Hamish McRae: Reports of global economic meltdown have been somewhat exaggerated

Is this just a mid-cycle pause, albeit a rather deep one, or are we catching a glimpse of something more alarming?

It does not matter whether you look at the UK economy or the global one: there has been a clear loss of momentum in recent weeks. The slowdown has been particularly evident here in Britain, partly because the UK was running closer to capacity than most developed countries and partly because we therefore saw an earlier tightening of monetary policy. But the US is increasing its interest rates now and faces similar problems of indebtedness, and the only reason the European Central Bank has not increased rates is that domestic demand has been so weak in much of the region.

To this general slowdown have come the specific blows of the rise in oil prices and Hurricane Katrina. The former affects everyone, the latter - in the first instance at least - mainly the US. But the world economy is so interdependent that were the US to slow significantly, this would also feed through to the rest of the world. So we are all in this one together.

The evidence, as usual, is mixed. Intuitively, it feels too early to be calling the top of this cycle. Looked at globally we are only four years into the expansion phase, which historically would put us about halfway though it. There are signs of strong health; for example, the surge in profitability and productivity of US companies. There is some slack in most economies, and an enormous amount of it in three of the G7 countries: Germany, Italy and Japan.

These positive factors have helped support share markets, which have now recovered a large part of the ground lost since the peak in 2000. Here in the UK the mid-cap index is around its all-time high, though the FTSE 100 index still has some way to go.

On the other hand, three out of the past four world recessions have been triggered by a sharp rise in energy prices, the exception being 2000-2001 which was set off by the collapse of the communications investment boom. In the UK and US consumers are heavily indebted, so indebted that in the UK the Bank of England has been pushed into its first cut in rates. And no major developed country has much leeway in fiscal policy and hence little ability to pump up demand by going further into deficit.

You can see some of these signs of strain in the graphs. Property repossessions have risen sharply, though they are not yet at the level of the previous housing crisis in the early 1990s. Household debt service payments are higher now than at any time since Labour came to power in 1997. And growth in retail sales is also down to about its lowest level since then.

It is impossible not to note also the relationship between house prices and consumption. You don't need a fall in house prices to check the ability of consumers to justify further borrowing to fund current consumption; all you need is for prices not to continue to rise, which seems to have happened.

One could add further concerns: unemployment is on an up-trend, albeit from a low base. And the impact of higher petrol and other energy prices has yet to move right through the system. We see the impact at the pumps but not yet in prices in the shops.

Finally, just for completeness, note that the great current account imbalance between the US and the rest of the world gets ever greater. At some stage that has to stop widening.

Anyone trying to make the case for us nearing the end of this cycle has to explain why markets are unfazed by all this. I think the main answer is that share prices are quite undemanding at present levels. When compared with bond prices, which have been depressed by the flood of liquidity created by the central banks, share prices are rather good value.

Put all this together and what emerges, surely, is a picture of an expansion that is under a lot of strain but not one that is going to be toppled just yet. If you think about it, a mid-cycle pause is exactly what ought to happen to a strong but skewed period of growth. It needs a pause because if there isn't to be one, the imbalances would just get worse and worse and the end of the growth would be more damaging as and when it did eventually come.

So how long does this pause last? My guess is that it will need a couple of years of below-trend growth in the fast-growing economies, in particular the US. The UK will share this experience. In fact we are already into a period of below-trend growth, with the big number this year probably being a one rather than a two: growth of perhaps 1.8 per cent.

The UK is quite important in terms of global demand - the world's third-largest importer - but what is really needed is for the US to grow below trend for a couple of years. What are the chances of that?

Katrina will hit growth this quarter but all our experience of the economic impact of natural disasters is that any output that is lost is quickly made up. So do not expect much of a lasting impact from that.

Expensive petrol, on the other hand, will take demand out of the economy: self-evidently money spent on filling up cars and trucks is money not available for other purchases, including imported goods. In the short term the increase in the oil price makes the US trade deficit worse. In the medium term it is neutral, as it damps down economic activity (and hence demand for imports) more generally.

It is plausible at least that the US will experience a couple of years of rather slower growth, though this is not yet in the mainstream forecasts.

A rather sensible view on this comes from the Bank Credit Analyst people in Montreal: their latest judgement is that "global economic activity is set to moderate, not melt over the next two or three quarters". They add that there might be some temporary relief from lower oil prices, which will help support activity for a bit.

However, if the pause is just that, then it won't do much to correct the imbalances. So we will head into the final part of this cycle with less fuel in the tank. The longer and deeper the mid-cycle dip, the more likely it is that the second phase will be strong and sustained. If trend growth is resumed after only a few months, then the final two or three years of the growth cycle will be more muted.

The bottom line is that an expansion puffed up by the US Federal Reserve's policy of cheap money - in real terms, free money - is bound to be less healthy than an expansion driven by broadly based global demand. That is what we have got and that is why it is faltering at the moment.

However, that does not mean it is over. Expect a pause now and reflect on the likelihood that the longer the pause, the greater the chance of a decent few years or more of balanced growth to follow.