PARIS (MNI) – Although the developed economies are emerging faster
from recession than expected and with less unemployment than feared, new
risks from the sovereign debt crisis along with overheating in emerging
economies could still derail the recovery, the chief economist of the
OECD cautioned Wednesday.

“Risks to the global recovery could be higher now, given the speed
and magnitude of capital inflows in emerging-market economies and
instability in sovereign debt markets,” Pier Carlo Padoan said in the
introduction to the OECD’s latest Economic Outlook.

“These risks indicate that policy challenges are substantial and
more demanding than appeared to be the case a few months ago,” he said.

“As activity gathers momentum, global imbalances are beginning to
widen again,” despite China’s new focus on domestic demand, which is
restraining its external surplus, Padoan noted.

Overheating in emerging-market economies “poses a serious risk,” he
said. “A boom-bust scenario cannot be ruled out, requiring a much
stronger tightening of monetary policy in some non-OECD countries,
including China and India, to counter inflationary pressures and reduce
the risk of asset-price bubbles.”

The chief economist called for a greater exchange rate flexibility
in China to lessen the pressure on monetary policy and allow more scope
for controlling inflation.

On the other side of the globe, the sovereign debt crisis gripping
the Eurozone has triggered instability well beyond its borders and
underscored the need for “bolder measures” to ensure budget discipline
and “dissipate doubts about the long-term viability of the monetary
union,” Padoan argued.

“Exit from exceptional fiscal support must start now, or by 2011 at
the latest, at a pace that is contingent on specific country conditions
and the state of public finances,” he said.

At the same time, the chief economist called for a “normalization”
of monetary policy. Given that the OECD expects inflation to slow to
1.0% next year in the United States and the Eurozone and remain negative
in Japan, the need for “normalization” hardly seems urgent.

In fact, the OECD’s scenario for short-term interest rates implies
the beginning of a gradual tightening cycle by the Federal Reserve and
the ECB towards the end of this year, probably simply by withdrawing
market liquidity at the outset.

Indeed, the OECD seems more concerned about the assets that central
banks have accumulated during the crisis. Nevertheless, asset sales
“should be limited in the near term and conducted at a slow pace when
they begin” in order to prevent yields from rising quickly and to avoid
any capital losses.

“Such a strategy would only be viable and compatible with eventual
increases in policy interest rates if central banks offset the impact of
such asset holdings on liquidity,” the report cautioned. “Low inflation
means that policy interest rates should reach neutral levels only by the
time output gaps are closed.”

For the ECB, this means no more than 100 bps of tightening from the
end of this year until the end of 2011, while the Fed should be “well
above half-way to neutral by end-2011,” it argued. The Bank of Japan
could postpone any rate hikes until 2012 “at the earliest.” The Bank of
England, by contrast, should target 3.5% by end-2011, given the upward
drift in inflation expectations, it asserted.

It is this risk of rising inflation expectations that worries the
OECD’s chief economist most: “The outlook for inflation remains benign
in the OECD area due to considerable economic slack, but inflationary
expectations may become unanchored” as robust growth in the emerging
economies fuels energy and commodity prices.

The downside risk for activity of simultaneous fiscal consolidation
throughout the developed economies is not lost on the OECD. Its solution
is to hone policy so as to limit the drag on activity.

“Spending cuts must be made to preserve and indeed increase the
cost-effectiveness of growth-friendly programmes, including innovation
and education,” Padoan suggested. “Revenue-raising measures, where
needed, must focus on the instruments that are least harmful to growth,
such as consumption and carbon taxes.”

Countries like Germany and France that have shortened their debt
maturities to profit from low short-term rates should consider
rebalancing their debt profile before long-terms rates rise as the
recovery gains traction, “so as to lock in currently low interest rates
for longer-term securities,” the report suggested.

–Paris newsroom +331 4271 5540; Email stephen@marketnews.com

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