UK Economy Sails into Choppy Waters

2008 marks my twentieth year teaching Economics and, for most of that time, students of macroeconomics have learnt their trade during a period of remarkable stability. After emerging from a painful recession in the early 1990s, the British economy has enjoyed a long run of low inflation, steady growth, more people in work and improving standards of living. Property prices have soared and share valuation, save for the bear market after the collapse of the dot.com bubble, have performed well.

Little wonder that media commentators have latched onto acronyms and sound-bites designed to capture the mood of the times. The nineties we were told was a ‘NICE’ decade (a time of ‘non-inflationary continuous expansion’!) And since the turn of the millennium we are said to have been living in the age of the ‘Great Stability’.

First the good news! Despite the crisis of confidence surrounding the collapse of Northern Rock, the British economy is still growing at a healthy rate of over three per cent, the fastest pace of growth since 2004. The number of people in work is at a record high climbing well above twenty-nine million. And manufacturing industry has enjoyed its best year of expanding production and better profits for over a decade. It is true that property prices are not rising at the same rate as a year ago, but a slowdown in house price inflation is nothing new (the last dip was in 2005) and there is a sound argument for expecting a weakening in demand and prices at this stage of an expansion already well into its seventeenth year. Company profits are healthy and the balance sheets of most businesses (a statement of their assets and their debts) are decent after years of rising demand and cost-cutting.

Why the panic?

Partly it is because the officially-published data on GDP,business profits, jobs and incomes are ‘backward-looking’, in other words they tell us about what has happened in recent months but not necessarily about where we are going! Imagine trying to drive a car along a hilly country lane with lots of peaks and valleys but where your only source of information about where to point the vehicle is what you can see in the rear-view mirror! The prophets of doom in press and on television are not looking back, their eyes are pointed firmly on what is coming in the opposite direction and they don’t like what they see! Of course, it is easy to be a pessimist, nobody ever got interviewed on television and radio for predicting ‘steady as she goes’! But it does seem to be that there are three major risks facing the UK economy as we head into 2008.

The return of inflation

Since the early 1990s consumers have enjoyed many years of low and stable inflation. Overall, the rate of price increases has been moderate, in the order of two to three per cent a year and comfortably within the target range set for the Bank of England to achieve. Indeed only once has the Monetary Policy Committee failed to hit the inflation target prompting the Governor, Mervyn King, to write a repentant letter to the Chancellor - the modern day equivalent of twenty lines or an unwelcome detention? The prices of many goods and services have been falling with price deflation of more than ten per cent a year for digital cameras, computers, MP3 players and other audio-visual equipment. Clothing has fallen in price and so too has the real cost of buying a new car and a second hand one!

Perhaps this age of low inflation is reaching an end. In 2007ccrude oil prices came within touching distance of $100 a barrel on the international petroleum exchanges and the prices of many staple foods are rising throughout the world – a trend not helped by the shifting of world wheat production into meeting demand for bio-fuels rather than feeding the global food chain.

In China, inflation has surged (pork prices are seventy per cent higher than a year ago) and, more generally, we are seeing a sharp rise in the prices of many raw materials and components, with higher prices for metals and softer commodities such as sugar, coffee and grains. All of this means that there are risks of a sustained rise in consumer prices in the near future. Indeed, UK businesses report that they are more likely to increase their own prices as a means of protecting their profits than at any time for the last ten years.

Rising inflation makes life tougher for people throughout the length and breadth of our economy. The danger is that people at work will bid for higher wages to compensate for a decline in real incomes; businesses will come under pressure to put a lid on costs which could lead to a hefty ‘shake-out’ of jobs. Put simply, the Bank of England faces a dilemma in the months ahead. Can it afford to cut interest rates yet further to bolster confidence and demand, at a time when inflation is higher than it would like?

