Recession gathers pace

Ruth Stroppiana of Moody’s Economy.com takes a look at the impact of recession and the measures the UK government is taking to alleviate the situation

The UK economy is in the midst of its first recession in 17 years. After stalling in the second quarter of 2008, GDP shrank 0.6% q/q in the third stanza. Economic conditions deteriorated further in the closing months of 2008. Business surveys show that services, manufacturing and construction all sank further into contractionary territory, pointing to a steeper fall in GDP in the fourth quarter.

Monetary policy response

Since the credit crisis escalated in the final months of 2008, Britain’s policymakers have acted aggressively, substantially loosening monetary and fiscal policy to prevent the recession from becoming deeper. The Bank of England (BoE) has slashed its key repo rate 450 basis points to a record low of 0.5%, the lowest rate on record. With borrowing costs nearing zero, the bank is also turning to alternative monetary tools to try to lift the economy out of recession.

Even as the interest rate fell from the 5% that prevailed last September, consumption and investment were in decline. Fourth quarter GDP contracted 1.9% y/y. Moody’s Economy.com expects the economy to shrink by around 3% this year on the back of weak domestic demand and falling exports.

Following the lead of the US Federal Reserve, the BoE implemented quantitative easing measures in March. For the first time in its 315-year history, the BoE purchased £2bn of UK government bonds, commonly known as gilts. The bank also planned to spend £75bn over the three months to June to purchase private sector assets such as commercial paper and corporate bonds and previously issued medium- and long-term gilts. These asset purchases were financed by the issuance of central bank reserves, which meant that the BoE pumped new money into the economy.

The bank’s use of quantitative easing has two goals. First, it aims to increase the funds available to financial institutions to lend to companies and potential home mortgagors. Second, it seeks to reduce the yields on gilts. This will put downward pressure on borrowing costs and also encourage investors to switch to assets that provide higher returns such as corporate bonds, which would help companies raise funding.

The government also announced a second comprehensive bank bailout plan, in a bid to boost bank lending to households and businesses. The package included an extension of the special liquidity scheme until the end of 2010 and a £100bn guarantee of mortgage-backed debt.

Most measures of inflation expectations in the UK plummeted in the final months of 2008. The sharp pullback in global commodity prices has placed substantial downward pressure on both consumer and producer prices. Rising unemployment and slowing wages growth are also pulling down domestic prices, as households rein in spending. The headline measure of consumer price inflation looks set to substantially undershoot the BoE’s 2% target in the medium term. Meanwhile, the annual measure of retail price inflation, a key gauge widely used to set pay and benefit increases, is likely to fall below zero by mid-2009.

While the risk of a prolonged, Japan-style deflationary scenario in the UK is low, sustained deflation would be bad news for the UK. Nevertheless, the combination of the BoE’s aggressive rate cuts and the government’s fiscal stimulus will provide some support to the economy and prices this year. The weaker pound should also help stave off deflation through 2009. In 2008, the British currency shed over a quarter of its value against the US dollar and the euro, and will be undermined by weak economic fundamentals. in the medium term.

Mayhem in money markets

Dysfunctional credit markets have diluted the impact of traditional monetary policy methods. Despite the BoE’s aggressive rate cuts and liquidity injections, elevated interbank and short-term lending rates prompted a sharp withdrawal of credit from the economy in the closing months of 2008. Banks reined in lending to households and corporates as they hoarded cash to bolster reserves and shore up their balance sheets. Financial institutions have also been slow to pass on the cuts in official interest rates to their customers, further dampening the impact of monetary easing on the economy.

Though aggressive action by the BoE and the government has now succeeded in lowering interbank lending rates, credit spreads – a gauge of the cash restraint in the banking sector – remain elevated compared with pre-credit crunch levels. In addition, the BoE’s fourth quarter Credit Conditions Survey showed lenders’ plan to further reduce the availability of credit to households and nonfinancial corporates in the opening months of 2009. Constrained credit flows will remain a major source of angst for Britain’s policymakers in the medium term.

Fiscal stimulus

With monetary policy impaired, the government has pledged £20bn, around 1% of GDP, in tax cuts and public spending. Higher government spending combined with lower tax receipts and increased benefits payments, particularly for unemployment, will greatly deepen the hole in public finances in coming years. After 2010, increased taxes and a pullback in public spending are expected to help ease the massive deficit.

The Labour government’s stimulus package is focused mainly on shoring up the decline in domestic demand by lowering taxes, including a temporary reduction in the VAT from 17.5% to 15%. To aid the domestic housing market, the government has allocated £1bn in housing-related initiatives. The government has also stepped up pressure on mortgage lenders to pass on recent cuts and delay foreclosures. Recently-released details of the government’s Homeowners Mortgage Support Scheme include plans to allow eligible households to defer mortgage interest repayments for up to two years, to slow the pace of repossessions. The government has also pledged additional funds to stem rising unemployment and to guarantee bank loans to small and mediumsized business. Since the escalation of the credit crisis, firms’ access to credit has reportedly been restricted. If prolonged, it will exacerbate the rise in unemployment and the severity of the recession.

