Do we face slowdown or meltdown?

There is no reason to fear a recession of the magnitude of the last two, so long as policy is eased quickly
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The Independent Online
THE MARKETS' verdict on the Monetary Policy Committee's bold move to cut rates by half a per cent earlier this month was clear. After a brief knee-jerk reaction, sterling has appreciated by around 2 per cent, and derivatives markets moved to discount higher, not lower, interest rates from the middle of next year onwards.

The markets seem to have come to the view that the Bank is moving early enough and aggressively enough to avoid a particularly hard landing, with recovery likely to be under way before the end of next year. By the UK's historical standards, such a brief and shallow downturn, after six years of uninterrupted growth, would be an extraordinary achievement. What chance is there that this view is correct?

A glance at the leading indicators of economic activity suggests a much gloomier outlook. The latest fall in business confidence, as measured by the Confederation of British Industry's Industrial Trends Survey, suggests that GDP is set to fall at an annual rate of 4 per cent - as bad as it got in the early 1980s recession. Business people, as the first chart shows, clearly take a very different view of the outlook for the economy than financial markets. Equally, consumer confidence is reported to have fallen to its lowest level since the depth of the early 1990s recession, which can hardly bode well for consumer spending - two-thirds of overall GDP.

A closer look, however, suggests that we may not be quite as gloomy as an initial look at the confidence indicators suggests. As the second chart shows, consumers respond very differently when asked about the state of the economy generally and when asked about the prospects for their own financial position. Expectations for the general economic situation have plunged as talk of recession has spread. But when asked about their own finances, consumers are just about as optimistic now as they have ever been.

Interestingly, a similar situation developed in the mid 1980s and was sustained for several years. At the time, official data suggested that the economy was far weaker than ultimately turned out to be the case. With the benefit of hindsight - and many successive revisions to the official estimates of GDP - consumers' perceptions of their own finances turned out to be a far better guide to the economy's prospects.

There are also good reasons for thinking that the most literal interpretation of the business confidence data overstates the gloom. The main CBI survey, of course, covers only manufacturing industry and, as the main victims of sterling's strength, it is not surprising that manufacturers are so gloomy. As the first chart shows, however, this measure of business confidence has been a good predictor of overall economic activity in the past. Why? Although manufacturing industry is only a small part of GDP, it has historically explained much of the variation in GDP. In fact, over the last 30 years, as much of the variation in GDP is explained by manufacturing as services, despite the fact that the service industries are three times the size of manufacturing.

With manufacturing and services now diverging to an almost unprecedented degree, it seems fair to assume that the outlook for the economy is rather less gloomy than the CBI survey initially suggests. All this is not to suggest that the near-term outlook for activity is rosy. Far from it. Our analysis of the survey indicators generally - including others from the Chartered Institute of Purchasing and British Chambers of Commerce - suggests that they point to overall economic activity stagnating but probably not falling in the early part of next year.

So far, then, the sanguine outlook for the economy that financial markets point to seems to be half right. There is little compelling evidence, as yet, that the economy is heading for the sort of deep, prolonged slump that characterised the last two downturns. But can we find any evidence that a further 1 per cent reduction in base rates - current market expectation - is sufficient to ensure recovery after a brief period of stagnation?

The answer depends essentially on two questions: how tight are overall policy conditions now and will they be eased? Turning first to monetary policy, current real interest rates, at a little over 4 per cent, are neither particularly high nor particularly low at present compared to recent cyclical averages. Excluding the period of exceptionally high inflation at the time of the first oil price shock, real base rates are only marginally below a level that might be considered normal.

The recent easing of the Government's spending plans certainly leaves the overall stance of fiscal policy looser than it might have been. But add in the impact of pre-announced tax increases - largely fuel, tobacco and the abolition of ACT - and the stance of fiscal policy does little more than move back to neutral, having been very restrictive in recent years. Add the strength of sterling to the melting pot, and there can be little doubt that the overall stance of policy is still restrictive, even after the three-quarter per cent reduction in base rates from their peak. Moreover, these measures of domestic policy do not take account of the global economic background, which is likely to show the weakest three-year period of economic growth since the war.

Whatever the current stance of policy, there is a general perception that policy is being eased at an earlier stage of the cycle now than has been the case in the past. Looked at relative to most measures of the economy's cyclical position, this seems to be the case. The current base rate cycle peaks at the point where output relative to trend was at its high point, albeit with the positive output gap at a low level compared to previous cycles. In the late 1980s, base rates did not move on to a clear downwards trend until two years after the cycle had peaked on this measure. And in the early 1980s recession, the output gap had dropped into massively negative territory before base rates started to fall significantly.

A similar picture emerges if we look at base rates relative to the growth rate of activity rather than its absolute level. In both the early 1980s and early 1990s recessions, growth was already into negative territory before a clear downward trend in base rates was established. The same picture emerges from the labour market, with base rates falling in the current cycle before unemployment had even reached a trough and, in absolute terms, is at its lowest level for virtually 20 years. On the basis of a range of cyclical indicators, therefore, it seems base rates are moving significantly more pre-emptively than has been the case in the UK's recent history. The same was true of the tightening of policy in the current cycle, despite the delay caused by the refusal of the last chancellor to raise rates ahead of the last election.

So the evidence is mixed. Policy is being eased at a relatively early stage of the economic cycle, but it is not clear that the overall stance of policy is anywhere near loose enough to ensure that activity recovers in the second half of next year. Against this background, we think the markets are premature in pricing in the trough in base rates so soon. The current profile implied by market expectations suggests rates will bottom at a little under 6 per cent in the middle of next year and are as likely to be rising as falling by the end of the year.

With inflation low, companies, households and even the current accounts close to financial balance, there is no reason to fear a recession of anything like the magnitude of the last two - so long as policy is eased quickly enough. On balance, the decision to cut rates by half a per cent in November, rather than the quarter per cent moves that have been the norm for the last four years, suggests it will be. We expect base rates to fall rapidly, to 5 per cent through the course of next year.

Adam Cole is UK economist at HSBC Economics and Investment Strategy

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