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Monday March 6, 2006 - 11:41:05 GMT
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Economics Weekly: Global economy showing faster growth in 2006 but is inflation threat building?

A growth rebound that raises inflation risks?
After three years of above trend growth, the world economy is still growing healthily. Fast growth in the developing economies is something that we are well aware of, but growth in the main developed economies has also picked up in the last few months. Economic growth in Japan zoomed up in 2004 and hit 5% in Q4 2005. US growth is still well above 3% and growth in the UK and the EU are also strengthening, albeit from a lower base, see chart a. We look at some recently released PMI’s to help assess what is going on.

A widespread and solid recovery in manufacturing activity is underway…
The latest UK manufacturing PMI index was disappointing on the surface, with the headline index in February at 51.7, a smidgen below the 51.8 in January and the weakest of the three countries looked at in chart b. But with the output balance at its highest level since 2003, at 54.4, the detail was more encouraging. New orders slipped back though, to 52.6 in February from 53.1 in January, suggesting that the pace of growth may slow if the momentum is not sustained. The export index rose to 50, from 48.5 in January and employment was 47.6 from 46.5. Overall, the index is consistent with manufacturing output growth of about 1% pa, rather than the fall of 2.2% recorded in December 2005. That would be quite a turnaround and support gdp growth in Q1. Moreover, these figures suggest unchanged interest rates with little chance of a cut at the March MPC meeting this week.

Data for the euro zone also revealed a rise in manufacturing sentiment, to a 19-month high in February. The PMI index jumped to 54.5 from 53.5 in January and now stands at the highest point since July 2004. The detail of the release shows that most of the sub components of the index rose in February, suggesting that the pick up may be maintained in the months ahead. It is worth highlighting that the production index rose to 57.4 from 56.6 in January, buoyed by the new orders index rising to 61.9 (first time above 60 since Sept 2005) and a rise in the backlog of orders index to 54.5 from 53.5 in January. Highlighting the current strength of the domestic economy, the strong rise in new orders came about despite an easing in the pace on new export orders to 57 from 58.5 in January. Inventories continued to contract but at a slower pace (49.6 from 46.5 in January). A one-year high for input and output prices will give the ECB more reasons to fret about upside risks to inflation, justifying the recent rate rise.

For the US, the manufacturing ISM was equally robust. The headline US ISM Manufacturing index rose to 56.7 in February, from 54.8 in January, its first rise in the past four months. The index has now been above the 50 level (signifies expansion) for 33 consecutive months and if the 56.7 for February is annualised, it suggests real gdp growth above 5% for the year. The release also again highlighted the strength of the US labour market, with the key employment index rising to 55 in February from 51.3 in January. This is the ninth consecutive rise and the highest reading since November 2005. It is also above the previous 6-month average of 54.0. It all bodes well for another solid US payrolls report on Friday.

…but it is in the services sector that output growth is fastest
Chart c illustrates that growth in the services sectors, which account for some 70% of developed economies output-based measure of gdp has been rising rapidly in the last few months in all countries. The ISM index rose to 60.1 from 56.8 in January. A 7pt increase in the sub-employment component is undoubtedly the highlight of the report . Job creation in the services industry in December and January was only half the pace of that in November but today’s number suggests hiring in the industry may have accelerated in February. Aside from employment, gains for the other ISM sub-components were also recorded for total orders, exports orders and imports.

The same picture of strength was apparent in the UK PMI for services. The UK services index rose to 58.9 in February, from 57.0 in January and is at its highest since April 2004. Looking more at the detail of the release, although the headline business activity index rose sharply in February, not all of the subcomponents were higher than in January. The biggest rise was seen in the new business index, to 58.2 from 56.9 in January, only just below the 20-month high (58.3) in December. Respondents to the survey highlighted an increased willingness from clients to spend and the positive introduction of new products. There was also a rise in the outstanding business index to 51.8 from 50.8, highlighting a growing backlog of orders yet to be filled. The only other sub-index to rise in February was for input prices, up for a third consecutive month, at 59.0 – the highest since October 2005.

Even in the euro area, services boomed. The strong set of euro zone manufacturing PMI’s earlier in the week were replicated for the services industry. The euro zone services PMI rose to 58.2 in February and the index now stands at its highest level since September 2000. This paves the way for stronger GDP growth in the first quarter, given the share of the services industry in the economy. Looking at the components, we note stronger readings for both sub-indices (prices charged +0.8pts to 53.1, the highest since April 2002; employment +0.5pts to 53.1, the highest since June 2001). These tally with the ECB’s observation that risks to headline inflation are skewed to the upside while stronger hiring will help to galvanise household spending.

...but inflation is also on the rise
Indeed, this is one of the key themes emerging from the recovery in these indices, where price inflation pressure is building. Bond markets are getting that message and yields are rising in response as prices fall back. Chart d highlights the rise in inflation pressure, though it is still at weak levels in the UK, it is nevertheless likely to intensify. As the economic recovery gathers pace, UK growth may well hit 2½% early than anticipated this year.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
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