• The sharp fall in equity markets will dampen economic growth next year: global output is forecast to increase by 3.4 per cent in 2003.

• Lower stock market wealth means that the United States will grow by 2.9 per cent next year, 0.6 per cent less than our previous forecast.

• The euro area will grow by only 1.2 per cent this year, more slowly than in 2001.

• The Japanese economy will shrink by 0.1 per cent this year, a better performance than previously expected. However, output will only grow by 0.7 per cent in 2003.

Global economic activity clearly rebounded in the first half of this year. The pick-up from the weakness in the latter half of 2001 was especially marked in North America and Asia, with GDP rising by around 1½ per cent in the first quarter in the United States, Canada and Japan. Activity in Europe was more muted, with GDP rising by 0.3 per cent in the Euro Area and 0.1 per cent in the UK. Although recent monthly data have been mixed, and a number of temporary factors that boosted growth at the turn of the year may have run their course, it appears on balance that there was a further broadly based pick-up in activity in the second quarter of the year. Outside the major industrial economies improving conditions in the IT sector have provided a significant stimulus to some emerging market economies, especially in Asia, but several economies in Latin America have seen a marked deterioration in domestic economic and financial conditions. All told, we expect world GDP growth (measured at purchasing power parities) to be around 2¾ per cent this year, little changed from our previous forecasts. This would be a modest improvement on the growth of 2½ per cent last year, but well below the trend increase of 3½ per cent per annum experienced over the past 30 years.

Economic activity has rebounded strongly in the US economy since the relatively mild recession experienced last year, helped by the accommodative stance of monetary and fiscal policies, and unusually buoyant productivity growth. GDP rose by 1½ per cent in the first quarter, the fastest quarterly rate of growth since the end of 1999. Although recent monthly data have been somewhat mixed, on balance they suggest that economic activity continued to strengthen in the second quarter but at a slower pace than earlier in the year.

The outcome for growth in the Euro Area in the first quarter of 2002 was slightly weaker than our April projections. Output rose by 0.3 per cent relative to the previous quarter, following a decline of the same magnitude in the final quarter of last year. The recovery stemmed primarily from a sharp drop in imports of 0.8 per cent, rather than a pickup in domestic or external demand. The weaker outcome for the first quarter, coupled with recent developments in financial markets, dampens the outlook for the year as a whole. Industrial production rose by 0.8 per cent in March, but declined by 0.7 per cent in April and edged up by only 0.1 per cent in May, supporting our expectation that recovery will be gradual. We forecast growth of 1¼ per cent in the Euro Area this year, but anticipate a stronger improvement next year helped by a recovery of domestic demand. This will be supported by tax cuts in several countries, despite the fact that the Euro Area's three largest economies appear unlikely to meet their Stability Pact pledge of achieving a budget at or close to balance by 2004. We expect output in the Euro Area to grow by about 2½ per cent next year, and by about 2½ -2¾ per cent per annum throughout the medium-term.

In recent weeks, equity markets have been very weak and the euro exchange rate has risen by more than 10 per cent against the dollar. The UK's effective exchange rate has also depreciated, removing some, but not all, of the overvaluation we identified in the April Review. We report on recent movements in table 1, and their implications are discussed in the UK and World forecast chapters in this Review. To an extent the movements in the US stock markets and the exchange rate are linked, but there does seem to be some ‘excess strength’ in the euro, which will in turn contribute to the weakness of Euro Area equity prices.

In the period of floating exchange rates a distinct dollar—D-mark polarisation was noted, whereby periods of weakness for some European currencies relative to the dollar coincided with periods of strength relative to the Deutsche mark and vice versa. The relationship continued to be observed for those currencies such as sterling which remained outside the Exchange Rate Mechanism for most of the period. The observation, although more ‘an empirical regularity in search of a theory’ than a model (Buiter et al., 1998) seems reasonably robust; recently the dollar has fallen sharply against sterling while the euro has risen. An analysis of this relationship and its stability is important because it provides a guide as to how the euro might be expected to move against sterling as a part of any adjustment against the US dollar. In turn it sheds some light on the degree to which a dollar depreciation might affect Britain inside the Euro Area.

