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Monday January 16, 2006 - 11:45:27 GMT
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An uncertain UK economic outlook for 2006

Economics Weekly: An uncertain UK economic outlook for 2006

Will the economy recover?
At the end of 2005, the UK economic outlook for the year ahead was increasingly talked about as looking exceedingly bleak. After growth of 3.2% in 2004, the expansion in 2005 is going to be 1.8% at best, and possibly as low as 1.6% depending on how growth in the final quarter of 2005 turns out. This would be the slowest annual rate of economic growth since the current expansion began in 1992. What is likely to happen in 2006? Will the economy recover or weaken further and interest rates therefore need to be cut as inflation falls below the 2% target?

Consumer spending has slowed sharply…<.b>
Latest figures show that unemployment has risen for the last 10 months, consumer confidence has fallen for the last three months in succession, consumer debt is at an all time high, retail sales growth has been weak and, to cap it all, the manufacturing sector is back in recession with exports faltering. On this view, it is easy to understand why there are such vociferous calls for interest rates to be cut, with one prominent forecaster expecting interest rates to reach a low of 3.5% in 2006, a level last seen in 2003. But this is not a view that we take; far from being about to contract, the economy is actually about to recover and consumer spending is likely to strengthen in 2006, helping business investment spending to pick up as well.

…but recovery may already be underway
A cut in interest rates now would be wrong for the economy and likely to be quickly reversed. In fact, there could be pressure for a modest rate rise by the end of 2006 (taking back the August 2005 cut which was insurance against a sharper slowdown), if some trends that we see developing actually emerge. We base this view on continued recovery in the housing market, particularly a sustained high level of mortgage approvals, sustained employment growth and service sector expansion and solid growth in the global economy. The latter should help UK exports and boost business investment, even though overall economic growth will remain tilted toward consumer rather than investment led spending.

Growth will continue to be led by services…
UK economic growth in the last five years has certainly been led by consumer and government spending, accompanied by increased debt in both sectors, with relatively weak expansion of business investment. But it seems somewhat simplistic to say that a rise in debt is always bad, because, in the case of consumers, it could have been outweighed by an even bigger increase in assets, such as the value of their homes and their holdings of equities.

...as housing and equity wealth underpins borrowing
This is exactly what has happened in the UK over the last few years. Chart A shows that UK household net total worth was £5.8trillion at the end of 2005, with borrowing at a record high of £1.2trillion, but rising at a slower pace than asset growth. The reason for the fall in net worth during 2000, as shown in the chart, was the share price collapse that year; the reason for the recovery is the continued rise in house prices (albeit at a slower pace) and, now, the recovery in equity prices as well. As for the view that the government is at the limit of its borrowing, this may indeed be true in the sense that the budget deficit, at 3.6% of the economy is large, but it is also the case the UK public sector net debt is only 36% of gdp, low by international standards. Moreover, government spending acted as a stabiliser, rising when the economy was weak, just as theory suggests it should. Equally, of course, it should now slow as the economy recovers so that debt is repaid.

What is fuelling the recovery in the UK housing market?
The short answer appears to be that consumer confidence is being underpinned by growing employment and reasonably healthy growth in incomes. Despite falling in the past few months, consumer confidence is still above its long run average and consistent with growth in retail sales of around 4% a year, see chart B, a rate that we expect to see in official sales data in the next few months. In addition to these positives, the fast growth of UK money supply, up by over 12% in the year to December 2005, is the highest in eight years and potentially inflationary. This shows that there is ample liquidity around in the UK to fund faster consumer and company spending. Our own monthly FMD survey of consumers shows that inflation expectations are higher than the consensus and hence that interest rates will rise in 2006. But overall consumer borrowing growth has fallen, as consumer spending on credit cards and other non secured borrowing has declined quite sharply, helping to create room for more modest expansion based closer to growth in income. We are looking for a modest recovery in consumer spending to 2.5% in 2006, up from 1.8% in 2005.

Investment spending to rise
But investment spending should also play a role. The latest Lloyds TSB Business in Britain survey shows that business confidence has risen sharply in the last six months, despite pressure on company profit margins. What appears to have held back investment is uncertainty about demand conditions, driven by the weakness of consumer spending. If that begins to improve, as we expect, investment spending should also accelerate. That would push economic growth up to the 2.5% range that we are looking for. In terms of output growth, a similar pattern of recovery is also discernible. Based on surveys of manufacturing purchasing managers, output growth is set to quicken modestly in coming months. With faster growth in the UK’s main export markets (US, EU), manufacturing growth should accelerate. Already, UK export volumes are rising - running at 11.6% in the year to November, with import volume growth at just 3.6%. The puzzle is that this trend is diverging from the domestic measure of UK output volume. One possible explanation is that UK firms are able to increase exports but cannot compete in the home market for goods that UK consumers are purchasing at increasingly lower prices.

What about inflation and interest rates?
Low UK wage inflation has been one of the main reasons why overall price inflation has stayed subdued in 2005. This has helped to offset the inflation effect of higher oil prices boosting energy costs. Also, inflation expectations remain low in the UK, shown by low long term bond yields. Indeed, the current negative slope of the UK yield curve is due, in our opinion, not to short term interest rates being too high but long term interest rates being so low. But we would look for confirmation of stronger growth to lead to a positively sloped curve in early 2006. Consumer price inflation has fallen from its September peak of 2.5% as the inflationary effect of higher oil prices eased back, but in recent month’s oil prices have moved higher again so inflation may also rise back. This means that price inflation may remain above its 2% target for most of 2006, limiting the downside for interest rates. If growth slows, a cut in interest rates is most likely. However, if economic growth accelerates, worries about wage inflation are likely to resurface, even though they are just 3.6% at present, and the pressure towards the year end will be for the modest increase in interest rates we expect. However, in the near term, it appears to us that UK interest rates are likely to stay at 4.5% well into 2006 as the MPC waits to see how the economy develops.

Trevor Williams, Chief Economist
trevor.williams@lloydstsb.co.uk
www.lloydstsbfinancialmarkets.com
Lloyds TSB Bank,
Financial Markets
Division,
Faryners House,
25 Monument,
London EC3R 8BQ
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