The global economy expanded by 5.3 per cent in 2006, one of the fastest rates of growth in the past 35 years. We project further expansions of 5 per cent this year and 4¾ per cent in 2008. The key risks to the forecast that we highlight in this Review relate to global housing markets and the current stance of monetary policy. The US economy is restrained by the recent correction in its housing market, which is expected to continue to weigh on the economy through 2008. There is some concern that the housing investment downturn may spread to other economies, and in this report we explore the areas most at risk to such a contagion. We also consider the recent volatility in the oil price, which makes it difficult for monetary authorities to distinguish signal from noise. If too much emphasis is placed on what subsequently turns out to be noise, policy settings could turn out to be overly lax or stringent.

The pattern of real exchange rates has changed significantly since February. Our currency forecasts at that time were in line with the implied forward rates in financial markets, with the yen projected to appreciate slowly against the dollar, rising from 100 to the dollar in the first quarter of 1995 to around 90 to the dollar in 1997. Within Europe, we projected a further small appreciation of the D-mark and a continuing depreciation of the lira and the peseta. Overall, we expected ‘real exchange rates to stay approximately stable’. In the event, the yen rose strongly in March and April to around 80 to the dollar, while the D-mark rose from around 1.50 to 1.38 to the dollar. At the same time, the lira/D-mark exchange rate fell by over 10 per cent and the Exchange Rate Mechanism was placed under renewed strain, with both the peseta and the escudo being devalued. As a result, the Japanese and US real effective exchange rates are respectively 15 per cent higher and 7 per cent lower than we had previously expected. These developments also had a wider impact on financial markets. The discount rate was cut in Japan and Germany and long-term rates rose in Italy and Spain. Equity prices fell sharply in those countries with appreciating currencies and jumped up in most of the countries whose exchange rate has depreciated.

With the uncertainty induced by the prolonged run-up to the general election having come to an end and renewed signs that consumer and business sentiment has begun to improve, it now seems as if the economy is poised to emerge from the recession over the coming months. It may be some while before the evidence of any improvement emerges from the official statistics and it is quite possible that the various monthly sectoral and industrial surveys will continue to give conflicting signals as to the strength of the economy at the present time.

The public sector finances have been transformed in recent years as tight expenditure control has been combined with buoyant revenue. In the last fiscal year, the overall budget was in surplus by almost £6 billion. Official estimates indicate that the current balance was in surplus by £10 billion, thus comfortably meeting the Golden Rule.(1)

This article is one of a series describing attempts made at the National Institute to develop formal methods of preparing short-run forecasts of United Kingdom exports. The first article was concerned with British exports of manufactures to industrial countries and the second with exports to primary producers.

One method of short-term economic forecasting is the use of indicators which normally change direction in advance of business activity as a whole. This method has been extensively developed over many years, with some success, by the National Bureau of Economic Research in the United States. In the present article we have explored the possibility of finding such a set of leading indicators for the British economy, with special reference to post-war movements.

The growth of output in OECD member countries has been abruptly checked. Helped perhaps by relatively favourable weather, industrial production appears to have increased by 1-1½ per cent in the first quarter. In the second, however, there seems to have been quite a significant fall in Western Europe as well as in the United States, and a marked slowing down of growth in Japan (table 1). We no longer expect the aggregate rise for the year in member countries to be any more than ½ per cent (implying a drop of similar magnitude from the first quarter's rate), and the OECD secretariat has been forecasting a marginal fall. In terms of GDP the change of trend has been less pronounced but may well have been equally general. Though both we and OECD are expecting a rise of a little more than 1 per cent for the whole of 1980, some fall seems likely in the second half of the year.

Problems arising in the US economy and financial system are frequently of global significance, and the inauguration of a new President provides a convenient occasion for taking stock of the US economy's recent performance and prospects. In this article we include some tonger-term background as well as an assessment of the current situation. The article is a sequel to one which we wrote nearly four years ago and which focused mainly on the remarkable recovery from recession achieved by the US economy in the period 1982-4.

This analysis and forecast for the economy is mainly concerned with the effects of devaluation and the associated measures taken. It begins, therefore, with a separate analysis of these effects. These are then superimposed on the pre-devaluation forecast for 1968. Briefly, this pre-devaluation forecast showed a rise in real gross national product of 3½ per cent between the years 1967 and 1968, and a rather higher rise than this—of nearly 4 per cent—between the fourth quarters of 1967 and 1968. It also showed a ‘basic’ deficit, on current and long-term capital account (including a ‘normal’ balancing item) of £275 million in 1967 and £250 million in 1968.

In this article we propose a policy framework for inflation targeting that contains elements of both optimal and simple rules. We use a simple feedback rule for the interest rate to look after monetary policy in the long run whilst using optimal control in the short run to determine appropriate responses to shocks. The composite policy is capable of substantial welfare improvements over using a simple rule alone whilst maintaining tractability. We see the use of such a framework together with a fully specified model as a feasible approach to practical policy design.

Prospects for the world economy now appear bleaker than they have for more than five years, with the growth of output and trade having begun to slow in all regions. GDP growth in the OECD area is expected to slow particularly strongly this year. During the emerging markets crises of 1997 and 1998 the downturn in the world economy was driven by events outside the major industrialised economies, and a combination of the automatic stabilisers of the market mechanism and the prompt action of the monetary authorities ensured that the phase of strong growth was not interrupted. The current conjuncture is different, in that the origins of the slowdown appear to be within the OECD region, and they are difficult to offset with policy and hard for market-based stabilisers to absorb. The slowdown in production, trade and investment in information technology related industries is at the core of the problems facing policy makers, and their tools are not well adapted for dealing with cycles driven by specific industries.

We investigate trends in regional cost competitiveness in China's four regions (Coastal, Northeast, Interior and West) over the past thirty-five years. We find that the Coastal region lost its initial cost competitiveness as its higher relative labour productivity (RLP) was offset by rapidly rising relative nominal labour costs (RNLC) due to rising wages. The Northeastern region still has cost advantages in the traditional Manufacturing sector. The Interior and West regions improved their competitiveness in most industries due to low RNLCs. There is convergence of relative unit labour cost (RULC) in all industries before 1995, but only in Finance after 1995. However there is convergence in RLP in five industries in 1978–95 and 1995–2009, offering prospects for robust growth for China into the future.

This time last year we published in the Review an article comparing macroeconomic policy in Britain and France. That article and the present one are both based on a three-year project in which we compare events and policies in Britain with those in the other major European countries.

How important are small firms as sources of new jobs? Research by Gallagher and Doyle, reported in British Business (1986) suggests that they are disproportionately important: in terms of employment small firms in the UK were found to be growing more quickly than large firms. In this note we examine their evidence. We conclude that their case is not proven, although there are features of recent experience which may point in that direction.