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London Terror Attacks – economic impact likely to be small

Economics Weekly: Economic Research and Analysis

London Terror Attacks – economic impact likely to be small

London hit by terror attacks
The London terror attacks have clearly come as a shock (even though they may not have been a surprise) and one question amongst many is: what economic impact are they likely to have? There are a number of channels through which they could impact the economy. These range from financial markets, consumer and business confidence and the real economy, although all are interrelated. Economic fears were quickly reflected in the financial markets, with equity markets off sharply, bond prices up and interest futures pricing more aggressively for a rate cut from the Bank of England as gold prices also rose. But are there also likely to be effects on the ‘real economy’ - consumer spending, investment spending and so on?

Financial market impact
First of all, the initial financial markets responses were predictable: equities fell; bond prices rose (yields fell), the currency fell and interest rate markets were looking for a quick base rate cut from the Bank of England. By the end of the day, however, some of these losses were already unwinding. The Bank of England kept interest rates at 4.75% at its July Monetary Policy Committee (MPC) meeting, equity markets were rebounding, and gilts were shedding some of their gains.

At close of play today (Friday, 8th), the equity markets had regained all of their losses and the FTSE 100 was above its level before the news of the attacks broke. But gilts yields are still about 7 basis points below the level before the news, currently at 4.21% on the ten year benchmark. The UK currency was still down, but by less than 1 cent against the US dollar. The short term interest futures market was still marginally tilted toward a cut in base rates being more likely now than prior to the bomb attacks. But, overall, it appears that the UK financial markets seem to have calculated that the effects of the attacks on London are likely to be relatively limited in economic scope. Are they likely to be proved right?

Whole economy impact
Chart A shows that at the level of the whole economy the effects of the terror attacks in the US and Madrid, though clearly on a different scale to those in London (particularly the attacks in the US), seem to have had little discernible negative effect on the path of the US or Spanish economies. Of course, it is difficult to say what course they would have taken in the absence of the attacks, but in the quarter after the bombings, economic growth in each country was growing strongly, see chart A. In the case of Spain, growth remained robust during and after the bombing. In the case of the US, the economy actually moved from recession to growth, as fiscal and monetary policy was loosened. Since the attacks in London are smaller in scope and caused much less physical damage than previous attacks on the City of London by the IRA or the attacks in the US and Spain, it is likely that, at least at the level of the overall economy, the impact on the UK is also likely to be small. But will the bomb attacks have bigger effects at a sector level and hit confidence?

Impact at industry level
The first effect might be on consumer and business confidence, but it is difficult to say much more at this stage. If confidence does get badly affected, then the Bank of England does have plenty of scope to cut interest rates. Although interest rates were kept at 4.75% at the July MPC meeting, a rate cut in August is widely expected - though it was expected before the bombings due to significant downward revisions to economic growth in Q1 2005 and, to a lesser extent, slowing retail sales. In terms of the impact on specific sectors, the main effect is likely to be felt in the construction and tourism industries. There will have to be work done on the parts of the tube network that were affected, for instance. But this is likely to be small in spending terms relative to the size of the London economy.

There is also potential for an impact on retail sectors if consumer confidence is badly hit, especially as retail spending has been slowing recently. This may depend crucially on whether there are other attacks. But if it is the same terror group that was responsible for the attacks in the US and Spain, then it does not appear to wage a sustained campaign in one country. The City of London is not a retail centre, so people do not generally visit it just to shop. Hence, the direct retail impact may also be small, so long as other areas are not targeted. Tourism seems the industry most likely to be negatively affected, with visitors to the UK and to London both from other parts of the country and from overseas significantly reduced. London gets about a fifth of all the overseas visits to the UK, but some 50% of their spending, according to OEF research. But set against the £1,200bn economy of the UK, any impact is likely to be much less than 0.1% of gdp. And as chart A shows, if the attacks lead to an increase in government spending and cuts in interest rates, then the economy might even grow more quickly as determination spreads not be seen to give in to terrorist acts. In terms of policy, however, it does make it more likely that there will be a ¼% cut in base rates at the August MPC meeting. However, further cuts after that will not be automatic in our view, but entirely dependent on how the economy performs in the second half of the year as the MPC holds back to assess the effects of higher oil prices and a weaker currency on price inflation.

UK economic indicators
UK data this week will be eagerly awaited to see what impact high oil prices are having on imported price inflation; whether firms can continue to absorb the oil price increase in their profit margins or whether producer output price inflation is accelerating as they pass some of it on to customers. Certainly, we look for price data on Monday to show both an increase in firms’ input prices and their output prices. Higher oil prices may also lead to widening of the UK’s trade deficit, also due on Monday. Tuesday may show that consumer price inflation has moved above a 2% annual rate in June, after staying at 1.9% for three months. This is something that the Bank of England has warned this year about but the fact of the rise might induce some caution in financial markets about expecting the MPC to cut short term interest rates three times in the next twelve months, as they are just about expecting. Our view is more cautious, that a cut in August is likely, mainly due to data revisions and even if inflation moves modestly above target, but the MPC will try and keep rates on hold after that. Labour market data on Wednesday should show that wage inflation remains just within sight of the MPC tolerance level of 4.5% a year, and that economic growth is still sufficient to be leading to gains in employment.
Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
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