As the UK economy loses momentum, Philip Lawlor looks at why growth is so lacklustre and where we go from here.
For a professional firm the health of the economy will often determine the current focus of the business, as well as its appetite for risk and growth. With the UK economy losing momentum, many firms remain under pressure.
The growth projections of 1.7% (2011) and 2.5% (2012) used by the Government in the March Budget are now looking optimistic. The International Monetary Fund has revised its estimates for UK growth to just 1.1% this year and 1.6% next year. There are also questions over the sustainability of the current fiscal austerity programme. The deterioration in sentiment regarding the status of the UK economy has contributed to UK gilt yields hitting their lowest level since the 19th century.
Structural headwinds
The UK economy is facing several structural headwinds. Consumption expenditure, which constitutes two-thirds of the economy remains very fragile and is unlikely to rebound sharply. It has been impacted by sustained erosion in real disposable income and a deteriorating labour market (the unemployment rate has increased to nearly 8%). The Coalition Government's fiscal austerity programme has yet to impact on unemployment, although it has had a significant effect on confidence. Ultimately, recessions are about the incremental impact of purchase decisions being postponed, which is directly linked to confidence.
The credit culture that spanned the 1980s to 2008 resulted in household debt as a percentage of disposable income growing from 85% in 1985 to 180% in 2007. Consumers are no longer spending more than they earn – instead they're focused on reducing their debt. This is expected to continue for a while. So the decline in consumer lending is perhaps as much about a lack of enthusiasm for credit as an unwillingness by banks to lend. The housing market also remains moribund.
Net exports have failed to accelerate and with Government expenditure in contraction mode, corporate capital expenditure is the only visible source of growth stimulus.
Impact of inflation
Inflation has clearly been a major problem over the last 18 months, eroding disposable income and undermining the credibility of the Monetary Policy Committee (MPC). Earlier this year the markets exerted pressure on the MPC to raise interest rates, which governor of the Bank of England and chairman of the MPC, Mervyn King, resisted. He argued correctly that as most of the inflation was due to rises in commodity prices and VAT, a rate rise would have little impact. The MPC could have raised rates to push sterling higher and counter imported inflation, but this would have killed off the nascent recovery in the manufacturing sector. Importantly, there is no evidence of longer-term inflationary expectations ratcheting upwards.
What next?
The August MPC minutes indicated mounting concern over the direction of the economy and revealed that for the first time since May 2010, no member voted for a rate hike. Consideration was also given to whether there was a case for extending quantitative easing. Ultimately, the case was not quite strong enough, although it suggests further quantitative easing will be deployed if downside risks materialise.
If we have learnt nothing else from the eurozone debt crisis, it is that highly indebted countries must maintain nominal GDP growth above their bond yield. Failure to do so results in the debt to GDP ratio expanding. Fortunately the MPC recognises this risk.
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