1. How Serious of a Threat Is Global Deflation? Nariman Behravesh Farid Abolfathi John Mothersole Dan Ryan Todd Lee Howard Archer Global Insight Teleconference December 17, 2002

2. 1990s: A Deflationary Wave The bursting of the Japanese asset and investment bubbles The bursting of the Japanese asset and investment bubbles The Asian Crisis The Asian Crisis Deflation spreads to other parts of Asia Deflation spreads to other parts of Asia The bursting of the high-tech bubble The bursting of the high-tech bubble Worldwide manufacturing deflation Worldwide manufacturing deflation 2

3. Commodity Prices

4. Though Up in 2002, Commodity Prices Remain Well Below Recent Levels

5. With Prices For Many Soft Since July

6. Insights From Japan’s Deflation

7. Disinflation, Deflation

8. Bursting Bubbles JAPAN Stock market peak: December 1989. Inflation: rising in 1990, volatile in 1991 (with surges above 4% m/m) GDP growth: 3+% q/q through 1991. Overnight call rate peak: March 1991. United States Stock market peak: August 2000. Federal funds peak: January 2001.

9. Interest Rate Response

10. Japan’s Slow Response Due To: Unfamiliarity with slow growth. Return to “normal” (3-4%) growth rate expected. Anti-inflation bias. Post-WWII generation of policymakers. Emphasis on fiscal rather than monetary expansion. Public works projects.

11. Problems Peculiar to Japan Structural problems. Overly-dependent on manufacturing, construction, exports. Low productivity in services. Bad Loans + Extreme Asset Deflation Bad loans estimated at 8-40% of GDP Asset prices now 1/4 th of peak value. Money hoarding. Due to uncertainty, risk aversion. 1990: M1 = 25% of GDP Today: M1 = 65% of GDP

12. Japan: Causing Global Deflation?

13. Asia

14. Asia Recovery Continues (Real GDP, percent change from a year earlier)

15. Recovery Still Driven by Exports (Percent change from a year earlier, Q3/2002) * Private consumption represented by real retail sales; business investment from q1-q3; exports in nominal dollar terms # Exports in nominal U.S. dollar + 2002 Q2 data

16. Consumer Demand is Cooling (Real NIA Private Consumption, percent change from a year earlier) *Real retail sales

17. Exports Are Sizzling (Real NIA Exports, percent change from a year earlier) *Exports in nominal U.S. dollar

18. Asia Exports Rely on US Imports (Percent change from a year earlier)

19. Interest Rates Are near All-Time Lows

20. Liquidity Decelerates Despite Low Interest Rates Percent change from a year earlier

21. Deflation Remains A Concern (CPI, percent change from a year earlier )

22. Deflation Remains A Concern (Percent change from a year earlier, 2002 Q3 ) * Second quarter data

23. Fiscal Strain in Asia (Fiscal balance over GDP, percent)

24. Outlook And Risks Outlook Outlook Cautiously optimistic about 2003 Inflation will remain subdued in the near-term Accommodative fiscal and monetary policy will continue US growth rebound in 2 nd half 2002 will boost exports China, India, Korea, and Malaysia will lead the pack Risks Risks Deflation Dependence on U.S. imports Non-economic shocks: Terrorist attacks, War on Iraq Rapid consumer credit expansion Fiscal strain

25. Real GDP Growth Outlook (Percent change)

26. Real GDP Growth Outlook (Percent change)

27. Who Is Next?

28. Parallels with Japan JapanU.S.Germany Weak Domestic Demand Deflation? Real Interest Rates Too High Real Exchange Rate Too High Fiscal Rigidity Financial Stress ? Heavy Dependence on Bank Financing High Debt Levels Burst Asset Bubbles Rigid Labor Markets Poor Corporate Governance

29. Growth in Real Domestic Demand Versus Real GDP

32. Debt is High in Much of the G7 Source: OECD; National statistics *Estimate

33. United States

34. U.S. - Deflation Is Not A Threat U.S. growth has been closer to trend than most other industrialized economies U.S. growth has been closer to trend than most other industrialized economies Policy has been and continues to be aggressively expansionary Policy has been and continues to be aggressively expansionary A falling dollar will help A falling dollar will help Service sector inflation is still chugging along Service sector inflation is still chugging along However, there is no room for complacency However, there is no room for complacency 34

