FX Research - Weekly economic data preview - UK economy may have contracted in Q3; Economics Weekly - Uncertain outlook for UK economy
Economics Weekly 20
Uncertain outlook for UK economy
turmoil makes economic forecasts even more uncertain than usual...
The prospects for UK economic growth have deteriorated
sharply in the last two months. The main reason for this relate to the higher
than expected level of price inflation which has hit consumer incomes and company
profits badly and so is leading to weaker consumer and investment spending. In
addition, the intensification of the credit crisis - the loss of confidence in
financial markets nthat is reflected in sharp falls in share prices and housing
markets - is adding a more worrying twist to the outlook. This makes
forecasting economic variables and outcomes even more fraught than usual. In a recent
Weekly, we looked at how projections of economic growth 1 year ahead performed
in the last decade and noted that the average error in predicting gdp growth
was 1 percentage point, see table 1.
...and a single view
for the year ahead is almost certainly likely to prove incorrect
Point estimates in the
current period of extreme uncertainty and market turmoil are far less likely to
be accurate, or useful, than even the usual 1 percentage point error, which
itself is an average. For this reason, using a range of possible outcomes is
likely to be better than any point estimate, and these are likely to have very
similar probabilities attached to them as well. In other words, instead of
being much more confident about a central outlook than any other possible
outcome, it may be that a significantly different forecast can have a very
similar confidence attached to it. The reasoning is that, given how great volatility
is, the central view could be quite different from the view of a month earlier
that at the time seemed most likely.
This is true for a
range of key UK economic variables...
What does this view
imply for forecasts of some key UK economic indicators
for 2009? The range of outcomes for economic growth in 2009 is broad, between
+1.5% and -1.9%, with an average of -0.2% for the full year, based on consensus
economic forecasts made in October. This range is outside the 10- year average
error of 1 percentage point - based on a central forecast of -0.2%, any outcome
between +0.8% and -1.2% is equally likely â€“ but, given the huge uncertainty
currently, one would expect this to be the case. Indeed, it could be argued
that the forecast range in October is not wide enough. In this regard, it is
worth noting that the directional accuracy was only correct 77% of the time and
that the actual accuracy of the point estimate over the 10 year period we
looked at was zero, see table 1. In short, at no time in the 10 year period did
the consensus forecast correctly predict the actual outcome. Other variables in
the forecast for next year are equally subject to this uncertainty. In the
charts below we show the standard deviation of economic growth, household
consumption and consumer price inflation. These show that private sector
consumption may rise by 0.5% or fall by 0.5%. Also that price inflation could
fall back below 2% before the end of 2009 or it could end the year above 3%. It
should be remembered that there is also a 23% chance, or nearly 1 in 4, that
the direction of the forecasts for next year is wrong as well. This leaves a
huge range and implies that the outcome for interest rates in 2009 is equally
wide, from a range of 2.5% to 4.5%. With all the current uncertainty, point
estimates in our view are simply not very useful and a range of possible
outcomes would serve analysis best going forward, especially for financial
planning purposes, as what seems plausible or implausible now could easily
switch around next month as conditions change.
...making a better
approach to have a range of most likely outcomes as the basis for planning
Hence, our views about
the most likely outcome for the UK next year should be
seen in this light; it is just what seems like the single most likely outcome
now, but other outcomes are also almost equally likely at this time of such
huge turmoil and uncertainty. Nevertheless, there is clearly a lot of pessimism
about the UK economy and this is
reflected in the consensus forecast of -0.2% gdp growth in 2009. This suggests
that output will fall but not as deeply as in the early 1990s. We would tend to
concur with this view, but expect a slightly stronger number on the basis that
the authorities seem prepared to use fiscal, monetary and regulatory
instruments to ensure that a deep recession does not occur. For this reason, we
believe that interest rates are likely to be cut to 4% by the end of the year,
possibly in November. (Why wait? If the authorities are prepared to act to
prevent a fall in output, the sooner they do the better).
