The mismatch between the news from the business community and the perceptions of financial markets remains as wide as ever and I think the reason is that it will take longer than most people realise for the slowdown to make itself felt.
Yesterday, there were two major chunks of economic news: the labour market statistics and the Bank of England's Inflation Report. The former were pretty upbeat, indeed remarkably so. Unemployment is still falling on both of the main measures, with the claimant count falling by 10,800 in January and the ILO measure falling by 61,000 in the three months to end December. This is not the result of people being shuffled off into disability, for there is growth in total employment. If you believe the figures, the largest source of "new" labour comes from the oldies, with people over the age of 50 accounting for more than half the increase in employment.
So, in the labour market there is absolutely no sign of any downturn, rather the reverse. But at the same time, there is little sign of wage inflation, with settlements flat. So, a remarkably benign outlook?
Well, not quite so, according to the Bank of England. Its view is that the inflation outlook had deteriorated markedly since its previous report in November. Further, while its central economic forecast shows growth dipping to an annual rate of about 1.5 per cent this autumn, a technical recession (two quarters when the economy shrinks) is not out of the question.
Most economic commentators would agree. Inflation peaks at around 3 per cent, maybe a little above, on the central projection in the Bank's famous fan charts (see page 42) of the consumer price index. Indeed, if you look at what has been happening to the retail price index, still the main operating index for state benefits, pensions, index-linked gilts and many private contracts, the performance is worse. The RPI is stuck at well over 4 per cent. One of the oddities of the Bank's report is that it produces a mass of charts but no projection for the main operating index that it itself uses when paying interest on index-linked gilts. This is troubling because of the loss of confidence people feel in the CPI as an accurate measure of inflation.
The markets have interpreted the Bank's report, and the comments of Mervyn King, the Governor, as suggesting that it will drag its feet in cutting rates. It is certainly difficult to justify cutting rates if the inflation outlook is as bad as it appears. The Reuters poll of City economists suggests that the Bank will make only two cuts in rates in the next 12 months, to 5 per cent in June and to 4.75 per cent in September, with rates staying there till March next year. Were the economy to fall off a cliff, that might override things but there is really little sign of that at the moment.
But as financial advertisements are required to say, the past may be a poor guide to the future. If you look at the first graph, the remarkable thing is the stability we have experienced since the early 1990s: growth, employment and productivity have all remained positive, in marked contrast to the early 1980s and early 1990s. The world outlook remains reasonably positive too. There are some forecasts for the world as a whole, the US and the euro area in the next graph, with the blobs showing some decline but not a disastrous one.
The crucial question, of course, is whether this coming downturn will be more akin to the early 1980s and early 1990s rather than the early 2000s? That is a question for the world economy but as far as the UK is concerned it seems to me that our business community is assuming that it will be more like 2000. In other words, there will be little overall downturn at all. Otherwise, why would companies still be hiring at such a rate?
The counter response to that suggestion is that our fiscal position is much more adverse than in the late 1990s, when there was a budget surplus. Now there is a fiscal deficit of around 3.4 per cent of GDP. And our balance of payments position is much worse too.
Have a look at the third chart, also from the Bank's report. Thanks to a lurch into deficit on the investment income account, our current account deficit is now nearly 6 per cent of GDP. That is as bad as it was at the height of the Lawson boom in the late 1980s and a remarkable deterioration from being in balance in 1997. We know that the housing market is in similar shape as it was then in the sense that prices had risen far above their long-term average. We know too that prices are now falling. The parallels with the late 1980s are beginning to look uncomfortable. So why is there so little sign of concern in business?
There are two answers to this and I think a bit of both are relevant. One is about time lags. UK house prices peaked towards the end of 1989, though some parts of the country peaked in early 1990. But the downturn did not really bottom out until well into 1991. So there is a lag of at least a year, maybe two, between a turn in the housing market and its full impact feeding through into the economy. So it would be rational not to expect things to slow to any serious extent until next year. So it would be rational for employers to carry on hiring to meet the demand they still face. Unemployment is a lagging indicator.
The second answer is that policy will be better this cycle than it was in the early 1990s. The US is pumping demand back in to the economy by cutting rates, and there does seem to be some bounce as a result. The very latest consumer sales figures are up. We in the UK can cut rates if we have to, something we could not do when sterling was shadowing the German mark under ERM rules. Sterling can come down a bit more, which also helps correct the current account as well as giving some boost to demand.
Put these two together and what do you get? I still think that this year will be less of a problem than next year, though this may be turn out to be a year of two halves, with the first six months a lot stronger than the second. But the momentum is such that the bottom of the cycle will not be later this year, as the Bank expects but, at a guess, the middle of 2009. So I think the Bank is wrong in its timing. Seriousness? There, I suspect, it is right: that there will be a dip towards recession but quite possibly no actual recession in the technical sense. The next question is how quickly will the economy recover through 2010 and beyond – but that is a question for another day.Reuse content