The case of the amazing disappearing boom

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The Independent Online
The industrialised world has re- entered a period of growth after the recession which began in the United States in 1990 and rolled around the Organisation for Economic Co-operation and Development. The last declines in GDP were recorded in Germany in the fourth quarter of 1993.

According to the most recent data, all countries are now growing. In the spring of recovery, the young investor's fancies lightly turn to thoughts of a boom and rising inflation - with equinamity, perhaps, if he's an equity man, with apprehension if his business is bonds.

This turn of mind is encouraged by the statements of politicians that all is set fair for growth. Given the international competition among central bankers to show the hairiest chest over inflation, there is a widespread expectation that interest rates, already up in the US, will soon rise elsewhere.

Interest-rate futures markets reflect this mood. German three-month rates are expected to rise some 60-70 basis points over the next six months, while in the UK a rise of about 190 basis points is predicted.

Yet there is not much support for these predictions from economic forecasters. Consensus Forecasts, August 1994, Consensus Economics predicts growth will be slower in the English- speaking countries of the OECD in 1995 than in 1994, with significant slowdowns in the US and Australia, while the UK and Canada will grow at much the same rate in each year.

High real interest rates and a general move to fiscal restriction support this forecast, while private investment to GDP ratios remains historically high in Europe and Japan, suggesting any investment upswing will be limited.

Admittedly, the forecast growth rates for 1995 are a touch over trend, although not a great deal. And if two years of slightly above-trend growth cannot be managed without triggering meaningful inflation, things would be sad indeed.

The consensus forecast does, however, predict a modest pick-up in inflation in English-speaking countries of the OECD in 1995, of about 1 per cent. Meanwhile, in Continental Europe growth is expected to pick up in 1995 at a modest rate or just over trend, while inflation is not projected to rise at all from very low rates. A similar scenario is expected for Japan.

Markets are telling the economists they are being too pessimistic about growth or too optimistic about inflation. If the forecasters are right, policymakers should relax and investors should buy interest-rate futures. After all, real short-term interest rates are about 2 per cent in Germany, where inflation is still falling, and more than 3 per cent in the UK and France.

That is generally higher than the level to which five cuts have brought US real rates. Moreover, in the UK at least, given that the recovery started in 1992, one would normally expect 1993, or perhaps 1994, to be the year of fastest growth, especially as more tax increases are scheduled for next year.


Who is right, though - the forecasters or the markets? The answer may come in the next month or two. Evidence is accumulating that the US is coming out of the growth spurt that started in the second half of last year. And some data hints at a similar moderation in the UK.

There has been no gathering momentum in industrial production in the US or UK. Indeed, if anything, there has been a loss of momentum this year. In France, there has been a clear slowing since the end of the first quarter. Only Germany appears to buck the tendency in the past few months with a pick-up in the growth of manufacturing production.

Retail sales show a similar picture (see chart). There are clear signs of a slowdown in the US. The UK slowdown since April (the start of the new tax year) appears to have been only temporarily interrupted in July, as the second chart shows.

There was exceptional strength in food sales in July, probably weather- related. UK retail sales, excluding foodstores, actually fell in July. French retail sales are slowing fast. There is no slowdown in the German data, but there is no growth either. Retail sales have been flat or lower throughout 1994 and, given flat or falling disposable incomes, stand little chance of improving.

This picture of a gradual loss of momentum of retail spending is supported in each country by data on credit growth, money supply and surveys of distributive trades. There is no boom on the way. The situation is of steady growth or deceleration.

The picture from leading indicators is consistent too. In the US and France, the OECD's composite leading indicator has clearly turned down. In the UK, it has wobbled but now continues up, although at nothing like the rate of last year. Only in Germany does the leading indicator point upwards with undiminished slope.

If that seems to suggest that Germany, the laggard in the current cycle, is about to become the locomotive, forget it. German final demand, especially consumer spending, remains weak. German output growth has been triggered by net exports and is being sustained by inventory building in and since the second quarter.

Strictly speaking, German companies are not building up inventories; they are just running them down more slowly than last year, but that contributes to growth. Since survey evidence is that German companies still think inventories too high, there is little chance of inventory-building.

If the growth in the rest of Europe disappoints or even, in some cases, slows down, German output will follow. Given the stance of German fiscal and monetary policy, Germany is irredeemably a follower of demand developments elsewhere and not a leader. It has shown an impressive ability to maintain competitiveness and benefit from growth elsewhere, despite a higher real exchange rate, but it has shown no sign of generating demand growth.

If economic data in the months ahead confirms the picture of moderate growth and stable inflation, the chairman of the Federal Reserve, Alan Greenspan, and the Chancellor, Kenneth Clarke, can relax and leave interest rates alone while the Bundesbank could return to a policy of letting money market rates inch down. It might, however, take a long time for all that to affect the bond markets. Bond-holders have been so badly burnt this year, and the belief in an economic cycle and the inevitablity of inflation is so strong, that they will take longer to convince.


A halt to rate hikes in the US, and no change in the UK, risks being seen as a temporary reprieve. Further German rate cuts will be seen as the last ones in the cycle, even a 'bridge too far'. It will take a longer run of moderate data to convince people that growth is likely to be not far from trend in the next year or two. In most industrial countries, that trend is about 2.5 per cent. At such rates, corporate demand for funds will remain low, given mediocre investment rates and good cash flow. Governments will therefore have little competition in their borrowing, which will continue to be substantial even if declining in relation to GDP.

Moreover, it will take as long or longer to persuade investors that inflation will pick up only slightly from current rates, ranging from 1 to 3 per cent. Nominal GDP growth could hover around 5-6 per cent in many countries. That makes bond yields above 7 or 8 per cent in core countries with solid exchange rates look cheap. Unfortunately, there is no reason why they should not look cheap for a long time to come. Current hysteria about short-term interest rates should be dissipated quickly. Getting long-term rates down could take a lot longer.

(Graphs omitted)

The author is chief economist at Lehman Brothers, Europe