Not Giving Up on a Weak Recovery
November 01, 2010
By Melanie Baker | London
3Q GDP growth was much stronger than we had forecast. The strength of the UK economy has surprised us and consensus for two consecutive quarters. Ahead of seeing the GDP expenditure details, it is difficult to fully understand what has been the driver of this strength. It is clear though that the pace of recovery in some segments of the UK economy over the past couple of quarters has been much quicker than we'd expected and cannot all be attributed to one-off factors.
We think that this pace is unsustainable and still see a strong case for expecting a slowing in the economy in 2011, albeit from a stronger base.
3Q GDP growth overshoot: The preliminary estimate of 3Q GDP growth (0.8%Q; 2.8%Y) was much stronger than we and consensus had forecast (0.2%Q and 0.4%Q, respectively). This is the second consecutive quarter of relatively strong UK GDP growth, after 1.2%Q growth in 2Q. The mix of growth looked somewhat more sustainable than it did in 2Q: Construction was less of a driver than in 2Q (although it still contributed two-tenths of the 0.8%Q). Services growth was broad-based.
It is clear that the pace of recovery in some sectors of the UK economy has been quicker than we'd expected (and that this cannot all be explained by one-off factors). That is particularly the case for construction on the output breakdown of GDP and of inventories and business investment on the expenditure side. Government spending and consumer spending growth were particularly strong in 2Q at least.
We don't think this pace of recovery is sustainable: Absent a significant fiscal contraction, underlying recovery momentum looks stronger than anticipated. However, we remain unconvinced that the pace of recovery will remain strong in 2011 for reasons including:
1) We continue to think that the UK economy will struggle next year as the pace of fiscal tightening picks up. After another VAT hike in January 2011, this will be followed by departmental budget cuts over 2011-12 of around 4% in real terms.
2) In 2Q, real household disposable income contracted - but real consumer spending growth was strong: There was a sharp and unexpected decline in the savings rate. This will partly be a reflection of very low real interest rates doing their job. But real disposable income growth is likely to remain weak and we don't expect the savings rate to continuously decline. Households remain highly indebted and we expect more declines in house prices (a negative wealth effect for households).
3) Some of the strength in construction will reflect public investment that is set to be cut sharply. We expect only weak recovery in housing supply, partly on changes to the planning system.
4) The contribution to growth from inventories will fade.
5) Credit is unlikely to become abundant in this recovery and UK banks face considerable funding requirements over the next couple of years.
Still expecting a slower 2011, but from a stronger base: Hence, and ahead of seeing the 3Q expenditure breakdown, we still expect the economy to slow in 2011, but from a higher base (we have no reason to think that the estimates of GDP we now have for the first three quarters of the year will be revised down). So, fully incorporating 3Q's outturn raises our 2010 growth forecast from 1.4% to 1.8%. It also provides a better ‘entry point' for 2011, and so raises our forecast for 2011 GDP growth from 1.3% to 1.6%.
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More QE Anyone?
November 01, 2010
By Melanie Baker | London
The balance of risks to inflation has not moved enough to justify QE, in our view. GDP growth has been strong and inflation 1pp above target. But a broad set of UK activity indicators are deteriorating. We wouldn't rule out QE for February.
Private Demand and Inflation Expectations Key to Any MPC Forecast Changes
For the November meeting, the MPC will have formulated new GDP and inflation forecasts (with the publication of the Inflation Report coming a week later). In the October MPC minutes, it very clearly laid out what the two key opposing risks for medium-term inflation were: 1) Private demand growing too weakly to prevent an ‘under-utilisation of resources' that would cause inflation to fall below the target. 2) Prolonged above-target inflation causing inflation expectations to drift up.
1) Private Demand: Not a Cause for Big Forecast Changes
With 3Q GDP growth stronger than the Bank of England's central forecast (by some three-tenths), slowing momentum elsewhere will likely not be alarming enough to lead to any significant deterioration in the MPC's GDP growth forecasts and therefore changes in its inflation forecast. GDP growth is clearly a key variable for the MPC and will be a main driver of any assessment on changes in spare capacity. Comparing the MPC's ‘forecast surprise' in previous quarters, following 3Q GDP, any QE extension in November now looks a very low likelihood.
Central inflation forecast may rise: There is clearly a healthy two-way debate on the MPC on the scale and influence of spare capacity. But, the strong 3Q GDP growth would, all else equal, shrink slightly its estimate of current capacity and therefore raise its central inflation forecast. Further, our survey-based measure of spare capacity, for example, suggests that spare capacity is shrinking rather rapidly. We would still expect the MPC to show a sharp fall in inflation on its central forecasts in 2012, but see more reason for its central forecast to be revised up than down at that horizon.
But the skew may change too: The September and October MPC minutes showed that some MPC members thought the probability that further monetary easing would be necessary had increased. GDP aside, there is probably enough in the incoming data to dissuade these members from abandoning their view. They may argue at least for more of a downside skew of risk even if the central forecast is revised up a little.
2) Inflation Expectations: Still Significant Risks
Recent and current inflation at the top end of the band (and hence, significant near-term upside risks to inflation expectations) already presented a ‘hurdle' for the MPC in extending QE. CPI inflation remains more than a percentage point above target. The Bank of England expects inflation to remain above target next year and hinted at an upward revision to its near-term CPI inflation forecasts in the October minutes ("imported costs might have risen more rapidly than the Committee had assumed at the time of the August Inflation Report, so that CPI inflation in the near term might be higher.").
Note: Series takes the average of eight surveys (standard deviation from average) that measure spare capacity including from the BCC, CBI and BoE. These are weighted 70:30 services to manufacturing sector surveys, but before 1998 the measure is based only on all manufacturing surveys
Don't Rule Out February...
Our central case remains that the Bank of England will not extend QE (and will raise rates next year). Before then, however, and despite turn of the year data being difficult to read (given holidays and the impact of the VAT rise), we would not rule out a QE extension in February (the next meeting that coincides with an Inflation Report):
• Declining momentum in a variety of indicators: Momentum has continued to decline across a broad range of UK indicators. Particularly worrying from our own perspective has been the apparent deterioration in export orders, where we have seen exports as one of the few ‘bright spots' for the UK outlook. Employment growth, one of the areas surprising us most on the upside, is also showing signs of slowing momentum.
• Downside risks to confidence: In addition, we remain concerned about the potential effects on confidence of the Spending Review. See Clarity versus Confidence, October 20, 2010.
• Credit growth continues to look lackluster: Adam Posen's argument that the recovery in credit (and broad money) is "almost precisely tracing the track of Japan post-1993" will, we assume, carry some weight on the MPC.
• Wage growth remains subdued and there is no sign yet of any significant pick-up in households' medium-term inflation expectations.
...Running the Risk of Policy Error
But absent a move back into recession, extending QE in February could run a high risk of policy error, in our view. At least one measure suggests that spare capacity is shrinking rapidly, inflation will still be high in 1Q11 (on the Bank of England's own forecasts) and the early part of the year is key for wage rounds. We still think that the bank's forecasts for inflation in 2012 are too low. Further, with consumers having brought forward spending ahead of the VAT rise, we aren't expecting very weak GDP growth in 4Q (released just ahead of the February MPC meeting). Hence, the MPC would potentially run a similar credibility risk as it would by extending QE now: The risk is that more investors, businesses (and households) would think that the BoE had ‘gone soft on inflation'.
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