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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.


Moreover, unemployment 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 £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 now underway.

Trevor Williams, Chief Economist, Corporate Markets


Weekly economic data preview W/c 3 November 2008


BoE and ECB to cut interest rates by at least 50bp


Tuesday's US 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.


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.


• 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%


• 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%.

Nichola James, Senior Economist



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


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