November 6, 2014


Filed under: Economic Crisis, Economic Forecast, UK Economy — drderrick @ 11:12 am

Ongoing and accelerating economic growth over the past 18 months has surprised most economists, and forecasts have all been revised up. 12 months ago the consensus of the economists surveyed by the Treasury was for growth of 2.2% in 2014. That has now risen to 3.1%. A closer look at the key elements of the economy may help to explain why we have seen this unexpected rise in growth, and provide some clues as to how that may develop over the next few years.

While the economy is on track to expand by some 2.5 to 3% over the course of 2014, suggestions in some quarters that “the recovery is now firmly established” are premature. Looking closely at the published statistics, the only substantial growth in the economy has been almost entirely in the service sector, which accounts for over 78% of all economic output. Although the first half of 2014 has seen some growth in the production sectors, after a long period of static and declining output, most remain significantly below their 2011 activity levels. By contrast, most industries in the services sector have seen, and continue to enjoy, good growth. This is especially the case with the wholesale and retail trades, with transport and storage, and with professional and administration services, which have led the expansion of services output. Given the size of the services sector in the economy, recent indications that the growth of services output may be slowing suggest the economic recovery may be encountering renewed difficulties.

In terms of expenditure, the growth over the past 18 months or so can be traced to substantially faster than expected growth in household consumption and government spending. While it has been encouraging to also see a substantial improvement in business investment, there has been a correspondingly large increase in inventories, which suggests that there may be some moderation in investment spending over the coming months. Similarly, with government continuing to run a £100 billion budget deficit, it is difficult to imagine government-spending continuing at recent levels over the course of the forecast period. With global economic conditions deteriorating, especially in the Eurozone, net exports are unlikely to make any positive contribution to growth for some time. That leaves, household consumption – accounting for some 62% of domestic spending – as the only significant potential source of economic growth.

Over the past few years, household spending has been remarkably buoyant and resilient, but it is increasingly unclear how much longer it can continue to grow. There are a number of underlying reasons for the growth in consumer spending, including wealth effects from rapidly rising house prices, and improvements in employment rates. With average real wages under continued pressure, however, of particular importance have been a number of government initiatives to encourage borrowing and spending by businesses and households, and by the extremely low interest rates that ease the burden of servicing large and growing debts.

Chart 1: Household Net Lending (+) and Borrowing (-) – £ millions

Household Credit

Source: ONS

Bank of England figures show that net consumer borrowing began to increase about 2 years ago and has been accelerating since. It is currently growing at an annual rate of 5.4%. As a result, as shown in Chart 1, household finances are deteriorating and reductions in spending may need to be made – especially when interest rates rise.

Households spend just over £1 trillion each year, and Chart 2 shows a breakdown of that spending by type. It shows that households spend almost as much on “enjoyment” alone (£257 billion) as all the spending on investment in the economy (£281 billion). While much household spending is non-discretionary in the short term, spending on “enjoyment” can be trimmed relatively quickly. Any such curtailment of household spending, possibly due to the deterioration in household finances suggested by Chart 1, would quickly arrest the growth seen over the past 18 months.

Chart 2: Household Spending by Type

Spending by Type

Source: ONS

In short, there are no signs yet of a sustainable recovery of the economy, and the growth that there is remains very vulnerable to the interest rate increases expected during 2015.

In light of the challenges faced by the UK, as well as by other economies around the world, the outlook for the next few years is especially uncertain. Continued high private household debts, further constraints on government spending, and an expected start to the normalisation of monetary policy during 2015, contribute great uncertainty to growth forecasts over the coming 3 years. Currently I expect the economy to continue to grow throughout 2014 but start slowing as we move into 2015, and continue to weaken over the course of the following months. Of course, it would not be surprising to see some modest growth in some quarters over the course of the next 3 years but, in my view, there is little reason to expect overall annual economic growth to accelerate beyond the end of 2014.

The median estimate for GDP growth in 2015 of the economists surveyed by the Treasury is 2.3%, slightly higher than my forecast of 2.1% growth. Looking further forward, most published economic forecasts see continued, if modest, growth being maintained.

UK Growth Outlook

GDP 14-17

These outlooks are usually based on a few key assumptions that are increasingly doubtful:
With the economy growing at nearly 3%, and the unemployment rate at a 6 year low and falling at the fastest rate on record, the assumption that interest rates will remain unchanged seems increasingly unsustainable. The Bank of England is now widely expected to begin increasing interest rates by the middle of 2015.
It is also assumed that the deteriorating current account deficit becomes a growing surplus, but the latest official figures show that in Q2 2014 it had deteriorated to 5.2% of GDP, which is the worst in recorded history in both cash terms and as a percentage of `GDP. With the Eurozone economy – the UKs largest trading partner – suffering from a wide range of serious problems, there is no reason to suggest a turn-around in the foreseeable future.
Business investment is expected to continue to grow strongly, despite the many risks and challenges faced by the economy. Given the current economic uncertainties, it seems unreasonable to continue to assume that strong private investment will be maintained for long, or to be a strong driver of overall growth over the next few years.
Above all, the more optimistic forecasts assume household spending will be maintained and continue to grow: an assumption about which there is increasing doubt.
As David Kern, Chief Economist at the British Chambers of Commerce has argued:
“Rises in sterling, making UK exports more expensive, and uncertainties around early interest rate increases are adding to the difficulties, and our excessively large current account deficit is posing risks. UK growth cannot rely permanently on rising consumer spending, which is driven by buoyant housing market and excessive household debt. Unless investment and net exports make bigger contributions to growth, the recovery will stall.“

Given these problems, I suggest that UK average annual GDP growth will be somewhat weaker than the consensus outlook. I expect the economy to grow by 2.6% over the course of 2014, by 2.1% in 2015, 1% in 2016, and 0.7% in 2017. Moreover, the possibility of an in/out EU referendum in 2017 add great uncertainty and means that the risks are mainly that the outturn will be worse than currently foreseen.


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