The decoupling of the economies of the United States and the rest of the world is becoming more pronounced and is set to last, according to Merrill Lynch’s mid-year global economics report.

As a result of this phenomenon, the Merrill Lynch global economics team believes that the global economy will continue to grow in 2007, with no sign of a significant cyclical slowdown. The bank’s economists are more bearish than most on the prospects for the U.S. economy, but are more bullish than consensus about the rest of the world.

They also believe that this decoupling is not simply a cyclical trend. ”Structural forces, such as a sustained investment spending boom outside the U.S., are driving this global economic force — giving it longevity,” they say.

And, they note, that inflation poses the biggest risk to global growth and the threat it poses is higher than the market is currently anticipating. Merrill Lynch forecasts non-U.S. inflation to rise to 3.4% in 2008 from 3.2% in 2007.

“If anything, our bullish call on global growth last September was not bullish enough,” said Alex Patelis, head of international economics at Merrill Lynch. “Looking into the balance of 2007 our view stands intact: this is a year of transition as the U.S. passes the global growth baton to the rest of the world.”

David Rosenberg, chief North America economist, believes that the power of the consumer is key to the U.S. economy and he highlights signs that consumer spending could weaken. For example, higher oil and gas prices and higher grocery prices could trim discretionary spending.

Merrill Lynch also believes that Canada may struggle to boom economically in the face of a U.S. slowdown, but that prospects are encouraging after weak growth in 2006. Domestic demand and manufacturing have been driving a pick-up in first half growth. The strength in domestic demand and job growth points to continued vigor in spending ahead, Merrill says. “If demand is now rebounding, tighter monetary conditions are called for,” it says, noting that the yield curve has priced in the risk of rate hikes later this year.

“We don’t think those rate hikes will end up being delivered, as the stronger Canadian dollar looks to have done much of the Bank of Canada’s work for it,” Merrill says. “Looking ahead, should our base case view of substantial Fed easing prove correct, the BoC may actually have to ease modestly in late 2007 to mitigate the risk of an intolerable further appreciation in the Canadian dollar. For as resilient as the Canadian economy now appears, we can never expect Canada to outright boom under circumstances of US bust.”

The Asian economy is also displaying resilience, Merrill notes. GDP in the region is growing strongly despite a slowdown in exports to the U.S., thanks in part to higher exports to Europe and other parts of the world. Furthermore, Asian domestic demand is gathering momentum. TJ Bond, chief Asia economist, believes that a U.S. slowdown — and even a modest U.S. recession — would have a modest impact on Asian growth.

The Japanese economy is set to make a comeback after six slow months, it predicts. Consumer demand will recover after the sharp rise in savings rates seen in 2006. Merrill Lynch believes that higher productivity should fuel a rise in corporate profits. Pragmatic monetary and fiscal policies will help the economy.

Klaus Baader, chief Europe economist, says that prospects for the Eurozone and other European economies continue to brighten. He notes that Europe’s trade performance has been ahead of expectations and the region has withstood tighter fiscal policies, and governments will be under decreasing pressure to raise taxes as spending deficits fall.

Merrill also says that Emerging Europe, Middle-East and Africa appears well-positioned to weather a U.S. slowdown, thanks in part to continued high commodity prices and strong demand for exports. Latin America is on track to post a fifth straight year of solid economic growth and is grappling with how to ensure that positive effects of the favorable global environment reach the poorest members of its population, it adds.

Merrill Lynch expects the U.S. dollar to weaken modestly in the second half of 2007 against the euro and the yen. Investment levels in U.S. assets could fall with the global savings rate at historical highs and savers looking more towards non-U.S. assets, but central banks will continue to support the dollar.