Economics Weekly - Will this UK recession be as bad as last time? Weekly economic data preview - BoE and ECB to cut interest rates by at least 50bp
Economics Weekly 3 November 2008
Will this UK recession be as bad
as last time?
UK economy contracts for
the first time since 1992
The first decline in UK gdp since 1992 means
that the economy is heading for recession. Growth contracted by 0.5% in Q3, after
being flat in Q2. On balance, it is likely that growth will fall again in Q4
though not by as much as in Q3, which saw
a bigger fall than expected as manufacturing output dropped across the board. The global and UK economic backdrop has
worsened significantly in the last 3 months, with the capital injections, government guarantees
and cuts in official interest rates doing little to calm financial markets, though some of the panic
in equity markets seems to have abated. Such has been the loss of confidence in financial markets that
all global leveraged positions are suspect, for countries, firms or industrial
sectors. UK growth in Q3 was
especially hit hard by the sharp rise in price inflation, weakening in wage
inflation and the increases in petrol, gas and electricity charges that cut
real household incomes quite sharply.
Last three months have
seen worsening economic and financial market data...
In the last three
months, manufacturing output has fallen ever more sharply and retail sales
growth slowed further, see chart a. Consequently, business and consumer
confidence have fallen steeply. It is not therefore surprising that consumer
spending and investment spending growth have turned negative, see chart b. Once
the detailed figures by expenditure are revealed (due end November), it is
likely that consumer and investment spending fell in Q3 as well as in Q2. Falls
in house prices, measured by the Halifax and Nationwide
indices, are of the order of 12-16% year on year, and home repossessions are
starting to rise strongly. Car sales are down and the fall in house prices and
in house sales have hit durable consumer spending particularly hard.
is rising and wage inflation is stagnant in the face of rising price inflation,
leading to further falls in real, or inflation adjusted, income growth. The
credit crisis has also led to tighter lending standards and to a wider spread,
meaning that libor rates remain high even though base rates have been cut. It
is surely no coincidence that the recent wave of financial market turmoil
intensified in the weeks following the collapse of Lehman Brothers, as it
highlighted the counterparty risk that financial institutions face. The subsequent
falls in equity markets and rise in volatility seems to have badly impacted
consumer and business confidence around the world.
A key question
therefore is whether this current UK economic downturn will
be as sharp as in the 1990s. Then, output fell about 2.5% peak to trough.
However, this imminent recession is likely to be shallower. Why is this? After
all, in the last recession the world economy was not in the grip of the worst
financial markets crisis in Start of recession compared Q3 1990 Q3 2008 decades and was
perhaps not as interconnected as it is now. But table 1 gives some of the
reasons why this slowdown may not be as steep. For a start, as chart c shows,
the UK gdp decline of 0.5% compares favourably with the 1.2% fall in 1990, and
this is over a year into the credit crisis that was predicted to have led to
recession much sooner and deeper than seen so far. Short term interest UK rates, including libor
rates, are a lot lower than they were in 1990. Base rates are much lower and so
are long term interest rates. The reason is that price inflation is also much
lower. In turn, this is helped by wage inflation, which is also much weaker,
giving scope for price inflation to ease and so for interest rates to be cut
below the current level of 4.5%. The pound is lower in trade weighted terms,
making the UK economy more
competitive, even though growth in overseas markets is slowing as well.
Table 1 also shows that
unemployment is much lower now than in 1990 on the claimant count basis, and would
have to be 750,000 higher than it is currently, just to match the starting
level of the early 1990's recession. All in all, these are not the sort of
starting level, at least from these figures, that suggest an economy about to
plunge into its deepest recession since the 1990s or the 1980s. However, this
does partly assume an aggressive policy response. But one does seem to be underway,
with government spending commitments of the order of Â£500bn so far and both tax
cuts and further spending increases are likely to be announced in the Autumn
Statement later this year. Official interest rates have been cut by 0.5% in one
coordinated global move in the past month, and a further fall of 1 percentage
point is likely by end-year taking UK base rate to 3.5%.
Where price inflation may eventually end up, with a loose fiscal and monetary
policy and a weakening currency is uncertain, though it may be that policy will
be tightened pretty sharply once recovery gets solidly underway.
