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Friday December 22, 2006 - 16:10:43 GMT
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Economics Weekly: Global growth exceeded expectations in 2006, Will US growth outpace the euro zone and UK again in 2007?

Economics Weekly:

Global growth exceeded expectations in 2006

The prospects for the global economy in 2007 are partly dependent on how it performed this year. In this article, we look back at how the global, UK, US, EU and Japan economies performed in 2006 compared with consensus expectations for the year. Our conclusion? In terms of growth, there was outperformance, despite higher oil prices and higher short term interest rates. But there was also a lot of exchange rate volatility (see table 1) and consumer price inflation was also higher than expected. Despite this, bond yields remained low as expected, and equity markets boomed. The main reason? Buoyant liquidity, with large current account surpluses in Asia and in the oil exporting countries, combining with continued growth in the developed economies to generate rapid growth in money supply around the world. So strong equity markets meant that wealth effects encouraged consumer spending (offsetting the negative effect from high fuels prices) at the same time cheap finance meant that company investment spending picked up sharply.

Chart a shows that global economic growth was better than expected in 2006, at 3.8% in December this year against 3.2% in 2005 (comparing forecasts made in December 2005 for 2006 with the latest estimate for the year made in December 2006), but inflation was also higher than predicted, though with less of a gap compared with growth. This was despite the fact that in December 2005 the expectation was that the oil price (Brent crude) would end 2006 at $56 a barrel; instead it is currently at $63 and has averaged $66 so far in this year. This pattern of faster growth was repeated for all of the major economies, see chart b, except the US, where growth was only 0.1% less than expected.

With faster than expected global economic growth, it was no surprise that global price inflation was also higher than expected, though not by as much as the difference between expected growth and actual growth, see chart a. With regards to inflation in the UK, US, EU and Japan, it was also higher than expected, except in Japan where it was bang in line with predictions, see chart c.

With faster than expected growth and higher than expected inflation, it should come as no surprise to see that short term interest rates (3 month rates) in all the major economies are currently above expected end year rates. And moreover, the differences are quite large - 5% short term rates in the US, against expectations of 4.7%, 5.3% in the UK, against a view of 4.3% and 3.7% in the EU, against the 2.7% predicted. With this kind of increase in interest rates relative to expectations, why was economic growth not weaker? The short explanation is shown in chart e. Long term interest rates are pretty much as expected overall (lower in the US, though a touch higher in the UK and EU and Japan), despite faster economic and higher inflation.

So global liquidity remained very buoyant, as shown by fast growth in money supply and buoyant equity markets, see chart f. But what does this mean for 2007? We think the global economy is starting 2007 in a good position, with growth accelerating in a number of countries and, with oil prices lower than the average for 2006, economic activity should get a boost and price inflation may be pushed lower. US growth will slow but not as much as expected. Fast growth in the UK and EU will lead to further interest rate rises. And in Japan, continued recovery will lead to monetary policy returning closer to normal.

Trevor Williams, Chief Economist

Will US growth outpace the euro zone and UK again in 2007?
• After recent weakness, it is fashionable to look for a further fall in the dollar in 2007, but it could actually rally. US short-term interest rates may remain on hold in Q1, with the chances of a cut evenly balanced with that of a rise. The latest housing market data and consumer confidence and non-farm payrolls figures for December head up a relatively busy period for US economic data over the coming fortnight.

• Although the Bank of England MPC voted unanimously to keep interest rates at 5% in December, recent strong data suggest UK interest rates will rise early in Q1 2007 and we look for bank rate to rise to 5.25% in February. A strong housing market and fast growth in money supply may have helped net mortgage lending scale a near-record £10bn in November.

• Recent economic data from the euro zone suggest the rise in the German VAT rate from January may only have a limited impact on economic growth in 2007. However, the ECB may wait for some early confirmation before pressing ahead with further tightening. We see interest rates at 3.75% by Q1 2007. The 'flash' December CPI estimate should show inflation remains on an upward trend.

• The Bank of Japan is likely to remain very cautious about raising interest rates in 2007. Economic growth will slow slightly from this year's pace but remain healthy. However, inflation should remain subdued. We look for interest rates to rise only modestly from current levels, maintaining downward pressure on the yen.

In the UK, one of the biggest surprises of 2006 has been the renewed strength seen in housing market activity. Annual house price inflation has accelerated again recently and will probably exceed 10% on most measures in the coming months, despite two 0.25% hikes in interest rates. The BBA reported last week that lending for home purchase rose to a record £6.5bn in November, up from £5.6bn in October. The Bank of England figures may show overall net mortgage lending neared a record £10bn, when they are published on Friday. Mortgage approvals rose to 128,000 in October, the highest since December 2003, and are likely to have remained robust in November. This is clearly positive for housing market activity and price growth over the next six months and, if sustained, could see house price inflation again beat most forecasts for 2007. We believe that the strength of housing market activity also presents an upside risk for UK economic growth, which we forecast is likely to accelerate slightly to 2.8% in 2007, from 2.6% this year. This view should be supported by another set of strong PMI data for manufacturing and services output in December next week. The minutes of the December MPC meeting showed that while the decision to keep bank rate at 5% was unanimous, there were concerns about the near-term outlook for wages, rising inflation expectations, robust money and credit growth and faster than anticipated house price inflation. Data since the meeting have been particularly strong and are likely to lead to at least discussion of the merits of a further rate rise in January and we attach a slim possibility to the chances of a surprise hike. However, with the next BoE Inflation Report due in February, we believe this is the most likely month for the first rise in bank rate in 2007, to 5.25%, with a growing risk that this may not prove to be the last.

The chart below shows the consensus estimate for US economic growth in 2007 is sharply below this year's likely outturn of around 3.4%. This, and the related outlook for short-term interest rates, have been two of the key factors cited as being behind the recent sharp fall in the dollar. However, we believe that US economic growth could prove more resilient than most forecasters expect and look for the dollar to benefit from this in 2007. There are some key US economic data due over the next two weeks. This week, the outlook for the housing market will be in focus, with financial markets awaiting November data for new and existing home sales. A modest easing in both is expected. However, December consumer confidence, on Thursday, we think may show a small improvement. Looking ahead, the December labour market report, on 5 January, looms large and the minutes of the December FOMC meeting (2 January) will also attract significant market attention.

Key economic data from the euro zone are limited over the holiday period, but will be closely watched. M3 Money supply growth, on Friday, may have accelerated to 8.7% in November. The 'flash' CPI estimate, due 4 January, may show annual inflation rose to 1.9% in December. The data should add support to the view that euro zone interest rates remain on an upward trajectory in 2007.
Lloyds TSB Bank,
Financial Markets
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