Stephen King: China and India leaving G7 nations in the slow lane

Three big issues are likely to dominate the economic landscape in 2006. The first, and most obvious, is the rapidly evolving role of the fast-developing countries in Asia, particularly China and India.

The second, a demand-related story, is the relationship between monetary policy and economic growth. With US short-term interest rates likely to move above US long-term interest rates, the US yield curve is threatening to invert, a development that has sometimes, although not always, signalled the onset of recession.

The third issue is more a supply-side story with specific resonance for the UK: despite low inflation and stable economic growth, the UK's productivity performance seems to be steadily deteriorating, a development that is hardly encouraging for the longer-term health of the UK economy.

Let's take the China and India story first of all. The distribution of economic growth around the world in 2005 contained quite a few surprises. Those surprises, though, did not emanate from the West: US and eurozone growth rates came in broadly in line with consensus expectations at the beginning of last year.

China and India offered the really big shocks. Both of them delivered growth rates over 1 per cent higher than expected. Their strength is leaving the G7 nations behind in the slow lane of economic growth. Some 15 years ago, the G7 nations accounted for 70 per cent of global GDP: today, they account for only 62 per cent.

Asia's expansion, in turn, kept the demand for raw materials buoyant in 2005, leading to higher global prices for all sorts of basic commodities, including oil and natural gas.

Those higher prices led to elevated inflation in the US and greater inflationary headaches elsewhere in the world. US short-term interest rates went up a long way not only because of developments within America's borders, but also because of these unexpected developments taking place on the other side of the world. Towards the end of last year, the European Central Bank chose to follow suit, even though inflation in Europe, unlike US inflation, has hardly budged.

Should China and India carry on expanding at current rates - a likely scenario for 2006 - the global demand for raw materials will continue to swell, leaving Western central banks persistently uneasy about the future path of inflation.

Yet the monetary stance in some Western economies is now profoundly different from where it was a year ago. Most obviously, with Fed funds having risen to 4.25 per cent, and with more rate increases to come, the US yield curve is now flat and showing signs of inverting.

What does an inverted yield curve signify? Historically, inverted yield curves have presaged recessions, for two reasons.

First, inverted yield curves imply that the current level of short-term interest rates is high relative to the expected future level of short-term interest rates, reducing the willingness of banks to lend (they typically borrow short and lend long). Put another way, the current level of short-term interest rates suggests that monetary policy is unusually tight.

Second, inverted yield curves have typically been delivered only after a prolonged period of rising short-term and long-term interests: in other words, the cost of borrowing rises for all debtors, irrespective of the time horizon over which they borrowed their funds.

Currently, only the first of these two reasons applies. While long-term interest rates have shifted up a bit since the remarkably low levels seen in the first half of 2003, they have nevertheless remained incredibly low relative to market expectations. The overall level of the yield curve, therefore, does not suggest the presence of a biting monetary constraint. Only the slope of the curve is, therefore, a worry.

But I suspect that part of the reason for the flattening of the curve lies with the credibility of the Federal Reserve and of central banks more generally. If the general public believes that central banks will successfully hit their inflation objectives, there is no reason to think that the average level of short-term interest rates is likely to change very much over the long term, barring major productivity shocks.

If that's the case, central banks that decide to change the level of short-term interest rates must be doing so in ways that are likely to maintain price stability.

As a result, oscillations in short-term interest rates will take place around a very stable mean which, in turn, "hard-wires" the level of long-term interest rates.

The problem with this story lies in working out what central banks should do, and when they should do it.

To justify a rate change, the central bank has to assume that, in the absence of monetary action, there might be an undesirable shift in inflationary expectations.

In other words, the central bank has to "second-guess" the likely reaction of financial markets and the general public.

At times, this might seem easy enough. The public, for example, associate higher oil prices with higher inflation, suggesting that now is a good time to raise short-term interest rates.

Yet this is clearly not a view shared by all central banks. After all, the Bank of England cut interest rates last year.

And second-guessing is not the most desirable of policy rules. It suggests that credible central banks will eventually have problems with the transparency of their policy intentions.

I'm not sure that we'll see many rate cuts in 2006. The Federal Reserve is still in the mood to raise rates, although I suspect its views are beginning to mellow, and the European Central Bank is likely to maintain its bias towards tightening for a while yet. The Bank of England, though, may continue to buck the trend, allowing more rate cuts in 2006.

The UK economy has certainly weakened considerably over the last 12 months, providing some justification for the Bank of England to cut short-term interest rates further in 2006.

Increasingly, though, it seems that the UK's economic slowdown is not just a sign of demand shortfalls that can be corrected with a gentle re-calibration of the interest rate tiller from time to time.

The most worrying feature of the UK economy over recent years has been the gradual loss of momentum in productivity performance.

In the current government's first four years, whole economy productivity growth, measured through output per head, rose at an annual rate in excess of 2 per cent.

Over the last four years, productivity growth has slowed to a mere 1.3 per cent per year and must provide at least part of the explanation for the significantly weaker growth in 2005 compared with earlier years.

Forecasting productivity growth is notoriously difficult. Even Alan Greenspan has difficulties with this particular measure of economic performance. Fluctuations occur from time to time without any obvious explanation.

And, even when productivity growth does slow down, GDP growth may still hold up reasonably well: in recent years, the Polish plumber has kept UK GDP expanding at a reasonable rate, even if the output of the indigenous population has not been rising particularly quickly.

Nevertheless, despite its notable demand-side successes - Bank of England independence, price stability, the avoidance of recession - the Government's record on productivity is not looking very good.

This comes at a time when, on the other side of the Atlantic, productivity performance continues to impress. One to watch in 2006, I would say. After all, productivity performance is the true elixir of economic success.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com