Don't be surprised if growth slows significantly next year

The risk is that the hit on the real economy from exchange rate appreciation occurs as rate rises are biting and windfalls are fading from view

The omens for growth in 1997 look encouraging. Household income growth has accelerated, the labour market is tightening, house prices are rising and well over pounds 30bn of building society windfalls are due this year. An investment boom may already be under way. In the past six months its rate of annualised growth has been well into double digits and well in excess of the pace of consumption.

In the current environment talk of a hard landing looks misplaced. However, we can see reasons why growth could slow sharply next year, surprising a consensus which is conditioned to believe the boom times have returned.

It is understandable if many commentators think the strength of the pound will not prove much of a hurdle for growth. Despite more than a 20 per cent rise in the exchange rate, export volumes appear to be holding up relatively well and the UK's trade position has yet to deteriorate significantly. This will give the Bank of England even more reason to raise interest rates in defence of the inflation target.

However, to paraphrase monetary ideology, the exchange rate affects the economy with "long and variable lags". Conventional thinking seems to be that sterling strength is no substitute for higher interest rates in slowing the economy - the manufacturing sector may be hit but this would be dwarfed by the strength of services. We would caution against such a sanguine view on the role of the currency.

In our view, the relationship between the exchange rate and the economy has changed. Increasing global competition has led to UK exporters being much more price takers in world markets. Profit margins now do more adjusting to a change in the exchange rate. The chart shows what a close relationship there has been between the exchange rate and sterling export prices. Currency depreciations tend to be associated with rising sterling export prices and higher profit margins. Currency appreciations are associated with falling sterling export prices and lower profit margins.

Sterling export prices are only now beginning to come under pressure. However, because of contracts and recognition lags in 1992 there was an interval before the devaluation led to higher sterling export prices. Looking at the net export performance, one would be forgiven for thinking the 1992 devaluation did little to improve UK growth prospects. In reality, the currency itself proved very helpful, but the growth effects were delayed until 1994 and 1995. The massive leap in exporters' profitability brought a delayed but powerful supply-side push into export markets.

We find it unrealistic to assume that more than a 20 per cent appreciation in the exchange rate will not hit profits hard. Gross trading profits of all companies recently decelerated significantly, partly on the back of a pick-up in whole economy unit labour costs.

There also seems to be a degree of "money illusion" built into many analysts' company profit projections. Assuming inflation averages 2.5 per cent a year going forwards, nominal GDP will average at best 5 per cent a year (2.5 per cent inflation plus 2.5 per cent trend growth). Over the longer term, earnings will have difficulty beating that benchmark. Even without the rise in the exchange rate, profit downgrades would be in the pipeline.

The risk is that the hit on the real economy from the exchange rate appreciation occurs as interest rate rises are biting and windfalls are fading from view. We can see from the experience of the US that companies are now much quicker to address a squeeze on margins and a slowdown in order books. Next year would be a different scenario if unemployment started rising again in the UK. Household income growth, a key driver for consumption trends and the housing market, could decelerate sharply.

On a more general point, there seems little risk of a consumer boom without a decisive fall in the saving ratio. This is as high now as in recession. Part of the explanation for the high saving ratio lies with the labour market. Despite falling unemployment and evidence that average job tenure has picked up a little since recession, survey evidence suggests that job security has declined to record lows.

In the past, falls in unemployment were associated with a declining saving ratio. However, in the past falling unemployment did not coincide with rising job insecurity. If the UK continues following the US model, employee morale is unlikely to continue deteriorating forever. However, by historic standards it could remain very low.

Work we have done at Dresdner Kleinwort Benson has identified the importance of equity withdrawal from the housing market for the consumer boom of the 1980s. Official data confirms there is no evidence yet of equity withdrawal picking up. This is not so surprising. In the past there has always been a long lag before rising house prices led to equity withdrawal. A reduction in negative net equity might lead some individuals to repay debt at a slower rate or to stop repaying debt. However, others may use any improvement in income prospects to reduce their debts.

The Bank of England's task has been made harder by the polarisation that seems in evidence in the labour and housing markets. The top end of the housing market has recovered sharply but the national performance is not so impressive and turnover is relatively very low. Moreover, real wage growth per employee remains relatively low. Excluding the bonuses paid to the finance sector, real wages per employee are growing by not much more than 1 per cent a year, compared to the long-term average of 2 per cent.

