Divergent growth trends drive banks' policy

US GDP growth has decelerated sharply, from 5.6% annualised
in the first quarter of 2006 to 2.9% in the second quarter, below the US
long-term trend. US jobs have increased at a subdued pace since March, below the
rate needed to prevent unemployment from rising. Most disturbing, the US housing
market has plummeted, prompting fears of a severe cutback in US consumer
spending.

Consensus forecasts of US growth in 2007 have been cut markedly and some
predict outright recession. In contrast, the eurozone economy has expanded at an
annual rate of 3.5% in the first half of 2006, an exceptional performance given
the previous dismal record.

Rates Gloom over US growth has led the Fed to stop
tightening at 5.25%. A further Fed increase to 5.50% is still possible, but will
only occur if inflationary pressures worsen. In contrast, surging eurozone
growth has led the ECB to become more aggressive. Further interest rate
increases from 3% to at least 4% by mid-2007 are now expected.

Bonds The bond markets have given a muted response to
Europe’s recovery, and are mostly dominated by US trends. The gap between
benchmark 10-year government bond yields in the US and the eurozone has
continued to move in a very narrow range of around 100 basis points.
Significantly, the absolute level of bond yields has fallen everywhere over the
past few months, signalling that the US slowdown is more important than any
eurozone recovery.

Currency While the dollar fell against the euro earlier in
2006, the change in growth perceptions since July has hardly made a difference.
If, as expected, the US dollar weakens further, it will largely be due to
fundamental factors such as the US deficit and central bank reserve
diversification. European growth is unlikely to continue at its recent rapid
pace. The rise in ECB rates and the stronger euro will have negative effects. If
one compares growth in full years rather than in odd quarters, the US is
persistently stronger than Europe. If US growth plunges next year, the eurozone
will suffer. For the time being, the US remains the main driver of the financial
markets.

David Kern of Kern Consulting is economic adviser to the British Chambers
of Commerce. He was formerly NatWest group chief economist