Hamish McRae: There will be a slowdown in growth - the question is how fast

It is tricky this year. The multitude of economic and market forecasts are now largely published and there is a consensus of sorts. Most agree that the key issue will be how the world tackles the imbalances that have built up between the US on the one hand and China and Japan on the other. Most agree too that this year will see slower growth than last. And most are reasonably bullish on the investment climate.

It is tricky this year. The multitude of economic and market forecasts are now largely published and there is a consensus of sorts. Most agree that the key issue will be how the world tackles the imbalances that have built up between the US on the one hand and China and Japan on the other. Most agree too that this year will see slower growth than last. And most are reasonably bullish on the investment climate.

But it is not easy because both the timing and nature of the adjustment is quite unknowable. The decline of the dollar is already evident but there are wide differences of view as to how much further it might go and indeed whether this is the most effective response. Will the adjustment be gradual or sudden? And what are the consequences for a world that needs US consumer demand to maintain its growth?

The best place to start is with the likelihood of rather slower growth. In the first graph you can see this slowdown in the six largest developed economies, as forecast by HSBC. In every single case the number for 2005 is lower than that for 2004. The bank is perhaps a little more gloomy than most on the prospects for the big continental European economies but pretty much with the rest for the US and UK. Forecasts for Japan are all over the place but the sharp fall shown here seems to make sense given the continuing difficulties Japan has in generating domestic demand.

Some points about these forecasts. The most obvious is that the US economy will continue to grow at or even a bit above its long-term trend. Consumption accounts for 70 per cent of US GDP and everyone seems to think that the Great American Consumer will carry on spending for a while yet. The Federal Reserve will lean against this, as it tries to nudge interest rates back to more normal levels. Inflation is creeping up and it needs to be sensitive to that. Moreover it no longer the insurance it took out against deflation - that very cheap money policy was designed to combat the threat of the Japanese disease of steadily falling prices and stagnant demand.

But were US consumption to slow too dramatically, expect the Fed to stop increasing rates. Indeed it is perfectly possible that by the end of this year rates could be coming back down. The same goes for the UK. Last year growth was higher than anyone bar the Treasury expected. We will now see some slowdown in the growth of both borrowing and demand - there has already been a sharp slowdown in borrowing for home purchase. But were things to slow too sharply it is very easy to turn the tap back on again and it is quite possible that the next move in UK rates will be down, not up.

There are two other big growth questions. Can core Europe do anything to improve its performance? And will China continue to race onwards?

We are going into 2005 with German unemployment still rising and the French consumer boomlet petering out. Both countries now have unemployment on the European harmonised measure of 9.9 per cent. Were the dollar to fall much further there would be even greater pressure on German exports and there would be the quite alarming prospect of European growth being below even those forecasts shown here. Put another way, in Europe the risks are on the downside.

As for China, the answer is almost certainly that growth will remain around the 8-9 per cent level but there will be more pressure on it to ease its currency's peg against the dollar. Nearly all the decline in the dollar so far has been against the euro. A more important adjustment would be against the yen and the yuan, for Japan and China account for most of the US current account deficit. Yes, there is great domestic impetus to China's growth, but its economy is ultimately underpinned by exports to the US.

Much really does depend on the dollar and it is hard to escape the probability that it has some way to fall. The next graph shows the dollar's performance in real terms over the past 30 years. It may have come off sharply last year but on a longer view it is by no means at the bottom of its range. Nor has the recent decline been particularly swift by comparison to its fall after the 1985 peak. The red line is not a projection - merely an indication how low the dollar might go were it to follow the trajectory it took in the second half of the 1980s.

The question is how long the US can continue to attract enough foreign capital to cover its current account deficit, now close to 6 per cent of GDP. The Bank Credit Analyst group in Montreal, which prepared that chart, acknowledges that there must be a finite limit to foreigners' willingness to hold dollar assets. But it feels that limit is some way off as Asian governments have a huge vested interest in keeping the current arrangement going. The danger is that the longer the adjustment is delayed the greater the disruption when it comes. It could even be that the big fall in the dollar will be delayed until 2006. The US will keep a borrowing while other countries are prepared to lend it the money.

The borrowing boom is a feature of the English-speaking world, not just the US. The right-hand graph shows the impact a relatively easy money policy has had on the price of one particular and very important asset, people's homes, in the US, UK and Australia. As you can see a downturn in the annual rate of growth has already happened in the UK and Australia, with some falls on a month by month basis. US house prices are also overvalued relative both to rents and wages but they have yet to slow down. The US housing market is a more diverse one than the UK and the links to consumption are weaker. But were there to be sustained falls in home prices it is hard to see the consumer boom continuing.

Here in the UK what is there that can sensibly be said about house prices? One is that they could not carry on rising at double-digit rates forever. Another is that it is in no-one's interest to have a housing crash and the Bank of England would do a lot to avoid that. So a plateau seems the likely outcome and that would be consistent with the slowdown in growth. Here, there is of course the little matter of a general election looming and government that has mirrored the behavior of the electorate by borrowing big. A combination of weak house prices and the threat of higher taxation would not go down well with the punters.

But there is still decent growth. Go back to the left-hand chart. While there is growth in the world economy there is likely to be growth in profits for companies. That is why the consensus remains that this will be a reasonable year for the world of investment. A couple of years of rising share prices have not erased the memory of the crash that followed the 2000 bubble but in gneral the markets have recovered their nerve. Were it not for the instability injected by the dollar's plight 2005 might be business as usual on the world's share and bond markets. But the dollar matters hugely and until we have a better picture of that, the potential bumps are huge too.