Economic update – February 2011

The year 2011 looks like being very tough as tax increases and spending cuts actually take effect, reports Tony Dolphin with the February economic update.

The UK economy shrank in the final quarter of 2010, when real GDP contracted by 0.5%. Bad weather may have accounted for the entire decline, but output would not have increased even if the weather had been normal. The manufacturing sector remains strong, thanks to booming exports, but the service and construction industries, which rely more on domestic spending, have weakened.

Employment is now contracting and unemployment increasing. Inflation has risen to 3.7% and looks set to go higher in the early part of 2011.

Here is a scorecard of different economic indicators over recent months:






Down 69,000 in last three months – falls in full-time (37,000) and part-time (32,000) working; record number of involuntary part-time workers
Unemployment (Sep-Nov) Up 49,000 in last three months to 2.5 million – 951,000 unemployed aged 24 and under; small falls in claimant count in Oct, Nov and Dec
Real GDP (Q4) 0.5% contraction in Q4 (flat excluding snow effects) – much worse than expectations; manufacturing strong, services and construction weaker
Manufacturing output (Nov) Up 5.4% over last year – benefiting from strong exports
Exports (Nov) Volumes up more than 10% over the last year (imports increasing at similar pace)
Retail sales (Dec) Unchanged over year to December – weather affected; underlying trend weak
Consumer confidence (Jan) Falling sharply: VAT and employment worries, squeeze on real earnings, falling house prices
Manufacturing confidence (Jan) Surveys point to continued very strong growth – led by export demand; optimism on employment
Services confidence (Dec) Weakened again in December – fears about slower consumer demand growth and effects of public spending cuts
Consumer price inflation (Dec) 3.7% – expected to go higher in early 2011 due to VAT increase, food and petrol prices; now two MPC votes for a rate hike
Average earnings growth (Nov) Stuck just above 2%: real earnings falling, wage freeze in much of public sector
Public sector net borrowing (Dec) On track to hit official forecast after better than expected December number
Bond yields (Jan) Up significantly from October lows but still at historically low levels


Strong, improving, positive for growth

Moderate, little changed

Weak, deteriorating, potentially negative for growth

The government claims the tax increases and substantial public spending cuts that it has announced are necessary to bolster confidence in the financial markets about the UK economy and prevent a Greek-style fiscal crisis. However, the deficit could almost certainly have been reduced more slowly without the UK’s credit rating coming under threat.

What is becoming clear, though, is that the tax increases and public spending cuts have had a significant negative effect on UK households’ and businesses’ confidence about the outlook for the economy. As a result, growth in household spending slowed in the second half of 2010 and companies became more reluctant to take on extra workers and to increase their capital spending; output growth ground to a halt.

2011 looks like being a very tough year as tax increases and spending cuts actually take effect.

1. GDP declines despite a buoyant manufacturing sector: The first release of GDP data for the fourth quarter of 2010 shows the economy shrank by 0.5% compared to the previous quarter. This was largely due to bad weather in December, without which the economy would have been flat. This still represents a significant slowdown from growth of 1.1% in the second quarter and 0.7% in the third. Manufacturing output increased by 1.4%, but there were declines of 0.5% in the output of the service sector and 3.3% in construction. See Figure 1.

2. Retail sales remain weak: The volume of retail sales increased by just 0.2% between the three months to December and the previous three months, and sales in December were unchanged from one year earlier. The bad weather is likely to have held back sales in December (though the prospect of an increase in VAT in January will have had the opposite effect). The underlying trend is clearly weak and it is likely that sales are being hit by reduced spending power (because wages are failing to keep up with price inflation).

3. Manufacturing output still strong: Manufacturing output increased by 0.6% in November and was 5.4% higher than a year earlier. The underlying trend is strong and surveys of confidence in the sector suggest output will continue to expand at a rapid pace in the first quarter of 2011. The Markit/CIPS purchasing managers index is at a record high thanks to strong new orders and employment expectations. Buoyant demand from overseas has helped to insulate manufacturing from the effects of declining domestic confidence.

4. Employment growth falters: Following large increases during the summer months, employment has started to fall again, dropping by 69,000 over the three months to September–November 2010. Both full-time and part-time employment are now contracting. The number of people working part-time because they cannot find full-time work is at its highest level since records began.

5. Unemployment is increasing (or not): The Labour Force Survey (LFS) shows a 49,000 increase in unemployment between June-August and September-November, lifting the total number looking for work to 2.5 million. Youth unemployment (up to age 24) is now 951,000 and long-term unemployment (12 months and more) is 836,000. The unemployment rate is now 7.9% of the workforce. However, the less comprehensive claimant count measure of unemployment fell by 12,500 between September and December.

6. Price inflation jumped in December: Consumer price inflation jumped to 3.7% in December, from 3.3% a month earlier. Food and petrol prices were largely to blame, suggesting the inflation pressures are mainly external to the UK economy. Mervyn King, the Governor of the Bank of England, has accepted that inflation will rise above 4% in the early part of 2011. See Figure 2.

7. Wages fail to keep up with prices: Average earnings – both total pay and regular pay – are increasing at an annual rate just above 2 per cent. Wage inflation improved a little in the private sector during 2010, but fell in the public sector. Over the last year and a half, wages have failed to keep up with prices. This squeezes households’ spending power – the worst such squeeze since the 1920s according to Mervyn King – and helps to explain the recent weakness in retail sales. See Figure 3.

8. Government borrowing in line with expectations: November’s poor figure for public sector net borrowing was followed by a much better December number. As a result, borrowing (excluding the temporary effects of financial interventions) in the first nine months of the 2010/11 fiscal year totalled £118.4 billion, down from the £126.8 billion borrowed in the same period of 2009/10. The Office for Budget Responsibility forecasts borrowing in 2010/11 will be £148.5 billion, compared to £156.3 billion in 2009/10.

9. Interest rates remain at 0.5%; QE at £200 billion: The Monetary Policy Committee left interest rates at 0.5% and the amount of quantitative easing at £200 billion in January. But there are now two members – Martin Weale and Andrew Sentance – voting to increase the Bank Rate from 0.5% to 0.75%, with one voting to increase QE by a further £50 billion (leaving six in favour of no action).

10. Government bond yields a little higher: Bond yields edged a little higher during January. They are up significantly from their lows in early October, reflecting a trend to higher yields in other major economies, including the United States and Germany. But yields remain at historically low levels, suggesting investors have few medium-term inflation worries when it comes to the UK.

11. 11. Sterling unchanged too: Sterling started 2011 edging higher, but fell back after the release of weak GDP numbers for the fourth quarter of 2010 appeared to reduce the likelihood of an early increase in UK interest rates.

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