Monday, March 30, 2009

Economics Weekly : Is the UK Recession Deepening?

Not only is the UK economy in recession but there are few signs that the situation is improving. Final estimates for Q4 2008 show that output fell by 1.6% in the quarter and was 2% lower than in the year before, the largest drop in output since 1980 Q2. In fact, economic data so far in Q1 2009 suggests that the downward momentum has gathered pace and that the fall in gdp in the current quarter is likely to be even larger than in Q4 2008. We look for gdp to contract by about 1¾% in the current quarter, to take annual gdp growth to its slowest pace since the 1980s downturn. We look at recent monthly economic data for clues as to whether this gloomy outlook is a fair assessment of recent trends.

Whilst the manufacturing sector has borne the brunt of the downward adjustment so far, the retail and services sectors are not immune...

Manufacturing survey data in the past month suggest that sharp cuts in inventories and production are not yet over. Chart a shows that while annual volume retail sales growth still remains positive, manufacturing output is falling by an annual rate that is in double figures. The latest CBI survey of output expectations amongst UK firms was the weakest since the survey started in 1975, and suggests that the pace of the fall in output is not yet slackening, see chart b. Purchasing managers' surveys are equally downbeat, with the manufacturing, services and construction surveys all showing that activity is well below the key 50 level and so output in each sector is contracting. A composite of these surveys shows that economic growth has further to fall before stabilising, see chart c. In fact, the fall in economic output implied by the composite index is almost bang in line with our latest projection, which is that UK growth contracts by 3.8% this year. Such a fall would leave the peak to trough drop in UK economic output in line with or worse than the 1980s recession rather than the 1990s downturn.

The March CBI distributive trades' survey suggests that retail sales will fall sharply in the months ahead, see chart d. As if on cue, the volume of retail sales fell by 1.9% in February, the biggest monthly drop since June 2008. Sales fell in all of the main categories, with particularly sharp declines in ‘other non-food stores' and textile, clothing and footwear stores. The annual growth rate of volume retail sales slumped to 0.4% in February, down sharply from 3.8% in January and the weakest annual outcome since September 1995. Although the underlying growth rate (three month on three month) rose by 2%, up from 1.6% in January, indicating that the recent trend had been quite resilient up to February, this is likely to fall back sharply in the months ahead. Services activity is holding up a bit better but not by much. In the Q4 2008 national accounts release, services output fell by 0.8% in Q4 and monthly indicators from the services PMI and the ONS suggest that output is contracting by 1% a quarter. With the financial markets still clogged up, and employment falling, it is likely that this weakness in services output will extend well into the quarters ahead, see chart f. the weak pace of economic activity results in a sharp rise in unemployment and a fall in employment...

UK unemployment is now rising sharply as economic activity deteriorates. Claimant count unemployment surged by 138,400 in February, significantly more than the expected 85,000 rise, see chart e. The broader ILO measure of unemployment rose above 2 million for the first time since 1997, while earnings growth slumped to only 1.8% on the year. Chart e shows that the pace of the deterioration in the UK labour market seems to be accelerating. In short, it will get worse before it gets better. On current trends, we would expect ILO unemployment to top 3 million by the end of 2010 and claimant count unemployment to be above 2 million. But this is the reason why fiscal and monetary policy has been loosened so aggressively, to try and alleviate the extent of the downturn. Although this has led to some thawing in financial market conditions recently, they still remain extremely poor. And so, it is likely that quantitative easing and low short term official interest rates will persist well into 2010 on current trends.

...leading to a conclusion that growth should be bottoming out by end 2009 but trend (2¼% pa) growth is now unlikely to return until 2011

The UK economy is likely to contract by between 3% and 4% this year and perhaps modestly next year as well. The significant official policy loosening so far will have a positive impact in time of course, and the fall in UK growth ought to be bottoming out by the end of 2009. However, there is unlikely to be any recovery to the trend rate of economic growth - by this we mean the 40-year average of close to 2¼% a year rather than the 10 year average of 2.9% - until the second half of 2011. Lower commodity prices and low interest rates will help strengthen households' balance sheets, but saving rates are likely to rise - as shown by the jump to 4.8% in Q4 figures from 1.7%. This means that consumer spending will likely remain negative this year and next. And although a weaker currency will help prevent the UK's external deficit from deteriorating, there will be no growth in exports as the volume of world trade shrinks by up to 10%, the sharpest decline since the second world war. However, the fall in UK imports is likely to be greater than the fall in exports (partly as consumer demand falls), meaning that the trade deficit will likely shrink enough to make net trade a positive for gdp. If this trend persists, it could even turn the UK's external deficit into a surplus position in the years ahead for the first since Q3 1998 once global growth resumes.

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