'Goldilocks effect' is set to continue throughout the next year

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The Independent Online

Anyone studying the predictions issued by geopolitical commentators over the New Year would be forgiven for thinking the Four Horsemen of the Apocalypse were coming over the horizon at once.

The war on terror is bogged down in Iraq and Afghanistan and threatens to turn into a quagmire for US hopes for peace in the Middle East. Iran's nuclear ambitions highlight disunity among the major powers. Russia's oil and gas ambitions pose a threat to the West's energy security while the uncontrolled economic boom in China is doing the same for employment.

And that's before we consider the impact of rising temperatures on the world's breadbasket. In fact the prognostications are gloomy in all areas bar one - the financial markets. The forecasts are for a continuation of the so-called Goldilocks economy - economic growth won't be so cold it feels like a recession nor so hot that it stokes inflation.

This is true for the major industrialised economies and for the UK in particular. The International Monetary Fund has another year of red-hot global growth at 4.9 per cent, thanks to the super-cycles in China and India. Even the advanced economies are forecast for a respectable 2.7 per cent growth after 3.1 per cent in 2006.

Financial markets are also pricing in little risk of the major upset expected on the political stage. "Risk is very cheap at the moment across all markets in that markets are very sanguine at the moment," said Adam Cole, senior currency strategist at RBC Capital Markets.

While no one is forecasting a crash, the economy will, however, feel a little cooler this year, especially in the West. The UK Treasury's survey of leading independent economists shows they are expecting a slowdown albeit not a dramatic one. Growth is forecast to slow to 2.4 per cent from an expected 2.8 per cent for 2006.

Inflation, which was the big story of 2006, is expected to revert to the Government's target this year opening the door to the cut in interest rates that a third of those surveyed expect.

The growth forecast is far below the Government's forecast of between 2.75 and 3.25 per cent. The big difference is on the outlook for consumer spending. While the Treasury is betting on growth of around 3 per cent, the City is expecting something nearer 2.5 per cent. Given it makes up two thirds of the economy that difference has an impact.

Howard Archer, the chief UK economist at Global Insight, expects consumer spending to rise by 2.3 per cent, which would be the weakest since the mid-1990s apart from a sharp slowdown in 2005.

"This is due to the major headwinds that consumers face - high interest rates, elevated utility bills, moderate real earnings growth, an increasing tax burden, rising debt levels and pension concerns."

George Buckley, the chief UK economist at Deutsche Bank, that expects growth to slow to 2.3 per cent, says this slowdown would open the door to cuts in interest rates.

"Economic growth in the UK will run broadly around its trend rate in the first half of 2007, but then fall into rate-cut territory by the end of the year and requiring 50 basis points of easing by around the turn of 2008," he said.

Mervyn King, the Bank's Governor, always advises watchers of its Monetary Policy Committee to identify where the risks lie.

For Mr Buckley, the key negative risk is from US growth, which Deutsche expects to halve to 1.7 per cent this year, prompting the Federal Reserve to cut rates by a full percentage point during 2007. But he acknowledges there are upward risks to inflation and interest rates from rising house prices and inflation-busting new year pay settlements.

Lombard Street Research believes house prices are set for another strong price rise of between 10 and 15 per cent this year. "On our estimates the UK as no spare capacity and with growth likely to expand above trend, the positive output gap may widen and domestic inflationary pressures will continue to build," said Jamie Dannhauser, one of its economists.

Many analysts believe the inward flow of migrant workers into the UK will continue to hold down inflation by putting a lid on pay rises in key sectors.

Economists expect another large rise in public borrowing over the fiscal year, which has been declared by the Treasury the first of the new economic cycle.

The current cycle, which will be used to judge whether the UK has met the golden rule of balancing current spending over the cycle, will end some time in the next few months. The City expects the Treasury to meet the rule thanks to three redefinitions of the timing of the cycle with only a few billion to spare.

"Without large inherited surpluses going into the next cycle, Brown's successor will have to rein in government spending to avoid breaching the Golden Rule," said Matthew Sharratt, UK economist at Bank of America.

"The evidence to date shows that the Government is finding it difficult to lower spending following years of plenty."

But that will be an issue for the next Chancellor of the Exchequer who will take over after Gordon Brown. Barring late upsets, he will be able to claim to be the first Chancellor to quit on a high note since Roy Jenkins or Geoffrey Howe.

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