Economics - UK can escape worst of gloom.

The UK’s manufacturing industry has a gloomy look. Production fell consistently through the first half of this year – leading to claims that this sector, which accounts for about a fifth of the economy, is in recession.

Business surveys now show the lowest capacity utilisation since 1993 and the weakest export prospects for three years.

The high-tech sector has been hit particularly hard. UK manufacturers of telecommunications and related electronic equipment saw production drop by about 15% in the second quarter of this year alone. Computer manufacturers saw a drop in output of nearly 10%. The downturn in these sectors, which started in the US, is now becoming a global phenomenon.

But the behaviour of consumers paints a very different picture. Retail spending has been accelerating in recent months. Year-on-year growth of 6% was recorded in the latest quarter. This is double the trend rate of increase, and the latest figures show a similar rate of increase being sustained in July. The housing market, which is helped by low mortgage rates, is also holding up.

The UK is not alone in reporting this contrast between healthy consumer spending and weak industrial performance. A similar pattern has been apparent in the US and other European economies. This pattern of economic activity reflects three main influences. The bursting of the internet bubble has brought to an abrupt end an investment boom in high-tech equipment. Output and jobs have been cut most dramatically in these high-tech sectors, spilling out to supplying industries in services as well as manufacturing.

Industry has had to cope with high energy prices as the price of oil has been maintained at high levels by OPEC production cuts. With competitive pressures preventing companies passing this through into prices, profits have been squeezed, especially among energy-intensive manufacturing industries.

However, these negative effects have been offset by falling interest rates as the central banks of the major economies seek to head off the downturn. Interest rates have been cut most aggressively in the US, but recently they have also been falling in the UK, the eurozone and Asia.

Lower interest rates stimulate economic activity by encouraging consumers to spend more.

The overall performance of the economy depends on whether the pull from the continuing growth of consumer spending can offset the drag of the poorly performing manufacturing sectors. The UK economy has not slowed as dramatically as the US or Asian economies. The US has now seen four quarters of sluggish economic activity and the growth rate has dropped from an annual 5% in mid-2000 to 1.3% over the past year. The deceleration in the UK has been much less marked – from 3.4% to 2.1% over the same period.

However, worries are mounting that rising unemployment and continuing global uncertainty could erode consumer confidence and reinforce the slowdown in the second half of this year. Three factors will help to determine whether it is the healthy consumers or the depressed manufacturers that win out. The first is the severity of the global slowdown. Asia is already showing the strains of weak US and Japanese markets, with Taiwan reporting its biggest fall in GDP for 26 years. But Europe is likely to be more critical to the performance of the UK economy. Here, the latest evidence is mixed, with Germany and Italy suffering the most, but with growth in France, Spain and some small countries holding up.

A second factor is likely to be the performance of sterling. On this score, the recent weakening of the pound against the euro is helpful.

If this trend continues, it will help British industry maintain and increase its market share in difficult markets.

The third key element will be the willingness of the Bank of England to cut interest rates. Falling inflation could encourage the Bank to cut rates further if the economy remains weak in the months ahead. However, the latest minutes show opinion divided within the Monetary Policy Committee on August’s rate cut. Continuing evidence of strong retail sales could see the Bank return to its cautious stance of earlier this year.

The British economy cannot escape the impact of the global slowdown.

But with sensible interest rate policy and further falls in the pound against the euro, we should be able to stave off its worst effects.