Hamish McRae: Do the maths - if inflation is down, growth is on the increase

Were there even a modest recovery, living standards would rise again

Phew! The cavalry may have arrived in the nick of time to rescue a beleaguered UK economy – the cavalry in the shape of a sharp fall in UK inflation. The mounting evidence of a serious slowdown has been deeply worrying, even to those of us who believe that economic activity is being under-recorded in the official figures. The employment numbers, retail sales and tax receipts are all consistent with growth of around 1 per cent a year, not the near-zero number now forecast by the International Monetary Fund. But 1 per cent is still pretty dreadful. It is much worse than that expected by the Office for Budget Responsibility, the Bank of England and, until recently, most independent forecasters.

The only thing that can help is a fall in inflation. Exports are not going to be strong, given the deepening recession in the eurozone, where the present outlook is very worrying indeed. Government spending cannot help in any material way, given the need to keep trimming the deficit. Actually, notwithstanding all the noise about government cuts, public spending has been running up year on year, not down. More investment? Yes, that would be most helpful but the lags are long, for an investment decision now is not going to result in spending for months and years. So what we need, in the short term at least, is for consumption to hold up. Household consumption is half of final demand – government consumption is another 16 per cent, so that total consumption is two-thirds of demand.

But, as we all know, we have been experiencing a severe squeeze on living standards, with household incomes rising by less than 2 per cent a year and, until recently, inflation running at 4 per cent. Month after month, the average family loses ground. Surprisingly, consumption has held up but clearly has been a struggle. But were inflation to fall to below 2 per cent and were there to be even a modest recovery in pay growth, living standards would start to rise again.

The first, the fall in inflation to below 2 per cent, does really look a runner for the autumn, given that it is now down to 2.4 per cent; and while wage growth is likely to remain restrained, it is quite plausible to expect it to climb a little as growth recovers. The vicious downward spiral we are currently experiencing would become a virtuous upward one, with higher demand leading to greater confidence among producers and consumers alike.

Thus there is a direct mathematical impact on living standards from lower inflation. There is also a direct mathematical impact on published growth. For any given level of money GDP, you have to subtract the impact of inflation. If inflation is lower and money GDP the same, that translates into real growth. So the growth numbers are likely to flip round, too. We will experience real growth led by domestic consumption.

The huge question is whether the fall in inflation will be sustained. If energy and raw material prices continue to fall, we could see a few months at least when inflation undershoots the Bank of England forecasts, a sharp contrast to recent experience.

That leads to a final question. Could we all have been wrong in assuming that strong growth from China was in a way rescuing the world economy? It has been supplying some two-thirds of global demand for the past three years. But by putting such pressure on energy and commodity prices, China also made it harder for the rest of us to recover. Now that China is growing somewhat more slowly (how slowly we don't know, but I saw some figures that suggested electricity demand had been flat year on year), that burden is being lifted a little.

Part-timers signal a jobs revolution

The next set of unemployment and employment figures comes out today and, as in recent months, there will be several intriguing questions. The headline unemployment numbers naturally attract attention but as important will be whether the rise in employment has been sustained. It is possible that by the end of this year total employment will be higher than its previous peak in the spring of 2008. But note the changing composition of employment, not just the rise in private sector and decline in public sector jobs but particularly the rise of part-timers, the self-employed, and people beyond normal retirement age.

We are seeing a swift structural shift towards a much more flexible workforce, a jobs revolution in fact. In many ways, that is welcome. It has stopped unemployment rising as much as it might have done given the weak overall growth and it should enable us to meet additional demand without so many strains as growth returns. But we have hardly begun to think about the consequences. For example, the ONS produced some really shocking statistics on private sector pensions yesterday. Here is one: the proportion of self-employed men in a pension scheme fell from 64 per cent in 1998/9 to 37 per cent in 2009/10. So much of our policy is designed for a world that no longer exists.

h.mcrae@independent.co.uk