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Monday January 9, 2006 - 10:43:00 GMT
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What economic trends are the financial markets expecting in 2006?

Economics Weekly: What economic trends are the financial markets expecting in 2006?

Looking at economic prospects in the year ahead...
With last year’s economic performance proving surprising in some aspects, what are the consensus expectations of forecasters for 2006? We examine these through projections of economic growth, consumer price inflation and short term and long term interest rates for some major economic zones. These include, the US, the euro area, Japan and the UK. (With China overtaking the UK in 2005 as the world’s fourth largest economy in terms of market exchange rates, it is likely that analysis such as this will have to start taking it into account, especially in view of the global economic impact of its fast import growth, reckoned likely to be some 25-30% in 2006).

To summarise last year, economic growth in the US and Japan outperformed expectations but the UK and euro area economies underperformed. Whilst Japan still experienced falling prices or deflation, it only fell 0.1% more than expected; in the US inflation was 0.9 percentage points greater than the consensus. Inflation was 0.4% more than expected by forecasters for the UK in 2005 and was 0.2% higher than predicted for an underperforming euro zone economy. With faster growth and higher inflation it was not surprising that US short term interest rates turned out 0.6% higher than predicted, even though bond yields turned out to be 0.6% less than projected. The latter seems either a testament to the lack of investment opportunities outside of the US or that risk premiums fell during 2005. But bond yields were lower than expected in all the economies in the charts, so implies that a global change in investors risk perceptions occurred. Interest rates were 0.4% lower than expected in the UK at 4.5% but spot on for the euro zone at 2.5% (based on the 3m offer rate).

What about growth expectations?
An interesting point from chart a is that global economic growth is not expected to slow but to accelerate slightly in 2006. However, the pattern does change. US economic growth is expected to slow, though only slightly, but growth is seen to accelerate to nearly 2% in the euro area. Growth in Japan is expected to slow, to 2% from a faster than expected 2.4% in 2005. UK growth is also expected to accelerate, but only modesty from 1.7% in 2005 to 2.1% in 2006. This pattern implies that the emerging markets once again remain the fastest growing economies in the world, led by China.

interest rates in 2006
Global inflation expected to rise only modestly in 2006…
Despite the continuation of strong global growth into 2006, world inflation is expected to be only mildly higher, see chart b. This is likely due to the global deflationary effect of the faster growing emerging markets but inflation in the US is also expected to slow, though only by 0.4% to 3% from a 3.4% rate in 2005. In the UK and euro zone, inflation is expected to be modestly higher. For the first time in about a decade, inflation in Japan is expected to be positive.

…so short term interest rate rises are expected to be small…
With higher inflation last year in the US and faster growth, it is no surprise that short term interest rates are predicted to be higher, chart c. But, in the UK, the current view is that modest growth will still result in lower interest rates, even though inflation is just above the 2% inflation target, presumably because growth is below the long run average. For the euro area, short term interest rates are predicted to be higher, as is the case for Japan, though only to a rate of 0.3%.

...helping to keep down long term interest rates
On the whole, long term interest rates , shown in chart d, are reflecting that global inflation is expected to be very modest, with only a mild upward sloping curve (short term interest rates compared with long term rates) of 0.3% to 0.6% in 2006. This may seem a surprisingly sanguine view to take in view of longer term historical experience and it may seem a good bet to look for an upward inflation and interest rate surprise. But the financial markets are noting that despite a positive oil price shock in 2005 inflation remained low, so with a fall in oil prices likely to push inflation lower this year, it is likely to remain fairly muted. However, a lot of good news seems to be expected for 2006, looking at the modest changes in short term and long term interest rates compared with last year’s closing levels. If 2005 was anything to go by, 2006 is likely to be a more volatile year than forecasts are suggesting.

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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