Europe and Japan lead solid growth

Emerging countries’ growth will slow steadily and a tightening of monetary policy will push interest rates up in advanced economies, but the health of the global economy looks good.

The global economy has continued to grow at a robust pace, with a strong showing from emerging and developing countries and with above-trend growth in Japan and Europe. Meanwhile, the American economy has bounced strongly after a weak first quarter, but problems in the housing market and pressures on household finances suggest that it will be well into 2008 before a sustained acceleration gets underway.

This produces some contrasts in our GDP growth forecasts outlined in the table. The projections for developing countries are upgraded given the strong momentum seen in countries such as China and India. However, China is continuing to make a series of tightening moves in the form of interest rate rises and increases in bank reserve asset requirements.

Elsewhere, tighter global monetary conditions may make life more difficult for those countries that rely on external finance rather than domestic savings to support a high level of capital spending. Overall, our forecasts continue to incorporate the view that growth of the emerging and developing countries will slow steadily from the pace of the past few years while remaining robust by the standards of earlier decades.

The outlook for the main advanced countries as a group is a bit different. Growth in 2007 and 2008 may run slightly below the 2.5% pace of the last decade, reflecting the subdued picture in America and the tightening of monetary policy elsewhere.

That tightening is once again pushing up the average level of real interest rates, as illustrated in the chart. Nonetheless we look for some acceleration of growth in 2009, as American economic activity strengthens and assuming that risk appetite stays reasonably strong on the part of corporate and financial investors.

Taking a closer look at America, growth is expected to stay fairly subdued for several quarters as the economy rebalances away from its earlier consumer-led strength in favour of exports and business investment. Sustained faster growth should be possible once the housing market correction is complete.

On the inflation front, core measures have been well behaved in recent months and the one most closely monitored by the Federal Reserve – the core personal consumption expenditures deflator – should remain in the 1%-2% comfort zone at least for the next few quarters.

However, headline inflation measures are less reassuring, having been boosted by petrol and food prices. In our view, the window of opportunity for a Fed rate cut looks to have closed and indeed we see rates on hold at 5.25% over the next 12 months with the possibility of a hike in the second half of 2008.

Meanwhile, Japan’s economy is expanding robustly. However, with the labour market fairly tight, this suggests that continued robust growth will put upward pressure on wages, in turn supporting consumer spending but also implying weaker profits and a return to positive inflation. GDP growth may reach 2.6% this year but we expect an easing back to a sustainable 1.5%-2% in 2008 and 2009 as business investment slows.

Although consumer price index (CPI) inflation is likely to remain around zero or marginally negative until the autumn, we expect an upward move by 1.0% in 2008 and 1.2% in 2009. At some point the pace of interest rate rises is likely to accelerate.

Back in Europe, the euro area economy has continued to grow at an above-trend rate, shrugging off the headwinds from the German VAT hike and the slowdown

Shows weighted average level of G7 real interest rates, calculated using core inflation measures, to June 2007.Source: Swipin America.

However, we continue to expect activity to moderate slightly over the next year as the impact of higher interest rates and the strong currency begins to be felt. After growing at an above-trend rate of 2.8% in 2006, GDP growth is forecast to remain robust at 2.6% in 2007 before slowing to 2.1% in 2008 and 2009.

Headline inflation is likely to move back above 2% in the second half of this year as energy price base effects shift from being a favourable to an unfavourable influence. In this environment, the European Central Bank is likely to continue hiking rates, to 4.5% by the end of this year.

At home, the British economy remains buoyant with growth of 2.9% likely this year. However, in light of the hawkish stance adopted by the monetary policy committee (MPC), we now look for a distinct slowing to 2.3% next year followed by a re-acceleration to a 2.6% pace in 2009.

Our inflation forecasts show the CPI rate averaging 2.4% this year before easing to 1.9% on average in 2008. In our view an increase in interest rates beyond 5.75% is unnecessary given the prospect that the economy will soon start to slow and companies will find it harder to make price increases stick. However, an impatient MPC may push rates beyond that level over the next few months.