Sunday, December 31, 2006
Motoring along in a world of growth
Posted by David Smith at 11:00 AM
Category: David Smith's other articles


Looking back, looking forward. What kind of year was it, and what kind of year will it be?

The domestic surprises over the past year have been the strength of Britain’s economy, the return of inflation and a buoyant housing market. Beyond these shores, the world economy has been unusually strong — despite a few wobbles in America — helped by recovery in Europe and the emergence of China and India as the new global locomotives. Worldwide, this has been the best run since the early 1970s.

I will have more to say on prospects for 2007 over the next couple of weeks, and I will have a lot more to say on China and India come the spring, when I have a new book out on these countries.

But let me set out some of the parameters. In 2006 Britain grew by about 2.7% (we won’t know for sure until we get the fourth-quarter figures), within the context of global growth of a shade over 5%.

For 2007 the Treasury and the Bank of England expect growth of more than 3%, while the consensus among other forecasters is 2.4%. That looks a little low in the light of the economy’s momentum going into the new year but, equally, the Treasury and Bank forecasts look challenging. I expect 2.6%.

That depends on the global economy, where the outlook is for a still-strong 4% to 4.5% expansion. It also depends on the consumer, squeezed by higher taxes and energy bills. In both cases, there is probably more scope for weakness than unexpected strength.

What about inflation? The figures ended the year on a sour note, with consumer price inflation (CPI) at 2.7% and retail price inflation of 3.9%. The pay response to this is crucial, as pointed out last week.

The Bank and Treasury are optimistic, expecting CPI inflation to return to the 2% target in a few months and stay there. I tend to agree, and that is my end-year forecast (still consistent with RPI inflation of about 3%).

But there are clear risks, not just from pay and the buoyancy of money and credit growth, but also from another energy shock. I think oil prices will eventually return to lower levels than at present, but this is a jumpy time. The oil price rose above $70 a barrel during the past two summers. If it were to do so again, the Bank would have a problem.

Britain’s economy continues to be characterised by imbalances. Public-sector borrowing is locked at just under £40 billion a year, despite stronger economic growth. The current-account deficit was probably £37 billion last year (again, fourth-quarter figures are awaited) and will probably be close to £40 billion in 2007.

One of the unusual features of 2006 was that unemployment rose even as growth came through stronger than expected, because work was taken by immigrants and older people. This is likely to continue in the coming months, with claimant unemployment likely to end the year at or above 1m.

What about the housing market? This year’s rise of about 10% in prices was a surprise, even to those of us who have long rejected the idea of a crash. Forecasts for 2007’s house-price rise are concentrated in the 4%-8% range.

There is a temptation to ask whether anything can stop prices rising faster than that, but I suspect some of the current momentum will fade. I am looking for a 5% price rise.

There will be more to be said on these things. But looking back on 2006, how did forecasters do?

It was a tough year. Most would agree that they could have done a lot better, and that they were too pessimistic on growth and too optimistic on inflation. That certainly applied to me. I scored four out of 10 on my scoring system.But at least I can say that David Smith topped the forecasting league table. My namesake, visiting professor at the University of Derby and chairman of the “shadow” monetary policy committee, got the economy more right than most in what was his last forecast for Williams de Broë. He now runs Beacon Economic Forecasting.

Sharing top spot with him was the economics team at Barclays Capital. Like Smith, the Barclays Capital team was optimistic about growth and got the direction of Bank rate right. Like him, they were not quite gloomy enough about inflation, although that was generally true. We have become so used to the Bank of England hitting the inflation target that forecasters were unwilling to bet too hard against it.

Congratulations to Smith, Barclays Capital and also to Richard Jeffrey, whose optimism about growth and pessimism about inflation merited third place. His forecast was for Bridgewell Securities, but he is now with Ingenious Securities.

Last year the economy appeared to start growing only slowly, but quickly picked up pace. Retailers, having warned of something approaching armageddon on the high streets, were soon reporting strong sales. A spring stock-market wobble came and went. In February, there was still an outside chance that the monetary policy committee (MPC) would cut interest rates.

