We may be in for a few surprises

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The Independent Online
A SLOW start, but a strong finish? The first part is for sure; the second - well, we'll see. It is the season for peering ahead into the next year, but for economists this is a bit of a mug's game. For a start, every financial institution worth its salt has its own economic forecasting team which pumps out the stream of none-too-credible forecasts about the various economies which hit us every week. The inevitable result is "forecast fatigue" among those of us who receive them.

Besides, most of the forecasts are not very interesting, for the principal point in them is how they relate to the consensus: do they expect a bit more growth, or a bit less inflation, than the rest? The interesting forecasts are the maverick ones, but they are usually wrong.

Finally, even when an extreme outsider romps home first, there is no certainty that the same forecaster is going to perform well next time. There is a random element in economics, a capacity to surprise, which the conventional forecasts rarely catch. Three years ago, all the main economic institutions predicted both that the devaluation of sterling would lead to a rise in inflation and that it would be a long time before the expansion of the economy would cut unemployment. In fact, there was hardly any rise in inflation and unemployment started to fall almost immediately.

What then are the potential surprises in store in the world of economics? What do we know pretty much for sure and where might we be taken completely by surprise?

Start with Britain. The mid- cycle pause is a fact. After nearly 4 per cent growth in 1994, the economy was growing at only about 2 per cent in the second half of 1995. That is an average, of course, and conceals big differences in different parts of the economy. Services will have gone on growing at perhaps 3 per cent a year, but some of the more volatile industries, such as construction, may even be back in recession. The housing market is flat at best. True, it felt like a buoyant Christmas in the stores, but, given the slow half of 1995 and the slow growth of export markets on the Continent and in the US, it would be very odd if growth in the new year picked up right away. So expect a few months more of slowish growth, and continuing concern about this to be reflected in all sorts of ways.

The mainstream expectation is for growth to pick up in the second half of the year, making this the normal sort of pause which does occur quite often in the middle of a period of strong growth. Exactly that did occur in the mid-1980s, as the graph shows. But now the potential surprise: what if this mainstream view is wrong? The parallel with the 1980s cycle is instructive. Then, growth was stimulated by a sharp easing of monetary policy. Remember the interest-rate cuts across the developed world in October 1986, following Black Monday, the world-wide plunge in share prices? Those came on top of a string of cuts in base rates. Public spending was also allowed to rise (cynics would say in preparation for the next election) and export demand picked up too.

This time the prospects look less encouraging. True, interest rates are coming down, but cuts of a quarter per cent at the 5-6 per cent region have less dramatic impact than cuts of 1 per cent when rates are in double figures. On the fiscal side, public spending, far from increasing, is being cut, and the cuts will be only partly offset by the modest reduction in taxation. As for the external outlook, that is really quite sombre. The other set of graphs shows how the mood of the European business community (including the British) has turned down quite dramatically in recent months; with the US (which is also slowing), these are the main recipients of our exports.

It is possible, therefore, to build a strong case that there will not be much of a rebound in the second half of next year unless interest rates are cut much more sharply than the market at present expects. This view was outlined by J P Morgan in a recent research note, and makes a lot of sense. It also leads to a string of potential surprises, not just one.

Surprise No 1 would indeed be that the economy does not recover in the second half, as the Treasury expects. But that would be met by changes in interest-rate policy, so surprise No 2 would be a series of cuts in base rates through most of 1996: conceivably base rates below 5 per cent by the end of the year. This, however, would only be credible were inflation also to surprise: perhaps with underlying inflation below 2.5 per cent by the end of the year, and the retail price index lower still (for it would be further reduced by the fall in home-loan rates).

Now I do not think this low-growth, low-interest-rates, low-inflation outlook is necessarily going to happen: I would put the extreme figures noted above at a 30 per cent probability, no more. But it is the sort of surprise that might well happen, and seems just as likely as the rapid rebound in the second quarter that the Treasury seems to expect.

The probability would increase if the pause in growth elsewhere in the world turns out to be more sustained than is at present forecast. The December OECD Economic Outlook has the US growing at 2.7 per cent in 1996 and 2.8 per cent in 1997; for Japan the figures are 2.0 per cent and 2.7 per cent; for Germany, 2.4 and 2.7. Suppose that is all wrong and growth turns out to be a full percentage point lower in each case, that the gloomy business people are right and the modestly hopeful economists are wrong, then the slower growth/ very low interest rates/ low inflation scenario becomes much more likely for the UK. Meanwhile, watch for signals, particularly from the US and continental Europe: interest-rate cuts and evidence (or even talk) of renewed recession.

If that is the biggest potential surprise, what are the others? In no particular order, I would add three: a sharp rise in the dollar and a corresponding sharp fall in the German mark and yen; a surge, then a collapse, of US share prices (which would doubtless influence our markets here); and such severe swings among European currencies that plans for a common currency are postponed beyond 1999.

The probability of these? I think the recovery of the dollar is really quite likely. Some recovery is surely odds-on, and the issue is the scale of that recovery. Perhaps the really big surprise would be another collapse, bringing it back to the levels of mid-1995. As for US share prices, the scale of the fall will turn on the scale of the preceding rise. The least likely outcome, surely, is that which most investment banks and stockbrokers predict: a year of solid, steady gains in share prices, a "soft landing" from the heady heights of 1995.

As for European currencies, the most likely outcome is continued sharp fluctuations, encouraged by the preparations for European Monetary Union - that would not be a surprise at all - but no acceptance by the powers- that-be that EMU might not be such a great idea after all. The surprise there would be for economics to take over from politics, but that one is surely a better runner in 1997 than it will be in 1996. Happy New Year!