Slowdown in growth fuels hopes of rate cut

Economy: Expansion dips for the first time in two years but bid speculation boosts shares

PAUL WALLACE

Economics Editor

A sharp slowdown in economic growth triggered fresh hopes of a cut in interest rates, helping to drive the stock market to a new peak yesterday. The slide in growth was seen as further confirmation that the Chancellor, Kenneth Clarke, has won his interest rate tussle with the Bank of England Governor, Eddie George.

Sterling closed down two-tenths of a point against the basket of currencies as figures were released to show the economy expanded at only 0.5 per cent in the second quarter of the year, causing economic growth to dip below its underlying rate of increase for the first time in two years. The Central Statistical Office had initially estimated second quarter growth at 0.6 per cent.

The main reason for the slowdown was disappointing performance from exports, which have been affected by the general slackening in economic activity worldwide. These showed no sign of improvement in July, as the trade gap with countries outside the European Union widened to pounds 856m, its highest since the beginning of 1993 and much worse than the deficit of pounds 630m expected.

"The next move in base rates appears to be down, although probably not until next year," said Michael Saunders, UK economist at Salomon Brothers. The March short sterling futures contract, which was indicating a rise of half a percentage point only a week ago, closed at a level indicating that the City now expects rates will be under 7 per cent next spring.

In its quarterly review of the economy, the National Institute of Economic & Social Research said that interest rates could safely be left on hold without leading to anything more than a marginal breach in the Government's target of 2.5 per cent underlying inflation. Only three months ago, it forecast rates would have to rise by 1.75 percentage points by next year if the Government was to meet the inflation target.

Andrew Smith, Shadow Chief Secretary, said: "Slower growth, low investment, rising unemployment and the wider trade gap show the economic situation is weaker than the Chancellor makes out."

But a Treasury spokesman said the economy was still growing at a sustainable rate.

On the output side of the economy, the main reason for the downward revision to growth was that construction declined by 1.1 per cent compared with the first quarter, more than had initially been thought. Oil and gas extraction and energy supply were also lower than expected. In addition, services sector output was revised down from 0.8 to 0.7 per cent, with air transport showing no growth and insurance and banking weak.

The expenditure breakdown of growth suggested that the pace of economic activity could slow still further in the rest of the year as companies sought to run down stocks. This was the main danger of a downturn identified earlier in the month by the Bank of England in its Inflation Report.

Stockbuilding alone added 0.6 per cent to gross domestic product, with the stockbuilding of pounds 1.6bn in the second quarter the highest figure for six and a half years. The main build-up occurred in distribution and retailing, as wholesalers that had been destocking in the first three months of the year restocked and retailers increased stockbuilding.

The rise in inventories "looks like an involuntary response to the earlier slowdown in final demand rather than a sustainable source of growth," Mr Saunders warned. "Unless final demand surprisingly revives, then pressure to cap the rise in inventories is likely to slow the economy further and limit the inflation pick-up later this year."

However, a rebound in consumer spending, which had declined marginally in the first quarter of the year, allayed fears of a more lasting downturn. Consumer expenditure picked up by 0.8 per cent in the second quarter, although 0.2 per cent of that was attributable to the lottery effect and in particular the introduction of scratch cards.

With income from employment falling in the second quarter, consumer spending growth of just over 2 per cent is expected to remain subdued by past standards. However, the implied willingness of consumers to run down savings in the second quarter contrasted sharply with the surprise increase in the savings ratio in the first three months of the year. The bounce-back in consumer spending "will mollify worries of a sharp deceleration in economic growth", said Don Smith, economist at HSBC Markets.

After falling in the first quarter of the year, fixed investment recovered by 1.3 per cent thanks to greater purchases of aircraft and the inclusion of the cruise ship Oreana in the figures. The overall investment trend remained flat.

The overall effect was to boost domestic demand by 1.4 per cent. However, net trade fell by almost 1 per cent, the biggest decline since the end of 1988. Two-thirds of the decline was attributed by the CSO to a fall in exports, one third to an increase in imports.

Figures for trade in July with countries outside the EU suggested exports continued to be hit by the world economic slowdown, particularly in the US.However, while exports fell back, imports surged. Excluding oil and erratics, the volume of exports in the three months to July was down by 0.5 per cent, while the volume of imports rose by 5 per cent.

The resulting trade imbalance of pounds 856m was worse than the pounds 759m notched up in June. Although the deficit was little changed on a monthly basis once oil and erratics were excluded, there was a trend widening in the balance.

In the three months to July, the deficit was pounds 2.3bn compared with pounds 1.1bn in the previous three months.

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