Housing market recession

Britain is battling a housing bust. Since high interest rates popped the property bubble in the closing months of 2007, house prices have fallen sharply and transaction levels are near their lowest levels on record. Falling house prices are discouraging purchases as would-be buyers wait for prices to stabilize. Thus, mortgage approvals, housing sales and homebuilding have all nose-dived. Despite the sharp decline in house prices through 2008, residential property still remains expensive relative to earnings, suggesting house prices have further to fall. UK property prices became grossly overvalued during the boom. Despite lower mortgage rates in 2009, tight lending conditions and rising unemployment will continue to curb housing demand, fanning further house price falls and more forced sales.

The recession in the UK housing market is expected to continue through most of 2009. Despite the government’s housing support initiatives, deteriorating labor market conditions will continue to fan mortgage arrears and possessions – key indicators of housing market distress. House prices look set to continue to decline, with the average property likely to shed around 30% of its value peak to trough. Falling house prices and further write-downs from poorly performing domestic mortgage loans will further damage banks’ balance sheets and continue to restrain the supply of credit to the economy, compounding the impact of the credit crisis. Borrowers will be constrained by tight credit conditions as banks continue to restrict the number and size of loans and further tighten credit-scoring criteria. The medium-term outlook for Britain’s commercial property market is also grim. Weak economic activity and rising unemployment will further spur the office vacancy rate, fanning further declines in commercial property prices and rents.

Consumer spending crumbles

British consumers face surging unemployment, muted wage growth, and tight credit conditions. Consumers also still face elevated home energy prices, though a wide range of discretionary consumer goods and services have declined sharply in price recently. With future income streams in jeopardy, consumers will tighten their belts and slash discretionary spending. Retail segments linked to the housing market such as homewares have felt the brunt of the pain so far, but heavy discounting suggests the pain is spreading. The outlook for Britain’s retail sector is dour. Heavy price discounting by retailers in recent months has squeezed profit margins and has done little to stimulate demand. The toxic combination of weak sales and razor-thin margins is taking a heavy toll on UK retailers.

While the government’s 2.5% VAT cut will provide some support to consumers and retailers, its benefits will be limited. Rather than boost retail sales volumes, the VAT cut will likely result in a shift in income into savings and nondiscretionary goods and services. Any windfall stemming from lower taxes is also likely to be used to pay down debt. Households have already stepped up loan repayments, especially on mortgages. Housing equity withdrawal has fallen into negative territory as mortgage repayments exceeded new borrowing. Nevertheless, UK households remain heavily indebted, with debt servicing costs running around a quarter of annual disposable income.

Unemployment has surged in recent months, and job creation has slowed sharply as slowing sales have forced businesses to slash production and expansion plans and lay off staff. Mass redundancies in the financial sector have pushed the internationally comparable ILO unemployment rate to levels not seen in over 10 years. Slack in the labor market has also weakened wage demands, negating some of the benefit of lower consumer prices. The combination of surging unemployment, slowing wages growth, and falling house prices will continue to weigh on confidence and crimp household demand and consumer-driven sectors. With household debt as a percentage of disposable income near record high levels and savings as a percentage of GDP near record low levels, the deteriorating labor market will largely determine the severity of the downturn.

Synchronised global downturn

Most measures of business confidence in the UK have slumped to near record low levels. Slowing sales and restricted access to credit have seen confidence and employment expectations tumble across all sectors of industry. Businesses expect weak revenues and will continue to slash investment, production and workforces as they brace for a protracted period of soft domestic and external demand.

Whilst the sharp slide in sterling has vastly improved external pricecompetitiveness, plunging export orders suggest very little benefit will flow from the weaker pound. Recession in key export markets such as the US and the euro zone economies, which account for around three-quarters of outbound shipments from the UK, will act as a major drag on British exporters. Whilst export performance will remain weak, lower imports, particularly for consumer goods, should support net exports in 2009 and help to ease the trade deficit.

Outlook

Britain’s outlook has deteriorated sharply in recent months, with the weaker global economic and financial environment adding to the dismal state of domestic demand. Despite fiscal injections, support to financial markets and monetary stimulus measures, the UK economy will remain in recession through most of 2009. The UK’s heavy reliance on financial services and the housing industry in recent years mean that the downturn in Britain will be sharper than most other European countries.

While looser monetary and fiscal policy are expected to help put the economy back on track by 2010, growth will remain below potential. Households, corporates and eventually the government will all need to repair balance sheets. The hangover from the mountain of accumulated private and public debt will weigh on activity over the forecast horizon.

This commentary is produced by Moody’s Economy.com (MEDC), a division of Moody’s Analytics, Inc. (MAI), engaged in economic research and analysis. MEDC’s commentary is independent and does not reflect the opinions of Moody’s Investors Service, Inc. (MIS), the credit ratings agency. Both MAI and MIS are subsidiaries of Moody’s Corporation.

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