July 27, 2007 | posted by Michael Baxter in IABN |

And yet it isn’t all bad news.

For one thing, the market would appear to have a self-correcting mechanism.

Too much credit fuelled too much risk-taking and too much inflation. Now, the market is reacting to that by upping the rate of interest.

Sure, higher rates will spell a slowdown in the economy, but that should eventually stop inflation and enable rates to fall again. The fear is twofold. First, inflation will prove harder to crack this time, and second, the fallout from higher interest rates could be very serious.

And yet there are still plenty of bulls out there.

This morning the FT quoted Jonathan Morton of Credit Suisse who said that SP 1500 non-financial companies have free cash flow yields higher than their cost of capital. In other words, these companies are ripe for a buyout. More to the point, Mr Morton added, it would take a 5 per cent rise in the rate of interest before the number of companies with free cash flow greater than the cost of capital fell to below 10 per cent.

Not even the most pessimistic commentator thinks a 5 per cent rise in rates is conceivable, and so we should be pretty safe.

Then there’s China. Sure, credit is drying up, but as long as China has its 1.2 trillion dollars worth of foreign reserves, it seems likely that there will be plenty of money out there. After all, China is ploughing a big slug of money into the Blackstone float, not to mention Barclays Bank.

Then, this morning, the latest forecast from the National Institute of Economics and Social Research (NIESR) hit the streets. And while all around there was panic, NIESR gave us good news.

The World Economy expanded last year by 5.4 per cent, the fastest since 1973. This year, growth will slow only a little to 5.2 per cent, decelerating a bit further in 2008 to 4.9 per cent, it said. Against this background, it said, a pick-up in OECD inflation in 2008 will be moderate.

The US economy will grow by only 2.1 per cent this year, recovering to 2.6 per cent in 2008.
The Euro Area will grow by 2.8 per cent this year, much faster than it did in 2001-5, underpinned by the continuing vitality of the German economy, and Japan will grow by 2.3 per cent this year and by 2.2 per cent in 2008.

It’s a strong juxtaposition. On one hand you have the markets reacting as if all their worst nightmares have become reality at once. On the other hand, the NIESR tells a story of a global economy expanding at just below record pace. Even the US, which according to some is in dire straits, is expected to be okay.

And what about the UK? NIESR says GDP will continue to expand strongly but consumer spending growth will remain muted. House-price inflation is forecast to slow from 10.2 per cent this year to 3.3 per cent in 2008 and 2.3 per cent in 2009. One more quarter-point rise in the base rate, taking it to 6.0 per cent later this year, should ensure that inflation is around the target over the medium term. The current budget in the public finances will not return to surplus until 2010-11.

Its most positive comment it saved for last: “Demand has become more balanced with fixed investment contributing more than household spending to GDP growth in 2006, the first time this has happened since 1982.”
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