Hamish McRae: The rate-setters must restrain growth now, before it booms and bows out with a bang

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The Independent Online

Over the past month, there has seen a shift in mood about the direction that both the British and world economies are likely to take in the next year or so. For us in the UK, the principal change is that the next movement of interest rates seems likely to be up, not down. For the wider world, the change is that the peak in global interest rates may turn out to be higher than the markets expected.

This raises questions about the durability of the present growth phase of the world economy, the likely combination of factors that might bring it to an end and, I suppose, the nature of the ending - a whimper or a bang?

What seems to be happening is that the world economy is more resilient to higher energy prices and rising interest rates than most people thought. If anyone had known 18 months ago that the oil price would reach $70 a barrel, they would have expected a sharp slowdown in global growth. Most of us thought last summer that the rises in UK interest rates had stopped the housing boom and that prices would move sideways for some time.

That has proved wrong. The world economy has carried on expanding. The US has had very good growth in the first three months of the year. So has Japan. European growth is at last picking up. China and India continue to storm ahead.

The European story is important because the big three eurozone countries have been weak performers and that has held down interest rates. But now Germany, the weakest, is predicted by the German Federal Statistics Office to have 1.8 per cent growth this year. That may not sound a lot - it would be the same as Britain had last year and we were pretty miserable about it. But it would be Germany's best performance for six years and would clear the way for the European Central Bank to do what it would love to do: push up rates to try to curb inflation in countries such as Spain and Ireland.

Meanwhile, the British housing market seems to have recovered its confidence and is moving ahead again. Mervyn King, the Governor of the Bank of England, warned last week about the over-valuation of property prices and the extent to which some people faced difficulties servicing their debts. The conclusion could only be that we should prepare for higher rates.

The most important decisions, naturally, will come from the US Federal Reserve. As expected, it has just lifted rates to 5 per cent and the issue is whether that will be the peak - as the markets expected a month or so ago - or whether more increases are in train. The new chairman of the Fed, Ben Bernanke, has sought to keep the markets unsure of his intentions. Now it is thought that while there may be a pause, further rises are possible.

Step back from the minutiae of central bank decisions and focus on the big picture. The first graph shows the extent to which global capacity is shrinking - the output gap as calculated by the OECD. You can see the three recessions of the early 1980s, 1990s and 2000s, together with the twin peaks of the late 1980s and late 1990s. Two cheering observations: the amplitude of the cycle seems to be diminishing and we have not yet crossed into excess demand. But to stop another drift into excess, we ought to be tightening now.

In other words, to damp down the amplitude of the next global cycle, central banks have to lean against it early. That raises difficulties for financial markets as well as those of us who are over-borrowed. Legal & General, which used this graph in a recent investment presentation, concluded that risks were rising for global assets and that "boring is best" was the right investment strategy. In the past few days, markets seem to have been taking on this message and showing more concern than they were a month or so ago.

What might this mean for monetary conditions in the UK? There are, as always, a variety of views. The right-hand graph shows how the mood of both service and manufacturing business has improved since the middle of last year. If the relationship between these results and GDP growth is maintained (on the graph, the figures have been advanced three months), there should be a further speeding up of growth through the next few months. The economics team at ING, drawing attention to this, acknowledges that there is no longer a case for any rate cuts. How far they might rise is another matter. The market as a whole is now predicting another 0.75 per cent (to 5.25 per cent) and some expect more than that. Others, such as ING, accept there may be a pre-emptive rise of 0.25 per cent this summer, but they also think that rates may well be coming down again next year.

Actually, anyone wanting to know what will happen to UK rates should look at the housing market. On paper, the Bank of England reaches its decisions on rates after learned deliberation about the long-term trend of inflation, bearing in mind the requirement to meet the target of a 2 per cent annual increase. But if you want a shortcut, look at housing. If the economy does pick up speed, as the right-hand graph would suggest, that would put pressure on property prices and we will duly get higher rates to ward off the incipient boom.

The tone of our economy will depend, however, on global growth. That leads back to the matter of the output gap.

The world's central bankers do not want to make the same mistake as they have in previous cycles, when they tightened policy too late. Conditions are very different in different parts of the world, but as a rule, if they want to avoid letting things get out of hand, as happened in the late 1980s and late 1990s, they have to keep moving now. It is crude, I accept, but we are at pretty much the same point in the cycle as we were in 1987 and 1998. So there is still time.

Even if the central banks keep pushing up rates, there will still be another two years of growth. Maybe, maybe, maybe, they will succeed in smothering a rerun of previous booms. Maybe the present growth phase can end in a whimper rather than a bang and let's hope it does.

But to expect the developed world's central banks to get things exactly right is asking the impossible, especially as this will be the first cycle when China, India and, in a slightly different category, Russia have had such a gig influence on global growth. Meanwhile, the message to Britons is: watch the housing market.

What we need are European champions

Will European countries really allow businesses to become more closely integrated if the price is a loss of control over their national champions?

It is a question that has come to the fore in recent days, with a burst of cross-border take- overs and mergers and a corresponding bout of nationalistic sentiment. The question, I suppose, is whether continental Europe is prepared to take the hands-off attitude that we have chosen in the UK.

One area of activity is banking. In the UK, Abbey was taken over smoothly by the Spanish group, Santander. In Germany, the Bavarian bank HVB was bought by the Milan-based UniCredit. But concerns were raised in Poland when UniCredit bought a medium-size Polish bank and wanted to merge it with what it already owned. The deal was only allowed to go through after some strict conditions were imposed. Still, the fact remains that Poland's largest bank is controlled by an Italian one.

Another area of consolidation is energy. Britain does not seem to mind having a large chunk of its generation done by Electricité de France but on the Continent, concerns about national control are bigger. The French government sought to shut out foreign bids for its energy suppliers by engineering a merger between Suez, another utility, and Gaz de France.

Further to this pan-European consolidation, European assets have been gettng a lot of interest from outside - witness the Mittal Steel bid for Arcelor and maybe a bid from the Russian Gazprom for Centrica.

Angela Merkel, the German Chancellor, put the case for EU businesses linking up last week when she said: "I am convinced that we will only be able to use the opportunities offered by an internal market if we decide to develop European champions."

Three points need to be made here. One is that had there not been pressure for mergers, there would not be pressure for protectionism. That economic logic seems to be pushing for consolidation is, in a way, a sign of confidence within Europe.

The second is that it is hard to see the logic in distinguishing between different sectors of the economy. The US prevents foreign companies buying its airlines on the grounds of national security, but who would want to buy most of them? Banking is arguably slightly different to other industries because the dangers of bank failure would hit the entire economy, not just part of it.

And third, maybe more mergers are what continental Europe needs to lift its performance. The UK has surely benefited from foreign expertise. Would we be outperforming the eurozone without it? I think not.

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