It is the task of forecasters to try and identify structural breaks, which may have caused relationships which held true in the past to break down. We can identify several. We would not be surprised if economic growth slowed from over 3 per cent this year to under 2 per cent next.

The author is UK economist and director at Dresdner Kleinwort Benson

Start your day with The Independent, sign up for daily news emails
News
peoplePair enliven the Emirates bore-draw
Arts and Entertainment
tvPoldark episode 8, review
News
Britain's opposition Labour Party leader Ed Miliband (R) and Boris Johnson, mayor of London, talk on the Andrew Marr show in London April 26
General electionAndrew Marr forced to intervene as Boris and Miliband clash on TV
News
news
ebooks
ebooksA special investigation by Andy McSmith
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Ashdown Group: Treasury Assistant - Accounts Assistant - London, Old Street

£24000 - £26000 per annum + benefits : Ashdown Group: A highly successful, glo...

Ashdown Group: Business Analyst - Financial Services - City, London

£50000 - £55000 per annum: Ashdown Group: Business Analyst - Financial Service...

SThree: Trainee Recruitment Consultant

£18000 - £23000 per annum + OTE £45K: SThree: At SThree, we like to be differe...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + competitive: SThree: Did you know? SThree is the o...

Day In a Page

Not even the 'putrid throat' could stop the Ross Poldark swoon-fest'

Not even the 'putrid throat' could stop the Ross Poldark swoon-fest'

How a costume drama became a Sunday night staple
Miliband promises no stamp duty for first-time buyers as he pushes Tories on housing

Miliband promises no stamp duty for first-time buyers

Labour leader pushes Tories on housing
Aviation history is littered with grand failures - from the the Bristol Brabazon to Concorde - but what went wrong with the SuperJumbo?

Aviation history is littered with grand failures

But what went wrong with the SuperJumbo?
Fear of Putin, Islamists and immigration is giving rise to a new generation of Soviet-style 'iron curtains' right across Europe

Fortress Europe?

Fear of Putin, Islamists and immigration is giving rise to a new generation of 'iron curtains'
Never mind what you're wearing, it's what you're reclining on

Never mind what you're wearing

It's what you're reclining on that matters
General Election 2015: Chuka Umunna on the benefits of immigration, humility – and his leader Ed Miliband

Chuka Umunna: A virus of racism runs through Ukip

The shadow business secretary on the benefits of immigration, humility – and his leader Ed Miliband
Yemen crisis: This exotic war will soon become Europe's problem

Yemen's exotic war will soon affect Europe

Terrorism and boatloads of desperate migrants will be the outcome of the Saudi air campaign, says Patrick Cockburn
Marginal Streets project aims to document voters in the run-up to the General Election

Marginal Streets project documents voters

Independent photographers Joseph Fox and Orlando Gili are uploading two portraits of constituents to their website for each day of the campaign
Game of Thrones: Visit the real-life kingdom of Westeros to see where violent history ends and telly tourism begins

The real-life kingdom of Westeros

Is there something a little uncomfortable about Game of Thrones shooting in Northern Ireland?
How to survive a social-media mauling, by the tough women of Twitter

How to survive a Twitter mauling

Mary Beard, Caroline Criado-Perez, Louise Mensch, Bunny La Roche and Courtney Barrasford reveal how to trounce the trolls
Gallipoli centenary: At dawn, the young remember the young who perished in one of the First World War's bloodiest battles

At dawn, the young remember the young

A century ago, soldiers of the Empire – many no more than boys – spilt on to Gallipoli’s beaches. On this 100th Anzac Day, there are personal, poetic tributes to their sacrifice
Dissent is slowly building against the billions spent on presidential campaigns – even among politicians themselves

Follow the money as never before

Dissent is slowly building against the billions spent on presidential campaigns – even among politicians themselves, reports Rupert Cornwell
Samuel West interview: The actor and director on austerity, unionisation, and not mentioning his famous parents

Samuel West interview

The actor and director on austerity, unionisation, and not mentioning his famous parents
General Election 2015: Imagine if the leading political parties were fashion labels

Imagine if the leading political parties were fashion labels

Fashion editor, Alexander Fury, on what the leaders' appearances tell us about them
Phumzile Mlambo-Ngcuka: Home can be the unsafest place for women

Phumzile Mlambo-Ngcuka: Home can be the unsafest place for women

The architect of the HeForShe movement and head of UN Women on the world's failure to combat domestic violence