PARIS (MNI) – The fate of the world’s economy lies largely in the
hands of the policy-makers, who must contain the debt crisis in the
Eurozone and counter the planned fiscal tightening in the US to avert a
deep recession, the Organization for Economic Development and
Cooperation said Monday.

Central banks should keep interest rates very low as global
activity slows, while the ECB should cut rates sharply in the next
months, the OECD advised in its autumn Economic Outlook.

“More than usual, world economic prospects depend on events,
notably policy decisions related to the euro area debt crisis and US
fiscal policy,” it said.

In light of past experience and great uncertainty in the political
arena, the OECD’s baseline scenario is for further “muddling through” on
the fiscal policy front. This would mean “very weak OECD growth in the
near term, and a mild recession in the euro area, followed by a very
gradual recovery.”

Indeed, after the recession, Eurozone GDP growth is projected to
average just 0.2% next year and reach 1.7% only by the end of 2013,
giving an average of 1.6% that year. Growth in the US is seen picking up
to 2.0% next year and 2.5% in 2013. Japan would also see 2.0% growth in
2012 but only 1.6% in 2013.

Below-trend growth rates are forecast for the major emerging market
economies associated with further short-term weakening of sentiment and
confidence.

Cuts by the ECB in its refi and deposit rates rate, along with
expanded liquidity provisions, are expected to lower the overnight rate
to 0.35% by the end of this year. Short-term interest rates are seen
falling gradually to 0.4% by the end of 2013.

In the United States, the Federal Funds rate is assumed to remain
constant at 0.25% through 2013.

In Japan, “the current interest rate policy needs to be continued
until inflation is firmly positive,” the OECD said. The short-term
policy interest rate is assumed to remain at 10 basis points for the
entire projection horizon.

In Britain, the monetary policy rate is assumed to remain constant
at 0.5% over the projection horizon. The Bank of England is expected to
announce an additional bond purchase programme of Stg125 billion in
early 2012.

Long-term sovereign debt spreads in the Eurozone vs Germany are
assumed to decline by half over the course of 2013. In the US, Japan,
Germany and other countries outside the euro area, 10-year government
bond yields are expected to converge slowly toward a reference rate
which would reflect the public debt-GDP ratio.

Commodity prices are assumed to be stable through 2013, with Brent
crude around $110.

In its baseline scenario, the OECD sees confidence recovering
gradually from the second half of next year if worst-case outcomes are
averted.

“Serious downside risks stem from the euro area,” the OECD warned,
citing further contagion in sovereign debt markets driven by the
possibility of sovereign default. Without preventive action, the
Eurozone could plunge into “a deep recession with large negative effects
for the global economy.”

To stem contagion in the Eurozone, banks must have adequate
capital. “Convincing capacity, and commitment to use it, will be needed
to ensure smooth financing at reasonable interest rates for otherwise
solvent sovereigns,” it said.

In the US, a “serious downside risk is that no action will be
agreed to counter strong, pre-programmed fiscal tightening,” the OECD
said. This “could tip the US economy into a recession that monetary
policy can do little to prevent.”

“Contrary to what was expected earlier this year, the global
economy is not out of the woods,” OECD chief economist Pier Carlo Padoan
said in the introduction to the report. “Above all, confidence has
dropped sharply as scepticism has grown that euro area policy-makers can
deal effectively with the key challenges they face.”

“In view of the great uncertainty policy-makers now confront, they
must be prepared to face the worst,” the economist urged, warning of
“devasting” consequences if downside risks materialized.

The advanced economies could enter a recession, which would be
protracted in the Eurozone. The emerging economies would face a steep
contraction in global trade and the value of their international asset
holdings would depreciate.

In the downside scenario, “the financial sector must be stabilized
and the social safety net protected, further monetary policy easing
should be undertaken and fiscal support should be provided where this is
practical,” Padoan said.

In an upside scenario, a “credible commitment” with adequate
resources would have to come from Eurozone governments to block
contagion, he said. “This calls for rapid, credible and substantial
increases in the capacity of the EFSF together with, or including,
greater use of the ECB balance sheet.”

“The difference between the upside and the downside scenarios
reflects the impact of credible, confidence building policy action,” the
chief economist said.

–Paris newsroom +331 4271 5540; e-mail: stephen@marketnews.com

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