Reasons to be cheerful……?
Economies are usually regarded as having a trend rate of Gross Domestic Product (GDP) growth; a level above the trend rate is expected to lead to inflation, while a level below trend for a persistent period of time is disinflationary and might be expected to lead to recession.
An economy growing at below the trend rate has an ‘output gap’ – that is, the gap between the long-term average level of growth and the actual level of growth.
When an economy is growing at a rate faster than its long-term trend this is called having a ‘positive’ output gap. It is when the latter occurs that policymakers think about raising interest rates, in order to prevent the economies overheating and inflation becoming embedded in the system.
When the output gap is negative, and the economy is growing at a rate that is below trend, policymakers focus on cutting interest rates, in order to stimulate demand.
The issue faced by most developed market economies since the end of the pandemic has been that the inflation which came was not simply the result of economies overheating and the output gap being positive, but also of supply-side factors such as employee shortages and higher energy prices.
The impact of higher energy prices actually reduced the level of demand in the UK economy, as consumers had less discretionary income to spend. This meant the UK economy moved from having a positive output gap in the immediate aftermath of the pandemic, as people rushed to spend accumulated savings, to a negative output gap as consumer spending declined.
And there is the dilemma faced by the Bank of England (BoE).
Its mandate requires that it prioritises achieving inflation at or near the 2 per cent target set for it by the government.
With this in mind, the BoE raised interest rates during a period when the output gap was negative, thereby reducing growth in an economy where activity was already slowing.
The two most recent GDP data points for the UK showed growth of 0.6 per cent per quarter, which would equate to 2.4 per cent over a year, considerably ahead of trend.
With inflation already higher than the 2 per cent target, economic textbooks would usually highlight the need for interest rates to rise at this stage, rather than fall, but the most recent action from the BoE has been to cut rates, with the market expecting more rate cuts to come. Good news if you have a mortgage but bad news for cash savers.
A strategy that goes for growth is needed, but the options are more constrained now, so it looks as though we will get higher taxes. This is because the central bank believes inflation is on course for a fall below the 2 per cent limit, whether the output gap is positive or negative.
Guy Miller, head of macroeconomics at Zurich, says the stout level of GDP growth in the UK in 2024 so far is the result of the economy “catching up” on growth that did not happen in 2023, and he expects the growth rate to moderate throughout the rest of this year, but to remain robust.
Gabriella Dickens, G7 economist at Axa Investment Managers, elaborates on this.
She says: “Around 70 per cent of the growth we have seen in 2024 is government spending, and also the fact that in 2023 there were strike days, which haven’t occurred this year – that has boosted the GDP number, as it counts as an increase in the level of economic activity. But if you remove those factors, the growth rate is much more modest.
“The growth we have had has been about improvements to the supply side of the economy; household consumption and consumer services is quite weak in the data. I think if you strip out those one-off impacts, then growth in the UK is weaker and is below trend.”
While she does not expect a recession, she says “a slowdown is almost inevitable”.
Peder Beck-Friis, economist at Pimco, is another who expects the current rate of growth to slow in the UK. He says the quarters of negative growth in 2023 were partly the consequence of the negative impact of higher interest rates being felt on the economy, but 2024 has seen the impact of that wane, as it has now been a number of months since rates rose, or since market participants began to fear that rates would rise further.
He believes that, in particular, data related to the jobs market is showing some signs of weakness, which is likely to hamper growth in the near future.
Dickens says one recent feature of the economic data has been that while people’s real incomes – that is, their spending power after inflation – have improved, “they aren’t out there spending it.
“Higher energy bills are part of the reason for that, but also mortgage refinancing; people knew they would be refinancing this year or next year, and that it would be more expensive for them, so they have tried to minimise that [expense] by paying down debt now.”
Beck-Friis says that while the level of UK inflation has fallen “impressively” this year, he expects it to “tick back up” later this year as a result of the energy price cap rising.
One economist more optimistic about the outlook for growth is Gerard Lyons, chief economic strategist at Netwealth.
He says: “The BoE in particular, and the Office of Budget Responsibility (OBR), underestimated growth coming in to this year, and I suspect they will have to revise up their forecasts. It’s quite bizarre but some policymakers were taken off guard by the level of growth; the consensus among economists was for higher growth than the BoE expected.
“The bulk of the growth came from the services-side of the economy, but the latest purchasing managers’ survey data shows that manufacturing is starting to improve as well.”
Lyons says economic growth is a function of three things: “fundamentals, public policy and confidence, and of those three, confidence is the hardest to achieve. I can understand the political reasons, but the current government approach may not be helping confidence.”
Despite that, he says: “By the time we get to the budget, the OBR may be upgrading their growth forecasts and leaving much more headroom for the chancellor.
Beck-Friis says investors may have to get used to UK economic data being more “volatile” than that of the Eurozone and US, “because the UK is a smaller economy so any shocks have a greater impact.
“UK economic growth at the current level is well above trend and above the trend rate for developed economies, so I expect it to move back towards trend. Really the Eurozone is only at trend, and the US as well.”
Dickens says that most economists’ models for the UK economy “went haywire” in the years following the Brexit vote, but she feels that “people have started to get used to the new way of doing things, so distortions in labour markets are being eroded, and the usual economic relationships that work within economics are starting to work again.”
And so too interest rates.
Dickens believes the BoE will “look through” the growth figures and the persistent nature of the core inflation data and continue to cut inflation.
Core inflation strips out items such as fuel from the headline inflation number as fuel costs tend to be exceptionally volatile, so one particular month of data could be skewed by fuel costs, stripping out those therefore should provide a more reliable and consistent measure of inflation.
Core inflation in the UK is currently 3.3 per cent, while the headline rate of inflation, which includes those volatile items, is 2.2 per cent. Lower rates will lead to higher consumer spending, and so the portion of GDP growth contributed by government spending will fall, while the proportion contributed by consumers will rise.
Dickens view is that the lower rates should mean there are no negative quarters of UK GDP growth in 2024.
Beck-Friis expects rates to be cut imminently in the UK and expects that the peak at which rates will rise in future, known as the terminal rate, will also be lower in future.
Lyons says that with service sector inflation proving more “persistent” than might have been expected, “it is not the environment to aggressively cut rates right now”, but he does expect monetary policy to loosen from here.
He says the BoE has been too focused on the immediate term when deciding monetary policy, whereas it should have be more forward looking and so cutting rates now would be getting a little ahead of the curve, which he believes would be a positive.
But of course all this is pre-budget speculation…
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