...and the jury is
still out on whether this downturn will be shallow or steep
In any event, the focus
of fiscal and monetary policy is now targeted at mitigating the economic
slowdown, and solving the credit crisis. Of course, the eventual outcome of the
current downturn is very uncertain, more so than even in 1990. With falling
real wealth (equity and housing markets) and bank and financial institutions shrinking
their balance sheets, it is possible that the current economic downturn will be
as bad or worse than in earlier episodes. Although we would give this scenario
a much lower probability than a shallow recession, the jury is still out.
However, all recessions end, and the extent of this one will be clearer in a
few months, especially given the much more aggressive policy response that is
BoE and ECB to cut
interest rates by at least 50bp
presidential elections top the events calendar, as well as interest rate
decisions by the Bank of England and the ECB on
Thursday. Both central banks are likely to deliver at least a 50bp cut,
bringing UK base rates to 4% and euro
repo rates to 3.25%. It is possible, but in our view unlikely, that they cut by
100bp, both instead expected to act in line with the US Fed, which last week
cut its funding rate by 0.5% to 1%. Admittedly, the BoE and the ECB have much more
scope for lowering rates. But the ECB is likely to err on the side of caution
as far as taking risks on medium term inflation is concerned. In turn, the BoE
may not favour an asymmetric reduction vis-a-vis the ECB as it risks causing a further
fall in sterling. On the other hand it is possible that a 100bp cut,
representing a more aggressive UK economic stimulus
could be taken as a positive. Economic data in the run up to Thursday's
decisions will be gleaned for any early signs of Q4 performance and how this
will impact on decisions. In the UK, our view is that flat output is as likely
as contraction in Q4, as in Q3, GDP and net incomes took the hit from a massive
hike in utilities prices which will not be repeated. There is a danger of a
negative spiral, however, as economic surveys are very week and households are increasingly
concerned about job prospects, slowing their spending and so hitting company
sales. Eurozone Q3 GDP is not due until next week, but it is expected to
contract another 0.2%, meaning technical recession. October's US NFP jobs report could
show a loss of 180,000 jobs and a rise in the unemployment rate to 6.2% of the
workforce. The Reserve Bank of Australia will cut interest
rates by 50bp to 5.5% on Tuesday.
â€¢ UK business surveys and
official industrial output figures feature this week. PMI manufacturing and
service business surveys are due for October - the headline balance for manufacturing
rose to 41.5 from an upwardly revised 41.2 in September. The services PMI is
likely to fall to 45.0 from 46.0. Within the detail of the survey, we expect to
see further weakening in the input/output price and in the employment balances.
The construction activity PMI is also unlikely to show any great improvement.
Industrial production data for September is also published - this will complete
the data series showing contraction in each quarter this year. Manufacturing
output may fall 0.3% on a monthly basis and 1.6% annually. The NIESR rolling
three month GDP estimate for October may also point to economic weakness at the
start of Q4. Given the fact that this week's data will highlight the risk of
technical recession (two quarters of negative growth), we believe that the MPC
decision to cut interest rates on Thursday will be unanimous.
â€¢ PMI manufacturing and
service business surveys (final) also feature in the Eurozone and are likely to
confirm the preliminary balances of 41.3 and 46.9 in October. EU-15 retail
sales may have contracted in September, by 0.2% on the month and 2.1% on the
year, adding to the view that domestic demand is weak. The European Commission
releases its review of economic forecasts - there may be a significant downward
revision of economic growth and inflation projections compared with the earlier
release. All in all, given ECB President Trichet's comments last week and
prevailing economic weakness, it seems almost a certainty that the ECB will cut
its repo rate by up to 0.5%
â€¢ The US non-farm payroll
figure for October is likely to be very weak given survey reports, including
the survey of private nonfarm companies reporting lay offs. We expect a 180,000
fall in jobs for October, a deeper drop than the 159,000 outcome in September,
bringing the total number of job losses this year to 760,000. The unemployment
rate could rise 6.1% to 6.2% of the workforce, but we still expect average
earnings growth of 0.2% on the month. The ISM manufacturing and service
business surveys are also published - we expect further declines. Another key
indicator, non-farm productivity growth may have declined to 1.8% in Q3 from
4.3% in Q2 as firms' spare capacity continues to rise. Q3 annualised GDP contracted
by 0.3% and continued weakness so far in Q4 increases the chance that the US
Fed will cut interest rates below 1%.
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