35. U.S. - Growth vs. Potential Percent change from a year earlier

36. U.S. Consumer Price Inflation Percent change from a year earlier

37. Western Europe

38. Western Europe overall deflation risks limited Growth in Western Europe averaged near to 2% over last decade, so not a major output gap yet. Growth in Western Europe averaged near to 2% over last decade, so not a major output gap yet. Core Eurozone inflation stayed in 2.4-2.6% range through 2002. Inflation sticky in the dominant services sector. Core Eurozone inflation stayed in 2.4-2.6% range through 2002. Inflation sticky in the dominant services sector. Money supply growth strong, even allowing for distortions. Money supply growth strong, even allowing for distortions. ECB still has significant scope to cut interest rates. 50bp cut on December brought key rate down to 2.75%. ECB still has significant scope to cut interest rates. 50bp cut on December brought key rate down to 2.75%. If deflation really becomes a threat, there is ample scope for fiscal stimulus in the region, But authorities would have to at least make the Stability and Growth Pact more flexible. If deflation really becomes a threat, there is ample scope for fiscal stimulus in the region, But authorities would have to at least make the Stability and Growth Pact more flexible.

39. Eurozone - Growth vs. Potential Percent change from a year earlier

40. Eurozone Consumer Price Inflation: Goods and Services Percent change from a year earlier

41. Western European Latest Annual Inflation Rates CPICPICorePPICPICPICorePPI Austria1.8n.a.1.2Netherlands3.2*n.a.3.2 Belgium1.1*n.a.0.7Norway2.1*2.0*3.3* Denmark2.7*3.1*0.8Portugal4.0*n.a.1.4 Finland1.6*n.a.0.5Spain3.9*3.6*1.6 France2.2*2.0*0.6Sweden2.3*2.1* Germany1.1*0.8*0.3Switzerland0.91.0-0.4 Greece3.6*n.a.1.9UK2.12.30.6 Ireland4.8*n.a.-0.4Eurozone2.2*2.40.9 Italy2.8*n.a.1.1

42. Germany Deflation Risks Large output gap developing. GDP growth averaged just 1.3% over 10-years 1993-2002. Growth forecast at 1.0% in 2003, after 0.3% in 2002 and 0.7% in 2001. Large output gap developing. GDP growth averaged just 1.3% over 10-years 1993-2002. Growth forecast at 1.0% in 2003, after 0.3% in 2002 and 0.7% in 2001. Unemployment at 10%. Consumer confidence at 5-year low. Unemployment at 10%. Consumer confidence at 5-year low. Major structural problems - Labor & product market rigidities. Major structural problems - Labor & product market rigidities. Stock market been weakest performing of the major industrialized countries this year. Stock market been weakest performing of the major industrialized countries this year. Debt levels have risen. Bankruptcies up sharply. Debt levels have risen. Bankruptcies up sharply. Property prices have fallen, but not collapsing. Property prices have fallen, but not collapsing. Banking sector problems mounting, but not as bad as in Japan. No signs of a significant credit crunch. Banking sector problems mounting, but not as bad as in Japan. No signs of a significant credit crunch. Locked into euro at too high a rate? Will euro rise markedly against dollar? Locked into euro at too high a rate? Will euro rise markedly against dollar? Real interest rates too high. Fiscal policy restrictive. Real interest rates too high. Fiscal policy restrictive. Policy paralysis? Policy paralysis?

43. Germany vs. Japan Percent change from a year earlier

44. Reasons to Remain Worried Weak domestic demand and growing output gaps Weak domestic demand and growing output gaps Huge amounts of excess capacity in goods- producing industries Huge amounts of excess capacity in goods- producing industries Weak commodity prices Weak commodity prices Overvalued exchange rates Overvalued exchange rates Potential for policy mistakes Potential for policy mistakes 44