Economic update – December 2010

There is a widespread view that future growth in the UK economy will be more sustainable if it is driven by net exports and business investment and not by household spending. The third quarter GDP numbers provided mixed news for supporters of this view.

There is a widespread view that future growth in the UK economy will be more sustainable if it is driven by net exports and business investment and not by household spending. The third quarter GDP numbers provided mixed news for supporters of this view.

The good news was that net exports (the difference between exports and imports) contributed half of the 0.8 per cent growth recorded in the quarter. This is the first quarter since Q2 2009 (when the economy was still in recession) that net exports have added to growth.

The bad news was that the contribution to growth from business investment, though still positive, was lower than in the first two quarters of the year.

This is crucial to the outlook for 2011. The increase in the main rate of VAT to 20 per cent, higher national insurance contributions, public spending cuts, modest wage increases and a weaker housing market mean that any growth in household spending is likely to be moderate. If real GDP is to increase rapidly enough to allow unemployment to fall, investment spending and exports will need to grow strongly.

Exporters should still be benefiting from the boost to their competitiveness delivered by sterling’s decline in 2008 and in normal circumstances there would be little question that 2011 would see strong export growth. But two-thirds of the UK’s exports go to the rest of Europe and the last month has seen the sovereign debt crisis in the eurozone blow up again.

A bailout package has had to be put together for Ireland and long-term interest rates have risen sharply in Portugal, Spain and Belgium as investors try to identify the next country that will get into trouble. These developments can only damage the euro zone economy – and the prospects for the UK’s exporters.

Meanwhile, inflation increased marginally to 3.2 per cent in October and the Monetary Policy Committee (MPC) remains split over whether this is something that can be tolerated while there is so much spare capacity in the economy or a sign that the risks of a rise in inflation expectations are so great that interest rates need to be increased.

GDP growth boosted by net exports: The second release of GDP data for the third quarter confirmed that the economy grew by 0.8 per cent from the previous quarter. The details show that net exports – the difference between exports and imports – contributed 0.4 percentage points of this growth.

This is the first time that net exports have added to growth since the end of the recession and the first time that domestic spending and net exports have both added to growth in the same quarter since the second quarter of 2006, which is good news for those who argue that growth in the economy needs to be better balanced than in the past.

Retail sales remain weak: The volume of retail sales increased by 0.5 per cent in October, but this came after falls of 0.4 per cent and 0.5 per cent in the two previous months. Over the last year, the volume of sales has fallen by 0.1 per cent. The prospect of an increase in VAT from January might give a fillip to sales in the last two months of this year, but the broader trend appears to be for weaker sales as a result of reduced spending power and worries brought on by talk of austerity. See Figure 1

Retail-sales-growth-01-12-10

Manufacturing output still strong: Manufacturing output increased by just 0.1 per cent in September, but it was 4.8 per cent higher than a year earlier and the underlying trend still appears to be strong. The latest survey of purchasing managers in the sector suggests output growth in October was the strongest since March, helped by a renewed surge in export orders. The CBI’s survey of industrial trends points to continued output strength over the next three months.

Part-time employment is still surging: Employment continues to increase at a rapid pace, with a gain of 167,000 between April-June and July-September. But in the last couple of months the mini-revival in full-time employment has petered out and all the growth in employment is in part-time working. This would not matter so much if people were choosing to work fewer hours. But the evidence is that they are not.

There are a record number of people – 1,146,000 – working part-time because they cannot find full-time employment, and a further 597,000 doing temporary work because they cannot find permanent positions. This ‘underemployment’ is the hidden cost of the recession. See Figure 2.

Employment-01-12-10

Little change in unemployment: The Labour Force Survey (LFS) shows a 9,000 fall in unemployment between April-June and July-September. This is far less than the increase in employment over the same period, suggesting people are being attracted back into the labour market. Meanwhile, the claimant count measure of unemployment fell by 3,700 in October, after small increases in the two preceding months.

Price inflation edged higher in October: Consumer price inflation edged up to 3.2 per cent in October, from 3.1 per cent a month earlier. This triggered another open letter from the Governor of the Bank of England to the Chancellor, in which Mervyn King again set out the Bank’s view that high inflation is due to temporary factors, particularly an increase in the main rate of VAT, strong commodity prices and the lingering effects of sterling’s decline in 2008 (though this last reason cannot be described as ‘temporary’ for much longer)

The Bank’s latest Inflation Report shows that it believes inflation is likely to remain above 3 per cent throughout 2011, in part due to the increase in VAT scheduled for January.

Average earnings are only increasing slowly: Average earnings – both total pay and regular pay – are increasing at an annual rate of around 2 per cent. This is less than the rate of consumer price inflation, and quite a bit less than retail price inflation, which adds in housing costs (mainly in the form of mortgage interest payments).

As a result, real average earnings – a crude measure of the spending power of the average employee – have been falling. This helps explain the recent weakness in retail sales (and also shows that claims that ‘people have never had it so good’ are wrong). See Figure 3.

Average-real-weekly-earnings

Government borrowing is turning out a little lower than last year: Public sector net borrowing (excluding the temporary effects of financial interventions) was £81.6 billion in the first seven months of the 2010/11 fiscal year, compared to £87.5 billion in the same period of 2009/10.

Interest rates remain at 0.5 per cent; QE at £200 billion: The Monetary Policy Committee left interest rates at 0.5 per cent and the amount of quantitative easing at £200 billion in November. Once again, one member voted to increase the Bank rate from 0.5 per cent to 0.75 per cent, but another voted to increase QE by a further £50 billion.

Government bond yields increase: Since the Chancellor announced the results of the Spending Review on October 20th, the yield on a 10-year government bond has increased from 3.08 per cent to 3.43 per cent. Since the Chancellor was eager to claim that an earlier fall in yields was due to confidence in his policies, it would be easy to say that this was the markets giving a thumbs down to the Spending Review. But, of course, this is not the case.

The earlier fall was largely a reflection of international factors – particularly worries about the strength of the US economy – and so is this rise. The crisis in Ireland has led to higher yields across Europe, including in Germany, and UK yields have been unable to resist this trend.

One Response to “Economic update – December 2010”

  1. Tim Sandle

    RT @leftfootfwd: Economic update – December 2010 //bit.ly/e13WSo

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