Hamish McRae: Elections, oil, the weak dollar: don't expect 2005 to be more than OK

If the Chancellor's sums are as wrong as many people fear, the post-election economic policy tightening could be quite nasty

It looks very much as though 2004 will be a good year for the world economy - a secure recovery without any surge in inflation. But in recent weeks there have been more and more rumbles about 2005, some of them loud enough to be a cause for concern.

It looks very much as though 2004 will be a good year for the world economy ­ a secure recovery without any surge in inflation. But in recent weeks there have been more and more rumbles about 2005, some of them loud enough to be a cause for concern. The general perception seems to be that while 2005 need not be a disaster ­ it would be ridiculous to suggest that from this distance ­ it will be tougher.

Here in Britain this would translate into a lack of the feel-good factor, as reflected in evidence to the Select Committee, that that would obviously be bad news for the Government. But that is to see the outlook through a rather narrow prism. What matters most is whether the world as a whole prospers: if it does well, we as a particularly open economy will benefit, just as if it does badly we will be among the first to suffer.

The various City economists are now starting to make their first stabs at what might happen in 2005. As a starting point I have been looking at some forecasts from Deutsche Bank, which are summarised in the first chart. The most obvious point is the very different performance of the different regions, with Asia streaking ahead and the eurozone languishing. Less obvious but more disturbing is the fact that the forecasts for GDP growth in 2005 are lower than those for 2004 in every case bar one, the exception being the eurozone.

The history of this sort of medium-term forecast is, it has to be said, pretty bad. None of the mainstream forecasters predicted the recessions of 2001-2003. Indeed even a year ago, the official forecasts for Germany and France had growth of between 1 and 2 per cent, whereas the German economy shrank last year and the French one barely grew at all. But these figures are both brave and helpful, for the Deutsche Bank team has identified, I think correctly, the nature of the pressures on 2005.

One obvious pressure, that from rising interest rates, is shown in the next graph. These are long-term rates, not short-term ones. Short rates can of course be controlled by the monetary authorities ­ there is incidentally a buzz about that the European Central Bank is preparing for a cut in the coming weeks ­ but long-term ones can't. Growth though the downward part of the cycle has been supported by cuts in short-term rates but also by the fall in bond yields (see next chart). But now Deutsche Bank thinks there will be quite a sharp rise in US 10-year yields and a rather more muted one for euro yields.

One should not be too disturbed by this: after all, if growth does indeed pick up this year you would expect there to be more inflationary pressure and both short and long rates would pick up in response to that. But higher rates will take the edge off growth. The euro area is forecast to do better next year than this, but would still be growing at half the rate of the US. In a way it is expected to do better only because it has so much room for improvement.

If this outlook proves right, it is reasonably good news. Looked at from a global perspective the growth is better balanced and, as such, should be more sustainable. But there are risks. The bottom graph highlights one of these: a rise in oil prices. The consensus forecast for the average price of Brent crude this year, according to a Reuters survey, is $26 a barrel. When the survey was published the price was $31 a barrel. But forecasters consistently underestimate the price of oil: they have been too low for the past five years. If you look at the general pattern of prices through the first part of this decade vis-à-vis the prices in the 1990s (third graph) you can see the general pattern has been for it to be in the 20s rather than the teens. The absolute peak was higher in the 1990s, when it went above $40. But it did not stay high for long.

There seems to have been a fundamental change in the oil market. Deutsche Bank identifies as causes the weakness of the dollar, rising geopolitical risks and rising instability of global weather patterns.

The first is less of a concern, at least for the non-dollar world. In euro or even sterling terms the oil price rise has remained quite muted. In as far as a higher oil price simply reflects a weaker dollar, that is America's problem. If China is worried about expensive oil it has the obvious remedy of allowing the yuan to appreciate against the dollar. Ditto Japan and the yen.

As far as geopolitical risks are concerned, I'm not sure there is much that can sensibly be said except the narrow point that uncertainty about security of supply is encouraging stockpiling and the broad point that general confidence is being undermined.

As for the weather, well, we might actually have a more normal year, even if the general cycle of world weather is becoming less stable. But we might not.

There is a further point. This is an election year in the US and 2005 will presumably be the election year in the UK. Whatever happens in the US, once the election is over, it is reasonable to expect economic policy to tighten. This may happen willingly or it may be forced upon the Administration. Here, once the election is over, much the same will happen. If the Chancellor's sums are as wrong as many people fear, the post-election tightening could be quite nasty.

All these points are grounds for expecting 2005 to be a cooler year than 2004, but nothing more dire than that. Could there be something else that we are all missing?

To answer that is to round up the usual suspects. The twins at the top of the list must be a bump in China and US growth finally running out of steam.

At some stage in the next five or so years something is going to go wrong in China. Growth cannot continue at its present rate without there being an accident of some sort, particularly given the indebtedness of the banks and the reliance on the US consumer market. But no one can know what and when.

The US too has been relying on borrowed money. The issue here is whether the debts, both national and personal, can gradually be worked off without serious damage to growth. There is a danger but it is hard to gauge how serious that is.

Since those two countries supply two-thirds of world growth, their futures are the things that matter most. The sad truth is that somewhat better economic performance in the UK, however agreeable for us, is not going to help the rest of the world very much. And a further sad truth is that it is very hard to see the eurozone contributing much additional demand, even if it performs slightly better than it has in recent years.

What I think can be said with confidence is that 2005 may well turn out to be an OK year for the world economy; but it is not going to be a really good one.