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Economics: Recovery is incremental, but nowhere near business as usual

The Chancellor will deliver his pre-Budget report three
weeks before Christmas ­ probably his last in this Parliament. Since it will
cover the period beyond the 2010 election, it will be examined for hints of the
government’s election manifesto. And it comes hard on the heels of the Bank of
England’s latest quarterly inflation report, which discussed not only the
outlook for inflation, but the UK’s medium-term growth prospects as well. This
will be the benchmark against which Alistair Darling’s projections are judged.

Official statistics offer a gloomy backdrop to the inflation report. As it
became clear that the US and the European Union are both emerging from recession
and growth in China is picking up, the Office of National Statistics reported
that UK GDP had fallen by 0.4% for the sixth consecutive quarter in Q3. Which
makes this current recession the UK’s longest since 1945; the fall in output
from peak to trough is now almost 6%.

This figure came as something of a surprise because other numbers were
pointing in an upwards direction. In particular, the key surveys of business
sentiment, the PMIs, had turned in the Spring and in manufacturing and services
were above the threshold that implies expansion. The housing market was more
positive, with the Nationwide index showing year-on-year growth in the 12 months
to October. And even the labour market statistics surprised on the upside.

All of this and more led to Bank of England Governor Mervyn King suggesting
that the GDP figure could well be revised later: when the inflation report was
published, it was clearly more upbeat than in August, particularly about the
medium-term. But at the BoE press conference King’s words were much more
cautious than a reading of the report suggested. While the economy is now
emerging from recession, the road to full recovery will be bumpy and the risks
largely on the downside. In King’s view, while output is now likely to start
increasing, it will be 2011 before the economy gets back to its 2008 level. The
problems of tight credit, cautious consumers and the huge public sector fiscal
deficit will all take time to unwind.

That said, it is easy to start feeling optimistic by looking at the Bank’s
forecasts. For 2010, it has pencilled in GDP growth at a welcome but modest 2%,
then an above-trend 4% in 2011. This can, however, be achieved by keeping
inflation within the 2% target, largely because of the amount of spare capacity
in the system. With inflation starting to edge up from the present rate, some
increase in interest rates is likely, but not back to pre-recession levels.
Quantitative easing, low interest rates and a weak currency will be the main
drivers of the recovery.

There are, nevertheless, risks that the pace of recovery will be more subdued
and top of the list is tighter fiscal policy. During next year’s election, the
whole issue of government spending and taxation is likely to be centre stage and
the inflation report has emphasised the need for a credible exit strategy from
the current record deficit level. The worry is that the cuts end up too sharp
and take place before the private sector is able to fill the gap.

King says he feels that interest rates could be used to offset a fiscal
tightening.

On the question of the Monetary Policy Committee’s primary objective, keeping
inflation to the 2% target, the Governor was relatively relaxed. Although there
would be a spike early next year when VAT is restored to its full 17.5% rate,
the rate, he said, was expected and the price pressures would ease as the year
progressed. There will, of course, also be inflationary risks from a weaker
exchange rate and from higher commodity and oil prices as the world economy
recovers, but the King believes that the amount of spare capacity in the UK
economy would ensure consumer price pressures would remain weak. He is also
confident that the Bank could manage the unwinding of the QE programme to
prevent the £200bn injection converting into inflation.

Above all else, however, will be the debt overhang, the major legacy of this
recession. Businesses and households still carry high levels of debt ­
affordable with interest rates at historic lows, but with uncertain incomes and
profits there is little appetite to take on more. Savings appear to have a
higher priority. At the same time, the banking system is still far from restored
to full health. The process of reducing its leverage from the recent record
levels has some way to run and, until that point is reached, the supply of
credit to households and businesses will continue to be impeded.

The tone of King’s comments was probably more revealing than the numbers in
the Bank’s inflation report, a salutary warning that the end of recession does
not mean business as usual. The adjustment process will take most of 2010 and
recovery will be incremental rather than a sudden surge in activity. This view
passes the common sense test for many in the private sector and it will be
interesting to see Darling’s take on events in the coming weeks.

Dennis Turner is chief economist at HSBC

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