The fall out from the global credit crunch

My second risk is the effects of the credit crunch affecting many parts of the global economy not least financial markets and businesses in the UK. Just a few months ago we saw thousands of nervous savers queuing up to withdraw their savings after the first ‘run on a bank’ in over 150 years. Northern Rock has been bailed out by the government and has soaked up thousands of billions in emergency funding. It was the victim of its own risky and some would say foolhardy business model
which relied too heavily on borrowing from the international money markets and also by the effects of the sub-prime mortgage crisis in the United States. A credit crunch happens when lenders stop providing each other with finance causing the rate of interest on inter-bank lending to spike higher.

A secondary effect is a tightening of lending rules, making life much tougher for people and businesses who want to take out loans and overdrafts to fund their spending.

And there will be a nasty sting in the tail for over 1.5 millionhomeowners in Britain this coming year when their mortgage agreements come up for review. It is inevitable that hundreds of thousands of people will see their mortgage interest payments rise as the era of ultra-cheap fixed rate home loans comes to an abrupt end.

A change in expectations, higher prices for goods and services, more expensive mortgage
bills and a probable dip in average property prices – these are the transparent effects of changes in the global economy over which the government and the Bank of England has little leverage. Together they point to, at best, a slowdown in the paceof growth for the UK economy over the next year or two. But could things get a lot worse? The answer lies in what happens to expectations.

Economists love studying how expectations of the future affect our behaviour today! I suspect that few of us look much further ahead than the short term horizon. Will I still be in a job this time next year? What do I expect to happen to the value of my property? Should I delay making a big-ticket purchase such as a new car or a replacement television? Is now the time to save rather than borrow? Our expectations are shaped by how confident or pessimistic we are not just about where the economy is going, but in our own financial circumstances and the health of the businesses that employ us and pay our wages

The turn of the New Year does seem to herald a swing in confidence and expectations. There are numerous surveys of consumer and business sentiment published every month and I sometimes wonder about the people who inhabit each and every sample group. When I am asked to complete a stress survey at work, I tend to emphasise just what a taxing existence I suffer in the hope that the survey results might bring about an improvement in my working conditions! Perhaps the worried home-owners and entrepreneurs filling in their confidence survey do likewise, laying on the pessimism extra thick in the hope of persuading the Bank of England to nudge interest rates a little lower!

What are the numbers telling us? Firstly, consumer confidence is down quite sharply from the summer of 2007, not a surprise given the flood of negative headlines surrounding the Northern Rock fiasco. Business sentiment has also taken a turn for the worse, especially at retail level where there are regular profit warnings from high street chains about weak Christmas sales.

That said, the confidence data does not yet point convincingly towards a full-on recession. Indeed business sentiment about likely export orders and domestic sales remains quite robust, perhaps helped by the fall in the value of the pound against the Euro (Europe provides sixty per cent of our export earnings). And, although consumers have become more concerned about the general economic situation and are likely to hold back on those major purchases, they remain pretty upbeat about their own personal finances. It will take a major downturn in the housing market and a sharp rise in unemployment for fears to become deeply embedded and lead to a mass-exodus from the high street and the retail malls. For the moment, the vast majority of businesses report that they will hold onto their workers

2008 – A year of living dangerously?

Much will be said and written about the health of the UK economy in the coming months and there are sound reasons for believing that we already into a turning point in our business cycle. It may take some time for the fog to clear and for a picture to emerge about whether 2008 will prove to be a nasty end to the NICE era. We should remember that recessions are unusual for modern economies - the UK has only experienced a slump in two of the last twenty-five years – and the Bank of England retains the option of cutting interest rates aggressively if need be to help the economy weather the current storm.

Britain has been lauded by organisations such as the OECD and the IMF for having a flexible economy and credible framework for managing demand and inflationary pressures. Well, the resilience and durability of that architecture will be tested throughout 2008, and it may be that lower interest rates have little effect in keeping the economy afloat if confidence and expectations become more pessimistic.

Recessions are not inevitable and the global economy will continue to grow this year, largely on the back of rising incomes and spending in far-East Asia. The British economy is less of a racing yacht struggling to move forward against fierce headwinds; instead it resembles a freight tanker whose underlying forward momentum is slow but difficult to stop. We are sailing into choppier waters and the navigation equipment might be a little faulty, but we are not yet at the time to man the lifeboats.