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From Special Report: Global Opportunities - May 2012

Questions of balance in the UK economy

Rebalancing the UK economy will take time and patience

By Jenny Lowe | Published May 28, 2012 | comments

The end of April saw the UK economy slip back into recession, contracting by 0.2 per cent in the first quarter of 2012, according to first official estimates.

The causes of the contraction are similar to those being experienced in the eurozone – government austerity, shrinking lending to households as the banks repair their balance sheets, and stubbornly high inflation that is eating into real incomes. When combined, these have resulted in rising unemployment, stagnant growth and anaemic demand from businesses and consumers.

According to the National Institute of Economic and Social Responsibility (Niesr), such weakness is likely to persist in the next couple of quarters, and means that growth this year will be close to zero. From the start of next year, however, Niesr expects more robust growth, with a sustained period of above-potential expansion from 2014, which is necessary to reduce the gaps in output and employment.

Azad Zangana, European economist at Schroders, says: “The double-dip recession comes as no surprise to us. We have been forecasting another recession since last November when the eurozone crisis intensified. Indeed, we are forecasting a further fall in GDP for the second quarter, which will be caused by the extra special bank holiday to celebrate the Queen’s diamond jubilee.”

Room for improvement

According to Rupert Watson, head of asset allocation at Skandia Investment Group, however, the GDP report is not consistent with most of the other data that has been released, which suggests the UK grew modestly at the start of this year.

He adds: “The UK’s GDP reports are subject to significant revision, often a long time after the fact. When there is a difference between the early GDP reports and the business surveys, the business surveys usually turn out to be more accurate.”

Activity in the service sector was reported to have grown by only 0.1 per cent in the first quarter, far weaker than the growth implied by other data. In addition, construction was reported to have fallen by 3 per cent, although the business confidence index for the sector rose to a fairly high level and was likely to have been boosted by the unseasonably warm weather in February and March.

Mr Watson says: “That the data is likely to be revised higher will not provide much comfort to the government since by the time it does few will care. Indeed, for the government, second quarter GDP is also likely to be weak. However, the third quarter is likely to be artificially inflated by 0.5 per cent, suggesting a strong third quarter report, which will be released in late October. While most of us will hopefully enjoy a warm summer, the chancellor may have to wait until the autumn.”

Stimulus package

Niesr’s UK economic outlook argues that fiscal policy could be used to stimulate demand in the economy. Moreover, NIESR argues the UK could achieve this with little to no loss of credibility with regard to its fiscal plans.

The report states: “We have never and do not now advocate scaling back the government’s medium-to-longer term policy of fiscal consolidation. However, the UK also suffers from a lack of demand in the short term.

“As we noted in our January review, a 1 per cent of GDP increase in government investment this year would boost GDP by roughly 0.7 per cent, assuming no reaction by the Monetary Policy Committee (MPC). A temporary boost to net investment, which has been cut extremely sharply, would have no direct effect on the government’s primary fiscal target of balancing the cyclically adjusted current budget in 2016-17.”

The MPC is particularly unlikely to act to curb inflation as price rises are likely to remain limited when volatile factors such as energy are excluded. According to the Confederation of British Industry (CBI), while inflation is expected to be somewhat higher than previously thought throughout 2012, in part due to recent oil price rises, it should continue on a downward trend and come close to hitting the Bank of England’s target in the spring of 2013.

In addition, the CBI claims that household spending will remain subdued, with weak wages growth and unemployment rising to a peak of 2.86m in the first quarter of 2013. However, it predicts prospects should improve next year as inflation continues to fall further and disposable incomes begin to recover.

Partly as a result, interest rates are expected to remain unchanged throughout most of the forecast period, with a rise expected in the final quarter of 2013.

John Cridland, CBI director general, says: “The global economy continues to pose a number of significant challenges. Concerns over eurozone stability are on the rise again, oil prices remain high and confidence among businesses and households are still fragile.

“We have always said that the path back to sustainable economic growth will be a long and difficult one, with many bumps along the way. To rebalance our economy towards exports and investment will take time and patience.”

Jenny Lowe is features editor at Investment Adviser

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