Hamish McRae: The economy's strong, so why be grumpy?

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It sounds almost too good to be true. The economy growing at an annual rate of 3 per cent; the pound within a whisker of two dollars; and the Governor of the Bank of England suggesting that inflation - which has just led to an unexpected rise in interest rates - may well fall quite sharply in the next few months. And if it is true, why do people feel grumpy?

There have been a number of pieces of new information in the past few days about not just the British economy but also the world economy. Added together they suggest that fears of a global slowdown this year have receded. Insofar as there is a global threat to growth, well it seems not so likely to be felt in 2007, while the UK economy seems competitive enough to be able to continue to benefit from the growth on offer.

Most obviously we have just had the GDP figures for the final quarter of the year, showing that growth seems to have picked up a bit in the final three months of the year. That is mostly thanks to a continuing surge in services output, although manufacturing may have picked up a tiny bit too (see first graph). It is always harder to measure services output than manufacturing and these are just the preliminary figures. But this solid growth would square with the latest employment data, which have also been quite strong, and a not-too-bad Christmas season in the shops. So no evidence of slowdown yet.

This pattern is reflected elsewhere. In the US the weak housing market has flattened consumption a little but not by as much as many expected. On the Continent it seems that the effect of the VAT in Germany is not as serious as feared, and last year the country had its best growth since 2000. China and India both seem to be putting on a spurt. If the world economy can manage record growth when oil prices hit $80 a barrel, what can it achieve now that they have come back to $50? That is another quite surprising piece of global news: the ability of the world economy to grow swiftly without putting more evident pressure on resources.

Within this growing global economy the UK seems to be doing quite well. We are uneven, with parts growing exceptionally fast and other parts lagging. That will continue to be a concern, especially because we have, obviously, a single interest rate for the whole country. Parts of the UK will be able to brush off that last rise in rates; for others it will be a concern.

It will be a particular concern if there are further increases. Here the professional interest rate watchers are split. Ahead of Mervyn King's speech most expected one more increase, maybe two. Now some think we may be at the peak. The market last week was pricing in a rise to 5.75 per cent. (You can calculate what it expects the Bank will do in the future by looking at the different pattern of longer-term interest rates.)

If rates do rise again, either once or twice, what does that do to the pound? One quite good guide to the exchange rate is differentials between the sterling interest rate on the one hand and the dollar and euro rates (see other graph). Capital Economics, who put this together, only expects one more rise in interest rates, points out that the change in interest rate expectations has been larger than changes in US and European expectations and suggest that this is why the pound is at its highest level since the present sterling trade-weighted index was first calculated in 1990.

Pause a moment and think about that last point. Sterling is extremely high, raising all sorts of questions. Is that sustainable? If not, what then? If so, what does it say about the UK economy's competitiveness? Yesterday the pound shaded back a little from the $2 level but it was more than €1.50. So it is not just strong against the dollar because the dollar is weak. It is strong against everything. Yet we have a current account deficit of more than 2 per cent of GDP. While there are no balance of payments figures yet for 2006, it is even possible that the deficit could have risen close to 3 per cent. Nice for Britons be go abroad and feel rich. Not so nice if there is an unpleasant end to it all.

In the short run the level of sterling will continue to be heavily influenced by interest rates, so if we do go up towards 6 per cent and rises elsewhere are more muted, then the pound may become yet stronger. Markets being markets, they tend to overshoot, so a pound above two dollars seems to me to be an odds-on possibility. But long term?

There are two longer-term explanations for the pound's strength and the long-term level of the pound will be determined by their relative importance. One is the inflow of capital into the UK, the other the competitiveness of UK services. The inflow first. Sterling has three great advantages as an investment currency. It is not the dollar. It has a higher yield than the euro. And the UK is an attractive market for inward investment. So we have seen not only a wave of money coming in to take over UK companies but also to invest in UK assets, such as property. That is mostly private sector money. But we have also official flows into sterling assets, diversifying out of dollar ones. Interest rate differentials help on the latter tally, though not so much on the former one.

But relying on foreign inflows carries medium term dangers. Insofar as the inward investment helps the UK economy, that is fine; insofar as it is chasing higher rates, it is less attractive.

The other reason for the strength of the pound is the ability of the UK service industries to charge more to international clients. We have improved our terms of trade: buy fridges and televisions cheaply from China and sell legal and financial services expensively to Europeans and Americans. Manufacturing exports still matter, but in relative terms they matter less to the UK than to any other large economy. Services and other foreign earnings matter more and more each year and fortunately we seem to be able to charge a lot for them. These earnings do not completely cover the visible trade deficit but they are a dynamic element to the economy that gives confidence to the future, and to future investors.

So what is the balance between these two explanations for the strong pound? We don't know. There are other factors in the equation, including oil prices and North Sea output. But instinctively the pound does feel rather too strong at the moment, even if the long-term outlook is positive.

Given all this, why do people feel grumpy? Well, the overall economy may be doing well but real incomes are being squeezed by the combination of the highest inflation since the early 1990s, the high interest rates needed to combat that, and taxation rising as a proportion of national income. There is not much on the horizon that will alter any of this in the near future. Eventually inflation may shade back and interest rates respond. Eventually taxation will stop rising. Meanwhile we are allowed to grumble.

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