Christopher Smallwood: Why the hawks need their wings clipped

Are the world's leading central banks on course to overdo the present phase of monetary tightening, leading to a significant economic slowdown next year?

In the US and the UK, as well as in Europe, the stance remains hawkish. The Federal Reserve, having "paused" last week following an unbroken series of interest rate rises which began in June 2004, none the less left open "the extent and timing of any additional firming", indicating that the bias towards tightening remains.

The Bank of England's Inflation Report predicted that inflation would fall back to the 2 per cent target here only if interest rates were to rise again, as clear an indication as you could have that a further base rate hike to 5 per cent is more likely than not.

The European Central Bank, implementing yet another base rate rise the previous week, commented that monetary policy "remains accommodative" and that the remaining degree of accommodation "would continue to be removed" - central bankers' speak for more rises on the way.

Even the Japanese central bank is getting in on the act. What we are witnessing is a general concern about rising inflationary pressures, which central bankers are adopting a united front to contain. They have put rates up, and they are going to do more.

Yet given the lags with which interest rates operate - it takes anything up to two years for the full effect of changes to come through - there are real dangers that the effects of further rate rises now will only accentuate a slowdown which is already on the way in the United States, and which is set to spread from there to the rest of the world.

Of the three central bank decisions on interest rates this month, the most surprising was the Bank of England's. It was certainly not widely expected in the City, as evidenced by the sharp movements in sterling and bond yields as soon as the decision was announced.

It is not difficult to see why many City economists were more sanguine than the Bank about the longer-term inflation outlook. There is not much doubt that reported inflation will rise in the next few months, given the price hikes already in the pipeline. Higher oil prices will raise the price of a litre of petrol still further; the drought will push up food prices; electricity and gas bills have further to go; and higher university tuition fees will also have an impact. But these are all temporary effects - even the rise in oil prices, as long as it does not carry through to wage pressures or inflationary expectations more generally, and there is little sign of this at present.

The Bank is supposed to look through short-term developments and set interest rates in accordance with a two- or three-year view of the relationship between demand and capacity in the economy as a whole, reining back demand with higher rates if it shows signs of racing ahead of capacity, and conversely.

On this longer timescale, the Bank still expects demand to remain buoyant in relation to slightly reduced estimates of capacity, a view that assumes some recovery in consumer spending, and what to my mind seems a remarkably sanguine view of the international outlook.

The Inflation Report's projections assume that "US growth over the forecast period remains reasonably robust" and that "vigorous growth in Asia will continue to support the global expansion".

Now nothing is certain in economics, but there do seem to be strong reasons to suppose that the US economy will weaken significantly during 2007, and that this will affect growth in Asia, the European Union, and the UK as well.

US growth has been driven for many years by rampant household spending, but fundamental changes are bringing this to an end. The main one is a slump in the housing market. With real incomes having grown slowly for some time, the momentum of consumer spending has been maintained by equity withdrawal. Now, however, median house prices have stopped rising, housing starts are declining and, as the first chart shows, sales of new homes are in freefall. Not surprisingly, equity withdrawal is dropping sharply.

Purchases of consumer durables, closely related to housing transactions, are already dropping, and under the weight of stagnant incomes and higher interest rates, consumer borrowing has been declining in real terms.

As the impact of the long rise in interest rates illustrated in the second chart continues to come through, the glut of housing and consumer durables can only increase and consumer borrowing remain subdued. Add in the depressing effect of higher oil and petrol prices - which have risen proportionately far more in America since petrol is much more lightly taxed - and a prolonged slowdown in consumer spending is very much on the cards. The main engine that has driven American economic growth could well cut out.

If US growth does not "remain robust", as the Bank expects, Asian growth will not be so vigorous either. China is turning in another stellar growth performance this year, but this has been driven to an important extent by an exploding trade surplus - 50 per cent higher in the first six months of 2006 than in the same period last year.

According to Diana Choyleva of Lombard Street Research, exports account for 30 per cent of total employment in China, and America is the main consumer of China's exports. A consumer-led slowdown in the US will clearly knock away a vital prop of China's expansion.

The EU's tentative expansion - already under threat from rising interest rates, higher oil prices and, in Germany, higher taxes - would be unlikely to survive a downturn in America, especially since one result is likely to be renewed dollar weakness against the euro, pricing European exports out of American markets.

It must be obvious that the UK cannot be immune from simultaneous slowdowns in its most important regional market (Europe) and its most important national market (America). If the American consumer is finally running out of steam, as a gathering body of evidence now suggests, the base rate rise which has just gone through here will appear in due course to have been unnecessary, and any further rise distinct overkill.

My guess, however, is that, such is the power of "the news", the increases in the inflation numbers which are due to hit us over the next few months will indeed produce one more round of rate increases, not only here but in America and the eurozone as well.

As it becomes clear that the factors driving the figures up are only temporary and that a major slowdown is under way, the bankers will move smartly into reverse, cutting rates again through next year. But by then it will be too late to head off the downswing.

Christopher Smallwood is a director of Lombard Street Associates