The pattern of growth in the real economy is in some sense a mirror image of what was happening a year ago. Then there was considerable concern that stagnating international trade was depressing the performance of manufacturing at home and, through this, having a damaging effect on economic growth overall. Now there are the first signs that output growth is being led by a revival of manufacturing which, in turn, is probably linked to a revival of world trade. A year ago the US$ was close to record highs against the euro and sterling had been dragged up in its wake. Now a weakening US$ is taking sterling with it, so the exchange rate against the euro, although still high, is well below the values of last year. At the same time share prices have fallen from levels of last year which, although below their peaks, were still grossly inflated. At current levels they will once again encourage businesses to make sensible use of shareholders' capital and come to sensible decisions about appropriate forms of financing. On the other hand the recent growth rate of house prices is likely to prove unsustainable.

It seems likely that the economy expanded rapidly in the second quarter following a virtual standstill in GDP growth in the two quarters at the turn of the year. The bounce back in growth is likely to be somewhat stronger than we had anticipated in April. Our estimates of monthly GDP suggest that the economy grew by 1.2 per cent in the second quarter of 2002 led by strong growth in industrial production of 1.7 per cent. Output in the private service sector is also estimated to have risen rapidly by 1.4 per cent. The pick-up in the industrial sector in the second quarter is primarily a consequence of stronger external demand. Trade data to May suggest that growth in export volumes rose markedly in the first two months of the second quarter. We expect that export volumes rose by just under 5 per cent in the quarter as a whole, increasing GDP by around 1½ per cent. At the same time growth in the demand for imports has risen, albeit by less than the acceleration in export growth. Net trade is expected to have added 0.75 percentage points to GDP growth in the second quarter.

This is the last article in the series contributed to the Review from the CLARE Group of economists. Since the Group was formed in 1976, with the aim of counteracting the polarisation of opinion among economists at the time, over fifty articles have been published, initially in the Midland Bank Review. But members of the Group have lately come under increasing pressure of time from academic and other commitments, and it has reluctantly decided to dissolve itself. On doing so, it would like to record its warm thanks to the National Institute Economic Review for the hospitality of its pages since 1988. As for previous articles, drafts of this one have been discussed among members of the Group, but responsibility for the views expressed rests with the author alone.

From 1993 to 2000 in the UK, there was a welcome twist to the relationship between unemployment and inflation, subverting received ideas about the ‘Phillips Curve’. This is best accounted for by the onset of a relatively moderate rate of growth of real wages, which also helped the monetary authorities to keep inflation close to the target set. Several causes can be suggested for this moderation, but the major issue now is the extent to which it can be reckoned on to continue. There are reasons for taking a cautious view of the prospects.

It has been claimed using the concept of the Index of Sustainable Economic Welfare (ISEW) that there has been an absolute decline in sustainable living standards in the UK since the mid-1970s. Revisions to ISEW are proposed to make it more nearly a measure of utility-based real national income. In particular, ISEW should be revised to take account of much-improved life expectancy. Implementing any of the suggested revisions reverses the finding of absolute decline while implementing all of them results in a growth rate higher than that of real GDP per head in the national accounts.

Evidence is presented on the extent to which the possibility for the exchange rate to vary has been useful or unhelpful for UK monetary policy over the last two decades. ‘Large’ exchange rate changes and ‘large’ misalignments are identified, and the thinking and actions of the monetary authorities in response to the level of and changes in the exchange rate in successive monetary regimes are examined. It is argued that the exchange rate has not generally functioned as a useful automatic equilibrating mechanism or as a useful policy instrument; and that in nearly every phase there were movements of the exchange rate, or pressures on it, which for the authorities were unexpected and unwelcome. Thus the exchange rate has typically been a source of extraneous shocks.