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Monday January 28, 2008 - 12:36:24 GMT
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Economics Weekly - UK economy to avoid recession in 2008; Weekly economic data preview - US Fed interest rate decision & Q4 GDP and EU-15 flash CPI feature


Economics Weekly

UK economy to avoid recession in 2008  28 January 2008

Growth better than expected last year…
Overall, the UK economy expanded by 3.1% in 2007, well above the 2.4% expected at the start by most forecasters. This was in a year that oil prices doubled and the currency was strong – at least for the first half. Indeed, this fast growth in the economy resulted in a widening of the current account deficit to around £68bn, 5% of the economy and the biggest ever deficit in monetary terms. How is the UK economy likely to perform in 2008?

...but there are many risks to growth in 2008 and consumer spending may hold the key to any expansion…
The UK economy is actually entering 2008 with a lot of momentum, in spite of signs the pace of growth is faltering. Despite worries about imminent recession, growth in the final quarter of 2007 was 0.6% - almost bang in line with the long run average. This is despite the credit crisis, the slowing of house price inflation, oil prices averaging over $90 dollars a barrel in the final quarter of 2007 and a rise to a mid-year peak of 5.75% in interest rates (though cut to 5.5% in December). What are the main factors driving expansion of the economy? Consumer spending remains the key, with growth of 3% in 2007, helped by rising household wealth effects – stock market and housing, see chart a. Although both of the latter are slowing down – and showing signs of vulnerability - the fact is that in the last few years, they have been supporting a fall in the saving ratio and, by implication, growth in consumer spending. But there is a slowdown in consumer spending underway, with consumer and retail confidence both sharply off  their 2007 peaks and wealth effects in retreat, alongside a rise in energy prices and mortgage payments that are sapping real income growth.

...will consumers buckle under headwinds from weaker real earnings and a slowing housing market?
After worries last year that consumer spending would buckle under the pressure of higher interest rates and a rise in inflation that would reduce real spending power, the opposite was true. Growth in consumer spending rebounded. The reason? High levels of employment and continued low unemployment combined with high wealth effects (from a rising stock market and a strengthening housing market) encouraged consumers to lower their savings ratio in order to maintain spending levels. But what will happen to consumer spending in 2008 now that the housing market is weakening, stock markets are declining and the US economy is slowing after the bursting of the housing and credit market bubbles?

A strong labour market offers support to households and the economy
However, this does not mean that consumer spending will collapse. Rather, we are looking for a slowdown, to just over 2%  growth in 2008, down from about 3.2% in 2007 and just over half the 10 year average. The reason is that the UK labour market remains very strong, with the highest ever level of employment and the lowest unemployment rate since the mid-1970s, see chart c. Earnings growth is low but positive - so long as this combination remains in remains in place, consumer spending will remain positive and the economy will avoid recession. Further, whilst the slowing housing market is a negative for the pace of economic growth, here too, there should not be a replay of the early 1990s, when prices fell for 4 years, but of 2005, when they slowed sharply. Our forecast, in chart d, for house prices shows that, although in Q4 2008 there is an outright fall in prices of 1%, the average for the year is 2% and it recovers modestly in 2009. The reason for this is that: first, we assume interest rates are cut further, to 5%; second, there is a shortage of residential housing in the UK and this supports prices; third, employment growth slows but does not fall sharply.

And company investment, government spending and the trade deficit matter as well
However, UK economic growth in 2007 was not just about personal consumption, even though it is 70% of gdp. Business investment spending went up by around 7% and government spending rose 1.7% last year. Therefore, UK economic growth in 2008 will also depend on how these other sectors perform. But fast growth resulted in a wider current account deficit, and high government spending meant a large borrowing requirement, which will also worry the financial markets, keeping the pound weak. This is a constraint on public spending, and will prevent the use of fiscal policy as a tool to expand the economy. Moreover, price inflation is still a concern, with a sliding pound exacerbating the pressure from higher commodity prices. In this environment, interest rate cuts will be modest but growth will be near the long run average as strong global growth helps UK exports at a time that labour costs should remain low.

Corporate sector may offer strong support to the UK economy in 2008...
Investment spending in the UK has been strong in the last few years, but we are looking for a slowdown. However, that will still leave business investment spending rising by about 3% in 2008. A weaker currency, supporting export industries, and lower interest rates, supporting domestic spending, will underpin investment activity. This is made more likely by the fact that company profits are at a record high, see chart e. And this correlates well with changes in business investment spending over time. It also partly explains why, even though the company sector has become more worried about general economic conditions, it remains fairly bullish about its own trading conditions. The international background is therefore very important as well. The UK economy is very open to international trade and so a weaker currency, combined with fast growth in the world economy, offers an opportunity to UK exporters. So long as wage inflation stays low, they can gain a competitive advantage.

