Economics: Come rain or come shine, the recession will pass

Somebody once said that God created economists in order to give weather forecasters credibility. But after the disappointing and unpredictable summer that is now ending, meteorologists are joining economists in the forecasting doghouse. Just as the predicted ‘barbecue’ summer failed to materialise, so the hoped-for early end to the recession is proving elusive. Not only were the first three months of this year worse than first predicted, ­ the figures for activity in the April to June quarter were surprisingly weak.

Of course, the problem could be that the numbers are wrong. Official statistics are now in such a ropey state that there is probably more uncertainty about the past than there is about the future. When the Q1 GDP number was first published on 24 April, for example, it was claimed that output had fallen by 1.9%. By the third cut on 30 June, the figure was revised to -2.4% ­ a very significant difference. It meant Q1 was the UK economy’s worst quarterly performance for more than 50 years and the worst 12-month period since 1945.

In July, the first estimate of Q2 GDP reported another negative number, -0.8%, when the consensus view was for something less than -0.5%. That will almost certainly be revised by the time the third cut is published on 29 September, but, as was shown earlier, the revisions could go in either direction. Why did so many economists misinterpret the signals and expect a brighter outlook than actually occurred?

There were two major reasons. First, other data sources were suggesting that some parts of the economy were starting to recover and, second, that the widespread destocking that had dragged the GDP numbers down over the previous nine months had probably run its course. The stockbuilding point is a bit obscure, but quite important. During much of 2008, industry continued to produce in anticipation of a demand, which subsequently failed to materialise. Once spending growth slowed, demand was met from stocks rather than new output.

The Q2 inventories figure is not yet available, but in the previous six months, the reduction in stocks was around £9.5bn, around 1.5% of GDP. In other words, destocking has accounted for almost 70% of the fall in GDP during the first two quarters of the recession. This was about twice as much as the falls in consumer spending and investment (while government spending increased and net trade improved) and the single biggest contributor to the lower GDP number.

It is easy to see, therefore, that once stocks have been run down, even the current levels of spending could generate new production and perhaps employment. Not surprisingly, statisticians find it difficult to value and predict the run down in inventories, but it can make a huge difference. Previous experience shows that while the figure can be negative for a long period, there have been just three or four really big numbers at the start of the recession. And the need to restock can add to the pace of recovery as activity picks up faster than the increase in spending.

Another important factor influencing economists’ more upbeat views was the Purchasing Managers’ Index (PMI) results for the main industry sectors. These monthly inquiries take the temperature of the industry, are forward-looking and have proved reliable indicators of future activity. The critical number is 50: anything higher implies expansion and less points to contraction. Last November, the services sector PMI hit an all-time low of 40. It then rose for six successive months and has been in positive territory for the last two surveys.

Manufacturing and services are following a similar path. Manufacturing’s low point was also last autumn (35), but by June had climbed to 47. Construction had slipped even lower (28 in February) but is now in the mid-40s. Although these results do not yet spell expansion, a marked improvement is clearly discernible. Services, on the other hand, should be in growth mode, but the big surprise in the Q2 GDP figure was the poor showing by services. According to the Office for National Statistics, the fall in services activity accelerated in Q2, from -1% to -1.6% which, since it accounts for 75% of GDP, has a major impact on the total figure.

There are good reasons for thinking these survey trends reflect more accurately what is happening than the relatively small sample used by the ONS for its calculations. And other sources also give a more optimistic view than the official estimate, such as increasing signs of life in the housing market, better than expected retail sales figures, the slower than forecast rise in unemployment and the fact the MPC will not use the whole £150bn it allocated for quantitative easing.

It is obviously very difficult to plan where you are going if you don’t know where you are starting from, but it is likely that whether the fall in GDP in Q2 was 0.8% (as the ONS claimed) or 0.3% (as was generally expected), the economy is through the worst and recession will be over by the final quarter of 2009. The sun is trying to peek out from behind the clouds.