British American Business 2008

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ECONOMIC OUTLOOK

Gauging the risks to growth

Despite several financial jitters, UK expansion managed to remain on track late in 2007. However, the picture looks quite different this year. Dr Matthew Cairns, Senior European Economist at Moody’s Economy.com, assesses the risks the UK economy faces in 2008

Final quarter growth of 2.9% in 2007 surprised on the upside, though the outlook for the UK has weakened entering 2008.
The government’s fiscal balance sheets continued to deteriorate through the fourth quarter of 2007, adding to medium-term woes.
The Bank of England cut borrowing costs by 25 basis points in February, with futures markets now looking for an additional cut of 50 basis points before the end of this year.

Growth in the UK economy surprised on the upside during the final three months of 2007. Although key sectors such as business and financial services booked weaker rates of year-ago growth, the slowdown was not as pronounced as expected. The economy posted growth of 2.9% year on year and 0.6% quarter to quarter in the fourth stanza.

Despite banking jitters, tighter lending conditions, and the nearcollapse of a major financial institution, underlying drivers of the British expansion remained on track late in 2007. The new year offers a somewhat different picture, however.

The economy will be weighed down by the delayed impact of higher borrowing costs on business investment, higher borrowing rates for consumers, softer house-price growth, weaker spending, dampened business and service-sector expansion, and more expensive energy and raw material prices. We maintain that the UK economy has passed its peak for now.

Of clear concern is the prevailing weakness in house-price growth, suggesting that the housing market is a clear downside risk for the economy, in contrast with its role as a driver of domestic growth over the past 10 years.

This sector is slowing and its benefits are set to ease. Weaker rates of house-price growth, which should average between 5% and 8% in 2008, are expected to feed through to weaker consumption gains. Private consumption growth, having booked annual growth of 2.9% last year, is projected to come in at just 1.8% in 2008.

The wealth effect from a decade of steady gains in house prices has encouraged British households to increase spending. This has had the added benefit of boosting growth and consumption demand, although the outlook on this front has weakened. By offering households some additional easing in interest rates, monetary policymakers might ensure that the downswing is not as sharp.

There is less of a reprieve to be expected for financial markets, however, with Governor King clearly stating that: “The re-pricing of risk is not a process that we should try to reverse.”

The government’s financial house is not in order, adding to the uncertainty ahead. The budget deficit is growing rapidly, with December’s deficit hitting $15.6bn, taking the cumulative fiscal deficit for April through December to $86bn, against $64bn a year earlier. The deepening budget hole is due to lower-than-expected corporation tax receipts from slower economic growth and weaker revenues.

Government revenue was up 4.9% year on year in the April- December period, compared with a pre-budget report forecast of 6.4% revenue growth for the full year. Although borrowing is likely to have fallen in the final few months of 2007, an overshoot of $4bn to $6bn is likely, adding to emerging problems that have yet to really clamp down on growth.

Bank of England’s uphill battle

The Bank of England Monetary Policy Committee is concerned about short-term inflation pressures from supply markets, with oil, gasoline and food price developments listed as key risks. In a speech made on 22 January, Governor Mervyn King emphasized the downward risks to demand, and said, “We start the year from a position in which Bank Rate, at 5.5%, is probably bearing down on demand.” While the bank lowered its interest rate to 5.25% in February, King does not expect the lower base rate to significantly loosen lending conditions or spur economic growth.

The counter-pressures on inflation – upward on the supply side in the short term, downward on the demand side in the longer term – put the Bank of England in a tight spot. King sounded almost apologetic when he said inflation could at times rise above the bank’s 3% target this year and so require him to write letters of explanation to the chancellor, but he stressed the need to contain inflationary expectations.

Headline CPI growth accelerated to 2.2% in January, though households care more about the retail price index, which rose by 4.1%. The key risk then is that inflationary expectations may shift out of the bank’s control parameters.

The road ahead is not recessionary

Of great concern in the year ahead is whether or not a US recession will feed through and result in negative economic growth in Britain. When asked if a recession was possible in the UK this year, Governor King stated “predictions for growth in this week’s inflation report were not inconsistent with two quarters of zero or negative growth, the technical definition of a recession.” At this juncture, such an outcome is unlikely to occur. Although the UK economy is highly exposed to the US downturn in financial markets, the underlying factors dragging growth south in the US do not exist to the same degree in Britain.

The housing market in Britain is slowing and this will have negative consequences for consumption-driven growth; although the exposure to subprime (nonprime in the UK) is weaker, employment growth continues apace–headline unemployment is seen at 5.6% in 2008 against 5.5% in 2007–and extremely tight supply will support the housing market and, thus, help it avoid an outright crash.

Despite exposure to the US, the business and financial services sectors remain robust and will continue to perform well. Strong inward migration flows from Europe, particularly from Eastern Europe, have seen strong capacity added to the economy. Unemployment is low, though wage growth remains subdued, thus keeping wage-based inflationary pressures at play. This will not, however, prove enough to offset additional, rapidly growing price risks that will impact the UK economy.

Price dangers loom

On the release of its most recent inflationary report, Bank of England Governor King said in February that the UK’s current inflation profile was “significantly higher” than the Monetary Policy Committee’s previous estimate made in November. The bank’s latest projections have factored in recent announcements of increases in household gas and electricity bills on the part of private suppliers as well as rising import prices in light of a marginally weaker currency.

Rising food and energy prices continued to add to upward inflationary pressures throughout the final quarter of 2007, a common issue throughout Europe, and will continue to do so into 2008. Such influences have been factored into Moody’s Economy.com’s recent revisions to inflation, which put headline, harmonized annual CPI at 2.4% for the year.

The bank, meanwhile, anticipates that CPI inflation will rise sharply from 2.2% in January to hover around the 3.0% mark at some point in the first half of 2008. How then will the bank react when faced with slower growth and rising inflation?

Futures markets now look for an additional 25-basis point cut from the bank before June, over and above February’s cut. Markets are also beginning to price in a further 25-basis point cut before 2008 is out. This would take the UK base rate to 4.75% by December. Such a move is likely only if price pressures remain contained, although – given that the bank’s base rate is now well above inflation and economic growth, and still contractionary – an easing in policy is likely.

Softer gdp growth

Consistent with Moody’s Economy.com’s recent forecast revisions, the Bank of England projects annual UK GDP growth to dip below 2.0% in 2008 to around 1.75% on the back of tighter credit conditions and lower domestic demand. A rise in household savings rates is also forecast as consumers rein in spending. Even if the bank does cut more aggressively, softer GDP growth of 1.9% can be expected this year.

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