A downturn is as good as a rest to a slow recovery
Monday 20 March 1995
Chris Riley of the Treasury pointed out that the prolonged recovery of the 1980s, which lasted virtually the whole decade, was the longest upswing since the last century. So just when the Conservative Party was hoping that the recovery would become noticeable to the electorate, macro- economists are beginning to say that the UK is overdue for a downward correction.
But things surely cannot be that dismal. To make sense of forecasts of an impending "recession", we need to know how the statisticians define cyclical peaks and troughs, and what they mean by a "downswing" in activity. Economists define the peak to be the point where the gap between GDP and its trend level is at its maximum. Since the GDP trendline obviously increases over time at the UK's average rate of growth, the gap between GDP and its trend rises when the actual rate of growth in the economy is above average.
This is the upswing phase of the cycle. At the point where GDP is growing exactly at its average rate, the cycle peaks, and the downswing phase occurs when growth drops below normal. Note that output need not fall during the downswing phase - it may simply grow by less than its trend rate, which in the UK is about 2.5 per cent per annum.
The 1980s era seems to have been one of continuing boom, with the "feel-good" factor rising without interruption. However, that is not how the statisticians see it. They have split the period into two cycles, the first upswing hitting a peak in early 1984, and the first downswing hitting a trough at the start of 1986.
Surprisingly, therefore, 1984-86 is now classified as a recession. This was a time when GDP temporarily grew by less than its trend rate, partly because the coal strike damaged industrial production for several quarters. Output in the rest of the economy barely fell in this period, and few people now remember it as a recession. And even if it was a recession, it was certainly not severe enough to prevent a Tory victory in the 1987 election.
What does all this imply for the likelihood of recession in the next couple of years? If by recession we mean a substantial period - say six months to a year - of declining GDP, then the chances look pretty remote. But this does not rule out a downswing in which GDP grows less rapidly than its long-term trend rate. In fact, we may have already entered such a period. Based on the indicators for the first quarter of this year, the level of GDP may have risen by less than 0.5 per cent on the previous quarter, which is comfortably less than the trend growth rate. So when the statisticians look back at 1995, it is quite conceivable (though far from certain) that they will describe it as the start of the downswing,with the peak in the latter half of 1994. It would be a very good thing if this happened. The pause in the boom in 1984-85 definitely refreshed.The slowdown in the growth of demand allowed the supply side of the economy to catch up via a surge in investment spending - partly generated by the corporation tax changes in the 1984 Budget. As a result of this gain in capacity, the early inflationary strains which were building in 1983/84 were nipped in the bud.
It would be no bad thing if the same thing happens in 1995-96. The tightening in fiscal and monetary policy since early 1994 has been quite carefully designed to ensure that this will be the case. But it would not be such a good thing if a much needed pause in the recovery turned into a fully- fledged recession. Whether this will happen depends largely on two factors - the sustainability of the European economic upswing, which lies behind our export growth, and the prospects for inflation. The upswing in Europe started around the middle of 1993, and by the first half of last year European GDP was growing at an annualised rate of 3.8 per cent.
More than two-thirds of this growth was due to a sharp turnaround in inventories, which is quite a common in the first year of a recovery. In the second half of last year, the level of inventories stabilised, and European GDP growth slowed from 3.6 per cent in the third quarter to 2.4 per cent in the fourth. From now on, the main driving force behind the European recovery will be a sharp pick-up in investment spending. Leading indicators for capital spending are rising, and we are finally seeing a response from investment,which is up by 4.5 per cent in the latest 12 months. With overall European investment likely to rise by some 5-10 per cent this year, we can be confident that the European upswing - and with it the demand for UK exports - will remain robust.
But a more serious problem is developing on the inflation front. The recent decline in sterling has been sufficient to threaten the inflation target in the first half of 1996. Case B in the graph shows what might happen to inflation if sterling remains at the level (84.5 on the trade weighted index) it reached on Friday, while case C shows what might happen if the turbulence of the exchange markets takes sterling down by another 5 per cent.
If the Government wants to maintain the credibility of its inflation target, it would need to raise interest rates to combat any prolonged further fall in the pound. But that might be enough to tip the domestic economy into something worse than a "pause that refreshes". It has always been certain that, one day, the Government would have to choose between sticking to its inflation target, and allowing the economic upswing to continue. With a bit of luck, sterling will bounce back as soon as general market turbulence declines. But if the sterling bounce does not come within, say, 3 months, then interest rates will need to rise. Last week's row over the "feel-good" factor would look like a tea party compared with the political upheaval that would follow such action. But necessary it would be.
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