…but inflation is a concern and economic risks are skewed to the downside
However in 2007, the UK external deficit was the widest recorded in money terms, though not as a share of the economy. This implies that the pound will stay weak and price inflation remain a concern. Our forecast shows that the MPC inflation target may remain above 2% throughout 2008, and that the average rate will exceed the target just as it did in 2007. There may even be another open letter from the Governor to the Chancellor explaining why the upper limit of the inflation target (this happens when CPI is above 3%) has been breached. But inflation will fall back to the 2% target in 2009 so long as the economy weakens as we  expect see chart f. However, this will mean that there is little scope to cut official interest rates without the MPC losing credibility, making its task of hitting the inflation target even more difficult in future. Another clear vulnerability for the UK, and policy risk for the MPC, is that the UK is running a large budget deficit, likely to be some 3% of gdp this year and next. In this environment, cutting interest rates is even more worrisome from an MPC viewpoint, as it  could lead to a too loose overall policy stance and even higher inflation in the future. Although there are downside risks, from the credit crisis, high oil prices, greater fallout from the US slowdown and financial market turbulence, our view is that the UK economy can weather these headwinds and expand for a 16th successive year, helped by its open economy.

Trevor Williams, Chief Economist

Weekly economic data preview W/c 28 January 2008

US Fed interest rate decision & Q4 GDP and EU-15 flash CPI feature

The Fed's decision to deliver an inter-meeting interest rate cut of 0.75% to 3.5%, has taken some pressure off Wednesday's scheduled interest rate meeting. It is likely that the Fed will cut rates again, otherwise markets may fall sharply. If not, further cuts of at least 50bp are likely over the next few month. After that, more cuts will be dependent on  whether incoming data signals recession. Market futures show implied fed funds rates at 2.3% at end-year, UK base rates at 4.73% (from 5.5%) and euro rates at 3.72% (from 4.0%), see chart 1. This implies a more negative view of the US economy than our central view. However, US data this week is unlikely to improve the market view, and could worsen it. US Q4 GDP, published Wednesday, is likely to be sharply lower. On Friday, non-farm payrolls for January could increase by 80,000, compared with December's figure of 18,000, but below the recent average, see chart 2. Given the ECB's hawkish bias on interest rates, EU-15 flash CPI for January could cause a stir on Thursday should market expectations of 3.1% annual growth under- or over-shoot.

• The US Fed offers its fourth and final scheduled $30bn Term Auction Facility (TAF) at 3.00 today. Overnight, following the Bush administration's agreement on a $150bn stimulus package to boost the economy, the President delivers his State

of the Union speech to Congress which may give further clarification of the plan. Apart from that, US Fed policy and economic data releases will grip markets. Data is likely to present a weak bias, including new home sales, S & P/Case Shiller house prices, Q3 GDP and NFP jobs growth. The preliminary release of Q4 GDP could show just 1.5% annualised growth, down from 4.9% in Q3. However, the quarterly GDP deflator may rise from 1% in Q3 to 2.6% in Q4, highlighting inflation risk in some areas of the economy, and underpinning our view that monetary policy may be less aggressive than current market perceptions. Also, monthly measures of personal income and spending could show very weak growth in December. All this adds up to a picture of a weakening economy at the back end of 2007, but not necessarily recession. January surveys continue to paint a mixed picture - the Chicago PMI could stay around the 56-  57 level, the ISM manufacturing index could improve a touch from 47.7 in December to 50.0, while the University of Michigan Survey could be confirmed a touch below the first release of 80.5. The core PCE deflator, the Fed's preferred measure of inflation, may have risen to 2.4% in December from 2.2% in November. Although 1-2% is the Fed's comfort zone, this will not prevent the Fed from cutting rates further in coming months due to fears of recession.

• We disagree with comments that the UK is slipping into recession and expect GDP growth of around 2.25% this year. But markets are looking for data with a bias towards slowdown. They may be satisfied with stable net mortgage lending and a further drop in December mortgage approvals to 79,000 from a year-to-date average of 107,000 and a peak of 131,000 in November 2006, indicating a softer market 6-9 months ahead. Nationwide house prices for January could fall another 0.4% from a fall of 0.5% in December, adding to worries about the extent of the decline. In addition, the CBI distributive trades and the GfK consumer confidence surveys may come in weak.

• With inflation the key ECB policy concern for now, the flash January release of EU-15 CPI on Thursday is the weekly highlight. We expect the annual rate of inflation to remain steady at 3.1%, well above the ECB's preferred level of 2% and explaining their reluctance to loosen monetary policy to pre-empt slower growth, unlike the UK and the US. Should CPI be weaker/ stronger, market perceptions of euro interest rates could change sharply. Other data may show that consumer confidence weakened further in January, although PMI manufacturing and industrial confidence may be more robust. Speeches by ECB members Liikanen, Tumpel-Gugerell, Hurly and Bonello will be assessed for hawkish interest rate bias.

Nichola James, Senior Economist

Economic Research,
Lloyds TSB Corporate Markets,
10 Gresham Street,
London EC2V 7AE,
0207 626 - 1500

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