The economies of the main industrial countries continued to grow steadily in the first three months of 2006 but rising inflation and energy prices point to a slowdown later in the year.The global economy has started 2006 on a firm note with a reasonable amount of momentum behind it. However, as the year develops we continue to expect a slowing trend that will extend at least into the early part of 2007. The key factor driving this slowdown is the tightening of financial conditions around the world, including the sustained increase in official American and European interest rates, the rise in bond yields since last summer and the recent decision to end the policy of zero interest rates in Japan. The continuing high level of energy prices is also a factor in our projection of subdued economic growth. Overall, it appears that GDP growth in the main industrial countries has been strong over the first three months of 2006. As the graph opposite shows, this contrasts with surprisingly weak growth at the end of last year, which reflected unexpectedly low figures in America and the eurozone. The recent data from these two areas points to a strong rebound at the start of 2006, and in Britain growth may have accelerated a little further after a solid final quarter last year. Only in Japan, where quarterly growth was very high in the final quarter, is there likely to have been a slowdown in the first quarter of this year. We believe that, for the first quarter of 2006, the main industrial countries as a group will report the strongest quarterly growth rate for two years. In America, the fed funds rate still has further to rise and, indeed, we now look for a peak of 5% rather than 4.75%, and expect it to remain at that level until the last quarter of this year. In Europe, the European Central Bank is firmly in rate rising mode and we see the repo rate moving up to 3.25% rather than 2.75% by the autumn. Robust growth and lingering inflation concerns across the region are the key drivers behind the interest rate hikes. However, our view is that the 3.25% level should be the peak. Back in Britain, it now appears that it will take a lot to change the Monetary Policy Committee’s collective view that the economy is performing well. Any cut in British interest rates looks unlikely before the autumn. Meanwhile in Japan, the buoyant economy and an end to deflation justify the change in monetary policy. The Bank of Japan has instigated a major shift, with a return to targeting overnight interest rates in place of the policy of massive quantitative easing. The vast amount of excess liquidity in the Japanese financial system will be withdrawn over a period of “a few months”. It is true that this does not mean the immediate end of the zero rate policy – rates are likely to be kept effectively at zero until the final quarter of this year and may then be edged up only gently. Nonetheless, the changes in Japan will add to the overall tightening of global financial conditions even before interest rates start to move up. Spreads over government yields are also important. The cost of corporate long-term borrowing is no longer falling markedly – indeed, it is now moving up in line with government yields and, as a result, the boost to business investment is gradually fading. On the other hand, emerging market bond spreads have narrowed further, which has helped keep financial conditions relatively easy in Latin America but leaves economic activity in the area vulnerable either to a general tightening of global liquidity or to a reduced appetite for risk on the part of global investors. The continuing high level of energy prices is a further contributory factor to the slowdown in economic growth, mainly by keeping central banks on “inflation alert” as they worry about the outlook for wage costs against the background of tighter labour markets. We have now raised our oil price assumption by about $6 and assume an average Brent price of $63 in 2006 and 2007. Recent concerns over developments in Iran illustrate the upside risks to energy prices. Despite the concerns of central banks, underlying inflation developments have remained generally benign. Global competition and the emergence of China and other low-cost producers imply continued downward pressure on prices in the developed world. Moreover, developed economies are continuing to achieve productivity gains from the application of IT. Of course, productivity gains may slow for cyclical reasons, leading to some acceleration of unit wage costs. However, the result is likely to be much slower growth of corporate profits rather than a marked acceleration of underlying inflation. We can expect to see the global economic engine slowing as we progress further into 2006, with the tightening of financial conditions around the world and the continuing high level of energy prices proving to be the main headwinds to economic growth.