Economic update – September 2010

The main economic debate in the UK still centres on whether the economy is strong enough to stand the strain that will be placed on it by George Osborne’s fiscal consolidation plans.

The main economic debate in the UK still centres on whether the economy is strong enough to stand the strain that will be placed on it by George Osborne’s fiscal consolidation plans. His harshest critics argue that an increase in VAT, due in January next year, and substantial cuts in public spending will tip the economy back into recession. His response is that the economy grew by 1.2 per cent in the second quarter of the year, suggesting the risk of a return to recession is very low.

However, as I have already pointed out, most of the growth in the economy in the second quarter was due companies rebuilding their inventories after several quarters of running them down. Final private demand increased by just 0.1 per cent because an increase in consumer spending was largely offset by a decline in investment spending. This suggests that the underlying economy remains weak, despite the surge in growth in the second quarter.

Bond markets certainly appear to be alert to the risk of recession. The benchmark 10-year bond yield in the UK has dropped below 3 per cent – back to the low point seen in the depths of the recession. This is a sure sign that bond investors fear weaker growth and deflation. This is not just a UK phenomenon; yields in the US and German have also plunged to new lows following a series of data releases pointing to weaker growth in America and Europe.

There are also signs that Chinese growth has slowed in recent months. In many countries, government support for economies is being withdrawn, but, as in the UK, private sector demand is not yet strong enough to sustain output growth.

1. Output growth surged in the second quarter. Revised figures show real GDP – the total output of the economy – increased by 1.2 per cent in the second quarter of 2010 – its best quarterly growth rate in over nine years. However, lower growth seems certain to follow in the second half of the year. Construction output increased by an unsustainable 8.5 per cent. And, looking at the expenditure breakdown, growth was largely driven by a return to inventory building by companies. Growth in underlying demand remains weak.

2. The recovery in manufacturing is petering out. Manufacturing output increased by 0.3 per cent in June and was up 4.1 per cent from a year earlier. However, it was no higher than in March and indications from business surveys suggest that confidence has fallen since the budget. This would normally be associated with weaker growth – suggesting that the underlying trend in output is probably now broadly flat.

3. Employment surged in the second quarter. Latest figures show that employment in the three months to June 2010 was 184,000 higher than in the previous three months. This is the biggest quarterly gain since 1989. However, less than half of the increase (68,000) was accounted for by full-time employment; the rest was due to higher part-time employment. Since the start of the recession there has been an increase of 350,000 in the number of people working part-time who are doing so because they cannot find full-time employment.

4. Unemployment figures are falling, for now. Both the Labour Force Survey (LFS) and the claimant count (CC) measures of unemployment are now declining. On the LFS measure, unemployment in the three months to June was 2.46 million, down 49,000 from three months earlier, while the CC measure fell for the eighth month in the last nine and is now 166,600 below its peak. However, most forecasters, including, the Office for Budget Responsibility, think unemployment will increase again over coming months as economic growth slows and it is noticeable that the declines in the claimant count measure have been diminishing in recent months.


5. Wage growth remains subdued. Regular pay is only 1.6% higher than it was a year ago, while total pay is up just 1.3%. This is well below price inflation. Wage growth remains subdued in the private sector and is now on a clearly declining trend in the public sector.

6. Price inflation eases, but remains well above its target rate. Consumer price inflation was 3.1 per cent in July and has now fallen in each of the last three months. However, it remains well above its target rate of 2 per cent, necessitating another letter from the Governor to the Chancellor explaining why. The Governor continues to blame temporary factors but now thinks that inflation will remain above its target rate until the end of 2011.

7. Retail sales remain strong. Perhaps the most surprising development in the UK economy right now is the resilience of retail sales. The volume of sales increased by 1.1 per cent in July and by 1.7 per cent comparing the latest three months with the previous three. Higher employment will have helped to boost households’ spending power, but this will have been more than offset by the fact that wage increases are running well below price inflation. Either consumers are spending less on services so that they can spend more on retail goods, or they are once again saving less and borrowing more to fuel their consumption habit.

8. Government borrowing continues to follow the previous year’s pattern. After four months of the 2010/11 fiscal year, public sector net borrowing (excluding the temporary effects of financial interventions) totalled £44.9 billion, compared to £47.5 billion in the same four months of 2009/10.

9. Interest rates remain at 0.5%. Following its August meeting the Monetary Policy Committee left interest rates at 0.5%, though Andrew Sentence again voted to increase Bank Rate from 0.5% to 0.75%. For now, a majority on the Committee remain more worried about the growth outlook than about inflation, even though the latter is well above its target rate.

10. Bond yields have fallen to record lows. The 10-year bond yield in the UK fell below 3 per cent in August – matching the lows seen in March 2009 when the economy was in the depths of recession. Some shorter dated index-linked bonds now offer a negative real yield (that is, despite being ‘index-linked’ they will return less than inflation if held to redemption). Yields have also fallen in the US and Germany as investors fears of a double-dip recession and a period of deflation have increased.


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