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Quick, quick, slow: strong growth on both sides of the Atlantic will mean that interest rates should be rising sooner or later. David Ross explains why the US is likely to be far behind the UK in imposing an increase.

Any excitement that Gordon Brown's eighth Budget might have engendered has long since dissipated. There was less debate than usual over his forecasts for growth and more about the levels of government borrowing he anticipates over the next few years.

Brown's forecasts for the coming fiscal year differ little from those he presented to Parliament in December's pre-Budget report. After growing by 2.2 per cent last year (see graph), the economy will expand by 3 to 3.5 per cent in 2004 and 2005 before slowing to 2.5 to 3 per cent in 2006, according to the chancellor.

Relatively strong growth and low inflation were not enough to prevent net borrowing from exceeding the figure predicted in the pre-Budget report by 3 billion [pounds sterling]. Brown now forecasts borrowing of 3.3 billion [pounds sterling] in 2004-05. Only time will tell whether or not there is a black hole in public finances and tax hikes are inevitable. As a percentage of GDP, public-sector borrowing is now 3.4 per cent, exceeding the 3 per cent limit of the eurozone's stability and growth pact.

This worryingly high level of borrowing has been attributed to "the wrong kind of growth". There has been too much consumer spending and imports, and insufficient investment and exports. But commentators do believe that the economy will become more balanced in the second half of this year and into 2005.

The Monetary Policy Committee (MPC) is troubled by file unbalanced nature of economic growth. It decided to leave interest rates unchanged at 4 per cent (see graph) at its April meeting, but there must have been a lively debate. The manufacturing sector is staging an unconvincing recovery from its recession, house price inflation is showing no signs of abating and consumers are continuing to spend freely. An interest rate rise in the next couple of months therefore seems inevitable.

The US economy has been growing strongly, achieving 4.1 per cent at an annualised rate in the fourth quarter of last year, but until March it had been a relatively jobless expansion. That month's data, which showed that 308,000 new jobs had been created--the largest increase since April 2000--was welcome news for the Bush administration in election year. Despite this, and upward revisions to the January and February figures, the current recovery has still produced fewer jobs than any other since the second world war. Even so, these findings present the Federal Reserve with a dilemma.

It is for political reasons rather than economic ones that the US interest rate, presently at a 45-year low of 1 per cent, is likely to remain unchanged at least until file end of 2004. Yet, on at least two measures, monetary policy is at its loosest for 30 years. A number of US economists are now arguing that rates need to rise to the "neutral" rate of interest--ie, the rate that neither stimulates the economy nor slows it, but allows it to expand in line with its underlying potential while keeping inflation constant.

In the US, the neutral interest rate is reckoned to be around 5 per cent, but n o on e i s arguing that such a level needs to be reached in the near future. What is clear, however, is that 1 per cent is the trough and that the rate will be rising sooner or later.

But Americans are currently more anxious about oil prices reaching record levels than interest rate rises. Opec confirmed its February decision and cut production by one million barrels a day from 1 April. Oil prices now stand at more than $35 per barrel. The direction they will move in the next few months will depend on whether warmer weather in the northern hemisphere will offset soaring Chinese demand for fuel and the extent to which Opec members comply with quotas.

David Ross is an independent economics consultant. He can be contacted at
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Title Annotation:Economics
Author:Ross, David
Publication:Financial Management (UK)
Geographic Code:1USA
Date:May 1, 2004
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