In conclusion, expect
considerable variability in actual outcomes in 2009 compared with forecasts
For us, this would mean
that the UK economy may experience
a technical recession - six months of falling output â€“ for the first time since
the early 1990s. However, it may be that there is only 1 quarter when growth
falls but the economy stagnates for up to nine months, both are consistent with
modest economic growth in annual terms. So, either economic conditions improve
in the next few months, and we avoid recession or they do not and the economy
contracts by up to 1% in 2009, see chart d. This would clearly give a different
outcome for interest rates and exchange rates. In that scenario, Bank rate
would be cut to 3% in 2009. If not, we expect that it stays at 4% for most of
the year. This may mean that sterling could fall even further below our end
2009 central forecast of $1.58, which is based on base rates of 4%. But the key
point is that a number of very different outcomes are very possible for 2009
and forecasts are particularly prone to be wrong, however plausible they may
seem at the moment.
The preliminary release
of UK Q3 gdp and
developments in the money and equity markets will command most attention this
week. A negative outcome for gdp growth is widely forecast and would probably
add pressure on the Bank of England to further reduce
interest rates in November. The release of the October MPC minutes on Wednesday
should give further indication of how close the Bank is to relaxing monetary
policy in the light of a darkening economic backdrop and heavy losses in
equities. In the US, Fed chairman Bernanke
testifies on the economy on Monday where his
assessment may shape
expectations with regard to the FOMC meeting next week. In the euro zone, we
forecast further falls in the preliminary PMI surveys of activity in the
manufacturing and services sectors.
â€¢ Signs of some thawing
in UK money markets occurred
last week and offered some cautious optimism that the coordinated central banks
actions to provide liquidity is starting to bring back some life in the
inter-bank market. However, the decline in Libor rates is still mostly
concentrated in the very short-term maturities, where for example overnight
rate fell by more than 60bps last week. By contrast, the much smaller 10bps
drop last week in 3-month Libor to 6.16% is illustrative of continuing
unwillingness to lend for longer periods. Tight credit conditions and record
high inflation are likely to have caused business investment to shrink for a
2nd successive quarter and consumer spending to stagnate or fall, causing the
UK economy to contract in Q3 for the first time since Q2 1992. Our forecast of
a 0.2% q/q drop follows the stagnation in growth in Q2 and puts the economy in
the position of having a technical recession (6 consecutive months of falling
output). We expect Q3 growth to have slowed to 0.5% y/y from 1.5% y/y in Q2.
Rising unemployment and falling wage growth will help to bring down inflation,
the BoE's main objective, but could cause more economic pain in the interim.
The collapse in oil and other commodity prices should help to alleviate inflation
pressures, and assisted by below trend gdp growth, explains why BoE MPC members
voted for a rate cut. How this is changing the tone of MPC policy discussions
will emerge in the October MPC minutes, due on Wednesday. Market participants will
pay particular interest to the votes of MPC members Sentance and Besley, and
the Bank's latest appraisal of the growth and inflation perspectives to judge
whether another rate cut is imminent following the emergency reduction in base
rate two weeks ago. Another cut of 0.50% now looks likely in November. The CBI
industrial trends survey will be published on Tuesday and September retail
sales data are due on Thursday. UK public finances have
come under close scrutiny this month as a result of the government's capital
infusion in some of the country's banks. The September figures may show a
significant deterioration in tax receipts and higher borrowing. Unless this is
matched by falls in expenditure, we expect the cumulative PSNCR deficit to rise
to Â£18.6bn for the (fiscal) year-to-date, Â£5bn ahead compared to the same
period last year.
â€¢ A quiet week for US
economic data means the thrust of attention will be on Fed chairman Bernanke's testimony
on the economy on Monday and company earnings through the course of the week.
Very weak economic releases for retail sales and manufacturing activity last
week underlined the likelihood that the US economy shrank in Q3,
an outcome that may lead the Fed to again cut interest rates at the FOMC
meeting next week. Mr Bernanke cast a gloomy outlook on the economy at a speech
last Wednesday when he said that a 'broader economic recovery will not happen
right away', even if recent actions by the central bank help to stabilise
financial markets. Weekly initial claims are due on Thursday and may indicate
whether the labour market is stabilising. Last week's claims data showed a drop
â€¢ Prospects of further
interest rate cuts will also be debated in the euro zone this week where the
flash PMI indices for October are published on Friday. Business and consumer
confidence have taken a severe knock in the wake of the banking crisis and with
demand for new business and employment prospects dimming, we expect the PMI
indices to have fallen again in October. Taking on board the easing in
inflation pressures - euro zone CPI slowed to 3.6% in September - this could
make some ECB members more inclined to vote for lower interest rates in
November or December.
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