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It could be downhill all the way after Davos


By Liam Halligan, Economics Editor, Sunday Telegraph
Last Updated: 11:48pm GMT 27/01/2007
Page 1 of 3

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Sterling went on a roller-coaster ride last week. The reason: an increasingly uncertain outlook for interest rates in Britain.

On Tuesday the pound came within a whisker of the iconic $2 threshold. Ballooning inflation and this month's "shock" rate rise saw traders bet that the Bank of England would soon increase rates again, possibly as soon as February.

 
Click to enlarge: Sterling's roller coaster
Click to enlarge: Sterling's
roller coaster

This view was backed by a buoyant – read inflationary – industrial survey from the CBI. News then emerged that the economy grew at a brisk 3 per cent during the final quarter of last year.

All this led to a belief that rates would go up in successive months – and the resulting "hot" money flow pushed sterling to a 14-year high.

But not so fast! The next day, the minutes of the Bank's Monetary Policy Committee showed a 5-4 split. The MPC had voted to raise rates to 5.25 per cent by the tiniest of margins. Mervyn King, the Governor, stirred the pot further by saying inflation could "possibly fall quite sharply" later this year. And by the end of the week, with a February rate rise looking impossible, sterling was in retreat.

The City consensus – for now – is that while rates will peak at 5.5 per cent this year, the final increase won't come until April or even May. That seems relatively clear, say many analysts, unless the "global imbalance" comes home to roost – in which case all bets are off.

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At this point, you could be forgiven for scowling. With borrowing costs now at a six-year high, and up three times in six months, the public is worried that rates will rise again.

So what do I mean by global imbalance? How might it come home to roost? And why was it endlessly debated at last week's World Economic Forum in Davos?

This is a complex area. But this global imbalance could well determine the future path not only of UK interest rates but of global stock markets too.

After years of overconsumption, the United States has an $880bn trade deficit. That's 6.5 per cent of America's national income – a staggering 1.5 per cent of global GDP.

This unprecedented deficit is financed by corresponding surpluses in China, Japan and – increasingly – the oil exporting countries of the Middle East. In fact, the US is now pulling in no less than 70 per cent of global capital flows. That is the basic imbalance – the US spends too much and Asia saves too much.

America isn't alone. Britain, for instance, has a growing trade deficit too. But the big story is that Asian savings – in the form of massive purchases of US government debt and other assets – are funding America's ongoing spending spree.

This has its advantages. The "global imbalance" explains why, since the 2001 crash, stock markets have largely boomed. The massive Asian cash injection has kept the deficit countries' interest rates relatively low and financed a huge expansion in asset prices – property as well as stocks and shares. Those price rises have, in turn, collateralised further debt, fuelling growth anew.

In other words, the "global imbalance" has facilitated what is known as "Goldilocks" – a world economy, centred on the US, that grows fast, but without generating too much inflation.

But there are worrying signs that this imbalance could soon unwind. Were that to happen, we'd see a plunging dollar, a US recession – and serious turbulence on financial markets across the world. Interest rates in Britain might then fall – but amid the pain of a serious slowdown.

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Comments

I enjoyed this piece , however I feel that the global imbalances are a symptom of a transfer of wealth from west to east . Thus there could be a structural element to the trade imbalances . If the dollar weakens to relieve the US difficulties , and the saver nations diversify into sterling , then the wealth tranfer from the UK will become more acute . There is evidence that saver nations are moving into sterling as a hedge so we may be facing difficulties here . To ease this problem , I feel tax cuts are needed for our wealth creating companies asap .
Posted by David Lowe on January 29, 2007 2:12 PM
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