The glory days are behind us, but are things quite as gloomy as some attest? The coming year will be one of adjustment for the British economy, as the slide in the housing market undermines mortgage equity withdrawal, consumer sentiment, and therefore household spending. The slide in domestic economic activity will further weigh on an already-depressed industrial sector, while slackening growth in the euro-zone constricts the market for British exporters.

Meanwhile, both government spending and business investment will contribute less dynamically to growth; the former as the Treasury makes a small attempt to rein-in spending to comply with the Golden Rule, the latter as the capital replacement cycle draws to an end and lower production expectations bite. This trend will in part be offset by the jump in company profitability last year – a factor giving temporary lift to fixed capital formation

As the housing market slides . . .
The headline-grabbing matter of concern is, unsurprisingly, the housing market. By any available measure, the boom that helped foster a decade of continuous growth has come to an end. The number of mortgages approved is in decline, the seller-to-buyer ratio is rising, and annual price growth is retreating from its heady rates of 25% in late-2002/early- 2003 to an average gain of just under 15% in Q4 2004. The mortgage approvals numbers are a good forward hint of house price growth and these hit their lowest in nearly 10 years in November. We expect the slide to continue through the year – monthly gyrations aside – and to dip negative towards the end of 2005.

This shift will erase one of the economy’s supporting struts – annual house price gains have been above 10% for almost five years and were last negative in late 1995. The close link between consumer spending and housing prices, so prevalent in the late 1980s and early 1990s, has, according to the Bank of England (BoE), broken down in the last half decade. There is, however, close correlation between housing turnover – which is falling – and retail sales (a fraction of total consumption), where growth is also slowing. As a result, we expect slower retail activity in the months ahead, on top of relatively dour Christmas shopping. It is possible that the close house price/consumption link was due to other factors – the Monetary Policy Committee (MPC) posited this in its November Inflation Report. If that is indeed true, consumption should not fall as far as in previous housing market downturns.

The upswing in borrowing costs over the course of 2004 has led to worsening credit quality, as personal insolvencies rise and write-offs (for both secured and unsecured debt), while low, are likely to increase further in the months ahead. Total household debt as a share of disposable income rose from 90% in 1989 to nearly 130% towards the end of last year and while mortgage debt led the charge, both credit card and other unsecured leverage also rose as a share of post-tax income.

The risk of a debt service crunch, however, is less acute than in the past. Interest rates are much lower, leading to less onerous debt service payments, and the labour market is much stronger, deepening and broadening the positive impact of the recent boom. Households on the margin are those most likely to face unemployment as growth slows; in many cases, these only recently rejoined the labour force and have not accumulated the financial assets to counterbalance rising indebtedness. These are a relatively small percentage of overall borrowers and do not pose a systemic risk to the economy or the financial sector.

. . . interest rates to hold tight
The deteriorating housing market, gradually diminishing producer price growth, and a stabilisation in the labour market will help keep medium-term inflation on par with the BoE’s prescribed bounds and therefore put a lid on interest rates. The February Inflation Report does forecast price growth exceeding the 2% target two years out. However, the BoE was quick to emphasise that the balance of risks is to the downside. Yuletide talk of a cut in interest rates was wishful thinking, while the outside chance of a rate hike to combat quickening inflation is small. Current conditions argue for stability in interest rates, rather than a near term rate hike or cut.

The BoE, like its neighbour the European Central Bank (ECB), is in a holding pattern as the impact of recent policy, in the BoE’s case tighter interest rates, winds its way through the economy. The downturn in the housing market and the consequent dimming of domestic economic activity will instead translate to an easing cycle early next year. With pay deals largely linked to retail price inflation – which will remain well above headline Consumer Price Index growth for the coming months – an acceleration in wages will continue to push inflation upward in the first half of 2005.

Qualitative surveys point toward further hiring in the immediate months ahead; however, vacancies have fallen off in the most recent employment surveys, while the manufacturing sector, after a year of modest employment growth, has once again begun to pare back staff levels. Nevertheless, earnings growth remains a potential upside risk to inflation, though we expect the labour market to let out steam come mid-year. Note, however, that the change in trend will be due to a diminished rate of job creation that makes finding employment more difficult for new market entrants, rather than a large increase in layoffs.

All told, the incentive is for the monetary authorities to wait and see. Quickening consumer price growth is not so rapid as to cause concern and the fall-out from the turn in the housing market thus far appears orderly. Nevertheless, the BoE has some margin to manoeuvre should the housing market find itself on the edge of the cliff. With the benchmark rate at an historic cyclical low of 4.75%, the comfort zone available for rate cuts is not large, but short of an outright collapse, it should be large enough to bring a tottering bust back from the edge.

An easing pound and higher taxes
Despite what the media may imply, the housing market and interest rates are not the only factors in the UK outlook. The long-awaited industrial recovery never really got going and the fortunes of this much-beleaguered sector are somewhat ill-omened. Global growth prospects are easing somewhat, most significantly in the euro-zone, Britain’s largest trading partner. Runaway growth in China has slowed, but not so much as to diminish its voracious appetite for raw materials. As a result, higher commodity prices are here to stay, hinting that producer price inflation, while down from its spike in the autumn, cannot be entirely written-off.

While the increase in input costs is in no way the principal cause of the slowdown in the UK, it does not bode well for the UK’s beleaguered exporters. That said, we expect sterling to depreciate against both the euro and dollar in 2005 as growth slows and interest rates hold at present levels, offering a modest boost to export price competitiveness. All told, the negative contribution to overall growth made by the net trade sector is set to stabilise, as the diminished prospects for export growth are offset by the impact on imports of a downtick in consumption growth.

Finally, a few words on the government’s deteriorating fiscal stance. Thus far in Labour’s tenure, Chancellor Gordon Brown appears to have broadly stuck to the Golden Rule, but the prospects for the future are less sanguine. Labour’s public services improvement programme really got under way in its second term, while substantial public surpluses were built up during the boom years of the first term.

By most measures, unless the Treasury shifts the goalposts to meet its own story, Mr Brown will struggle to meet the Golden Rule, particularly as we expect growth to slow noticeably next year. This will have a winnowing impact on the tax intake, both in respect of personal income and corporate tax. As we face a period of slower growth, Labour is loathe to curtail spending aggressively and thereby deepen the slowdown.

The last spending review prepared by the Treasury outlined a 2.8% real increase in government spending in average terms, in 2006 to 2008. In order to fund the anticipated rise in spending for hospitals and schools, however, roughly £20bn of savings need to be found. Mr Brown intends to do so through efficiency savings.

However, we are sceptical given that this government has promised again and again to cut public sector administration costs and civil service jobs, and yet both have risen year after year. In the next economic cycle, an adjustment on either the revenue or spending side, if not both, will be necessary.

If Labour is re-elected and intends to continue its public services improvement programme, and given our belief that “efficiency savings” are more talk than practice, the burden of adjustment will fall on the revenue side.

That said, this Treasury has been adept at raising hidden, or so-called stealth taxes rather than directly boosting the income tax rate. We expect this to continue, with an increase burden also falling on council tax, social security contributions and other indirect taxes.

Source:
Economy.com (UK) Ltd

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Paul Guest is European Editor at The Dismal Scientist
Website: www.dismal.com

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