British American Business 2007

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ECONOMIC OUTLOOK

Onwards and slowly upwards

After ending 2006 on a high note, Moody’s Economy.com 2007 outlook finds the economy growing, but at a more moderate pace. Paul Guest reports

The economy ended 2006 on a high note, with the services segment driving the most rapid rate of expansion since early 2004.
The central bank opted for an earlier-than-expected quarter-point hike in January. A further rise to 5.5% is likely, but that still looks like the top of the tightening cycle.
Slower gains in business investment and a constrained expansion in private consumption, alongside a modestly less supportive global environment, imply a modest slowdown over the course of 2007.
‘Twas a good year.

The British economy finished off 2006 on a high note, managing gains of 0.8% q/q and 3.0% y/y in the final quarter. This puts real GDP growth at its strongest since the first half of 2004. The monetary tightening-induced slowdown, which engendered the soft landing in the housing market over the course of 2005, has now been fully reversed and the economy is growing more rapidly than potential (seen as 2.75%). The data are preliminary and based on industry value-added figures (and hence subject to revision), but the direction of growth (ie acceleration) will almost certainly not be revised away. Alterations of a tenth of a per cent in one way or another do not alter the near-term outlook for the economy.

Services were once again the mainstay of the economy, while the production sector was stagnant. In the services component, which accounts for about two-thirds of overall value added, business and financial services, previously the most dynamic component, slowed in the fourth quarter, notching growth of 1.0% q/q versus an average of 1.5% in the previous six months. A big acceleration in transport and communication and in distribution, catering, hotels, and repairs more than made up for it. The latter is partly a reflection of the unexpectedly strong Christmas retail season and may not be sustained into the new year. Nevertheless, the monthly services PMI suggests a moderately slower but still vibrant expansion in services in the new year. On the production side, the downswing in the mining and extraction sector appears to be bottoming out; the quarterly contraction in the fourth stanza was the shallowest since the beginning of the year. Meanwhile, manufacturing stood still after three successive quarters of growth. The orders figures in the monthly PMI suggest this malaise will continue into 2007.

The above-trend results will reinforce the central bank’s concerns regarding spare capacity and wage-driven inflation. The labor market has yet to return to the tight conditions of 2004, but the rise in the jobless rate has certainly stopped and hiring surveys are looking optimistic for the first time in several quarters. All in all, the economy is heading into 2007 with a considerable amount of momentum, justifying the central bank’s tightening bias and buttressing the chances of further rate hikes.

News from the monetary front

The decision to hike the base rate earlier in January was a closer call than most had anticipated. The MPC opted for the soonerthan- expected rise by a margin of a single vote; prior doves David Blanchflower and Rachel Lomax (who voted against the November hike as well) were joined by Charlie Bean (the bank’s chief economist) and Paul Tucker (executive director responsible for markets). The balance, including Governor King and Deputy Governor Sir John Gieve (responsible for financial stability) voted in favour. The closeness of the vote reduces the likelihood of a hike as soon as February, touted by some earlier this month, but does not eliminate the prevailing tightening bias that currently dominates the MPC.

Those voting in favour of the hike cited a strong global economy, real domestic growth “at least at its potential rate” (GDP data today show it was ahead of potential in the fourth quarter), diminishing spare capacity, rising inflation, and an environment in which producers were finding it easier to raise prices. In their view, price growth would not slow as quickly as envisioned back in November and there was a risk that the 50 basis points of tightening thus far would not be enough to keep inflationary and growth expectations under control. A rapid increase in the money supply and accelerating asset price growth only exacerbated the risks.

In contrast, those arguing against highlighted the fact that inflation would fall back later this year and emphasized that the MPC should be seen as “reacting to short-term volatility in CPI inflation”. These members believed that the Inflation Report would, if necessary, give greater scope to explain the hike in the context of medium-term price stability rather than a short-term reaction to volatility. The upward shift in market interest rates resulting from such a move could be excessive.

The difference of opinion centres around whether preemption is better than waiting for additional evidence. The MPC members agreed that the recent news was in line with expectations, but that the upside risks to inflation had increased. As in August, the move was designed to preempt any upsurge in expectations before the shift gets imbedded in pay negotiations. While this dynamic eliminates the likelihood of very near-term tightening, the heightened risks mean a further move is still likely, dependent on the evolution of pay talks and inflationary expectations. Fundamentals say price growth will slow quickly later in the year, but this will not happen if economic actors feed heightened expectations through to pay and price demands. This is exactly what the bank is trying to avoid.

And for the rest of 2007 ...

The year ahead will be one of moderate growth due to middling gains in private consumption, a diminished contribution from business and financial services, and a slightly less supportive global environment. In line with a broader European slowdown, real GDP gains will slacken to 2.2% in 2007 as some of the imbalances built up over the past half-decade unwind. On the household front, total private consumption growth will be constrained by slack disposable income gains, elevated debt ratios, and a very low savings rate. Borrowing costs have risen, and will rise slightly more in the early part of the year, increasing the pressure on household balance sheets, though only modestly. For this reason, a slow growth scenario for both disposable income and private expenditure seems most plausible, as opposed to any contraction. As private consumption accounts for nearly 65% of real GDP, this will have consequences for the overall economy.

Corporate borrowing will continue apace, although ultimately non-financial firms will feel the pinch of modestly higher interest rates. The net rate of return on non-continental shelf UK companies is currently 13.6% versus a long-term average of 12.8%. This implies sustained capex commitments, which will most likely keep fixed investment growth on a stable, if not upward, trend. Meanwhile, government consumption growth will prove relatively modest compared to recent years as the administration grapples with a weaker fiscal balance and a higher public debt burden. In order to meet its self-imposed deficit rules the government will perforce have to control expenditure over the next two to three years. Nevertheless, we expect a rate of public consumption growth averaging 2.4% through 2010, down from 3.0% in 2003-2006.

Finally, on the trade front, the on-going euro-zone expansion will continue to give business to UK exporters, though the local manufacturing sector is trending back toward stagnation after a brief growth spurt in 2006. Foreign sales will grow more rapidly than imports for much of the year, though only slightly. While this will curtail the current account deficit, it will not eliminate it. At less than 2.0% of GDP it is not, however, a concern. Sterling will remain close to its multiyear highs against the US dollar, boosting the price-competitiveness of imports at the expense of exports, though forward-looking monetary conditions do not appear supportive of an assault on the $2.00 threshold for the first time since 1992. The currency’s strength against the dollar will be more than offset by a slight softening against the euro; exports to the US account for less than 10% of total foreign sales, while the share going to the euro area is over 35%.

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