Follow bonds to read the recovery

THE next boom - or at least the next mini boom - is in sight, according to the OECD. Its new projections for world economic growth this year and next, 2.6 per cent and 2.9 per cent, are much in line with the consensus forecasts and come as no particular surprise. But they do represent a substantial rise from the OECD projections last December and as such should focus minds on the strength of the recovery, rather than its supposed fragility.

But both the OECD and the other forecasters are confirming what the bond markets had been signalling for three or four months: that the solidity of the recovery would need to be met with higher interest rates. If the authorities in the main countries were seen to be taking any risks with short-term rates, the bond markets would drive up long-term ones. This they duly did.

The interaction between forecasts for the world economy and the behaviour of bond markets raises two important questions. Are the latest forecasts right? And if so, what are the further consequences for financial markets?

On the first, despite the recent poor forecasting record of economists in general and the OECD in particular, it is possible to have some confidence. The OECD may have been too optimistic about the depth of the recession and then too pessimistic about the strength of the recovery, but now its forecasts feel more or less right. In particular they square with the optimistic tone of businesses in the main industrial nations.

The consequences for the financial markets are harder to call. We are talking about a solid recovery, but not one which ought, in most countries, to be straining capacity limits. The US, three years into recovery and with 4.0 per cent growth forecast for this year and 3.0 per cent next, is the only country where it would be reasonable to expect real strain in the next 12 to 18 months. In any case, investment there is racing ahead, increasing the capacity of the economy, and there are few shortages of labour evident.

As for Europe, unemployment is forecast to rise through 1995 to an average of 11.8 per cent for that year. If, with that level of spare labour, the European economies are already reaching full capacity, then we should be worried. The reality is that there should be at least another four years of decent growth ahead.

If there are few capacity problems, what about other influences on inflation? True, the commodity markets have tightened sharply over the past year, with the Economist commodity indicator, excluding oil, showing a rise year-on- year to end May of 31 per cent. But oil is down 13 per cent over the same period, and the rise in non-oil commodities can be attributed to the exceptional depth of the recession; commodities are rising now because they had fallen so far before.

In any case, the bond markets have not only been signalling that a strong recovery is under way; they have also been leaning against the recovery for several months. There is a good example of their impact here in Britain, where the fall in gilt prices has dried up the supply of cheap fixed- interest mortgages, which in turn has helped check the rise in house prices. The big question is whether the bond markets have tightened enough.

On paper they should have. A crude calculation of the real bond yield in both the US and Germany suggests that real yields are at their historic average. Take current bond yields and subtract current inflation: in the US the real yield is about 4.5 per cent; in Germany it is 4.0 per cent. Both figures are in line not only with real yields in the 1980s, but square with typical money yields towards the end of the last century when inflation, in effect, was zero. UK gilts, with a real yield of more than 6 per cent, now look a good buy.

If this line of argument is right, the present malaise in the financial markets is unwarranted. Accept the OECD's bullish projections for the world economy. Note that these confirm the decent recovery that the bond markets have been signalling. But also note that the shake-out in the bond markets this year should be sufficient to keep the recovery under control.

What has happened can be seen as an interesting example of the privatisation of monetary policy. The markets were worried the authorities would not increase short- term interest rates sufficiently quickly as their economies gathered pace, so they pushed up long- term rates instead. The effect was much the same, though the mechanism was slightly different.

If this line of argument is right, we can catch a further feel for the world economy in the months ahead from the bond markets. If they recover and long-term rates drop, they will both be signalling that economic growth is easing back, and encouraging it to pick up pace. If, on the other hand, they fall further, they will both be signalling that the recovery is running too fast, and leaning harder against it.