy will expand by 5.3% in 2006 and then 4.7% in 2007.

Q. How might oil prices in particular affect economic performance next year?

A. Oil prices will remain high in 2007 with only some slight downward pressure as OECD demand decelerates and new capacity come on stream but demand from the energy intensive emerging markets remains extremely strong.

Under such a scenario, we anticipate oil prices will slip back a little from current levels, which will help ease upwards pressure on inflation and avoid any significant impact of high energy prices on economic growth in 2007. However, oil prices could easily spike upwards given tight market conditions and the risks surrounding major suppliers.

So far high oil prices have had a limited impact on economic growth as demand rather than supply has been the major driver of price rises. But should a further sustained increase in prices prevail in the context of a slowing world economy, the consequences could be much worse this time round. Slowing OECD markets with stubbornly high rates of inflation will be faced with a much more difficult task of propping up growth while fighting off renewed bouts of rising inflation.

Under such a scenario, stagflation could emerge as a threat to some major economies, while non-OECD oil importers would be faced with slowing external demand and rising energy import bills.

Q. What is the outlook for the US economy?

A. The US economy is decelerating and this trend will roll over well into 2007, primarily driven by a sharp slowdown in household expenditure and more modest business investment.

We expect the US economy to expand by 3.4% in 2006 and slow to 2.1% in 2007. A cooling housing market will erode household expenditure by dampening both the wealth effect and prospects for equity withdrawal, both of which have been important drivers of growth in recent years. As consumers feel the need to increase savings rates and rebuild their balance sheets, household incomes will continue to be squeezed by the persistence of high oil prices.

The weakening of overall aggregate demand will not be matched by any significant fall in price pressures. The rate of inflation will remain uncomfortably high in the US raising the prospect that the Federal Reserve, keeping to its inflation-fighting role, will delay monetary policy loosening in support of economic growth. Should the Fed delay too long this could easily push the economy into recession.

We currently see the chances of a recession in the US before the end of 2007 at around one in three.

Q. What individual factors are likely to be significant during 2007?.

A. In 2007, the global economy will still be characterized by worrying large economic imbalances and could quite easily suffer from a sharp economic correction.

The huge US current-account deficit makes the US dollar susceptible to depreciation in 2007, particularly as the interest rate environment will be less supportive if, as expected, US rates fall while Europe and Japan continue with a tightening cycle. We expect the size of the US external deficit, combined with interest rate movements, to force gradual dollar depreciation throughout 2007 but there is a risk of a much sharper downward movement should investor sentiment move against the dollar.

A substantial decline in the US dollar would have serious knock on effects for the US economy and undermine growth prospects worldwide. Such developments would also increase financial market volatility and force up risk aversion to the detriment of emerging markets.

Geopolitical risks in general also loom large -- Iran's and North Korea's nuclear programs, conflict in the Middle East and protectionism all have the potential to undermine what is a generally benign global economic outlook.

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