In its first four meetings of the year Steve Nickell was the sole cutter. In May there was a three-way split, with the late David Walton voting to raise Bank rate while Nickell wanted to cut. That was when Mervyn King, the governor, signalled that the next move was likely to be up.

By June, with Nickell having left the committee, Walton was the only hiker. In July, after his untimely death, the MPC was unanimous in holding rates, which was why August, when a depleted MPC voted 6-1 to raise Bank rate from 4.5% to 4.75%, was a surprise, despite King’s earlier signal.

A follow-up hike in November, from 4.75% to 5%, took nobody by surprise, although it only occurred after a debate on the MPC, with Rachel Lomax, the deputy governor, joining David Blanchflower in voting against.

The Bank ended the year with honours even, a 9-0 vote for no change in September had been followed by 7-2 (for no change) in October, 7-2 to hike in November, and 9-0 (no change) this month.

Where does Bank rate go from here? We are at an interesting juncture. The Bank’s November inflation forecast, and indeed its August forecast, suggested 5% would be enough. But pay is a worry and the economy has ended the year on a strong note.

My best guess is that 5% will be enough, but by the same token I do not see the Bank rushing to cut. That would give us 5% at the end of the year. We could, however, get there another way. If the MPC feels obliged to send a strong signal to the labour market (and the housing market), rates could rise once or twice in the first half of the year and fall by a similar amount in the second. I would not rule it out.


PS: Apart from the sad death at 43 of David Walton, who had great things ahead of him, this year saw the passing of two great economists.

Milton Friedman, who died last month at the age of 94, was probably America’s greatest 20th century economist. That itself was something of a surprise. Much of his best work was done in the 1950s and 1960s, when he was outside the Keynesian economic mainstream. Had the “golden age” for western economies of that era continued, he might have remained on the fringes. As well as hugely influential contributions to economic theory, he became the guru of the inflation era.

Friedman, small, pugnacious and anti-establishment, could not have been more different from JK Galbraith, who died in April aged 97. Chronicler of the Great Crash and responsible for expressions like “the affluent society” (one of his first books), he was tall, elegant and part of the establishment, advising American presidents.

They both, however, had a great sense of fun. Galbraith used to tell the story of what LBJ (America’s president Lyndon Baines Johnson) once said to him after delivering a speech that Galbraith had written. “Did you ever think, Ken, that making a speech on economics is a bit like peeing down your leg?” LBJ said. “It seems hot to you, but it never does to anyone else.”

On that note, I wish you a happy and prosperous new year.


From The Sunday Times, December 31 2006


So, David Smith predicts CPI (currently at 2.7%) to fall back to 2.0% by end of March 2007 - you heard it here first. Let's all come back in 3 months and see how far off the mark he was.

Posted by: Hussein Shah at December 31, 2006 03:54 PM

Try and read the piece before putting your foot in your mouth. It says nothing of the sort.

Posted by: David Smith at December 31, 2006 04:03 PM

Happy New Year to you David. You're an interesting read. Please keep it up.

Posted by: Gary Bezowsky at January 2, 2007 04:41 AM

Nice summary David. You could add the massive rally in sterling versus the dollar to your list of economic events . I know it was mostly a USD move, but sterling is now very high on a trade-weighted basis, and cable is nearing the 2.0 handle. I wouldn't be surprised if this had taken place against a backdrop of high and rising UK interest rates, but that isn't so obviously the case. As you note the outlook on rates is uncertain, though it does seem that we are somewhere near the top of the tightening cycle. (For the record, I am short the pound against the dollar...cough, cough).

I, like many others, thought Friedman was great. I suppose the good news that came of his passing is that his thoughts once again caught the public imagination. His TV series 'Free to Choose' is essential viewing for anybody who wants to learn essential economic principles from a master economist and master presenter. His videos can be found kindly, free available on Google video and are also available on another site (I can't remember the name) in their entirety.

Posted by: Caravaggio at January 3, 2007 01:23 AM