eInsight, Economics Update Bulletin, November 09' _________________________
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UK last major economy still in recession »
The ONS published the latest GDP figures in October. The UK economy shrank by 0.4 per cent in the 3rd quarter - the sixth period of decline.
This preliminary data is very much a first draft, and future revisions can be expected. In general revisions are in the upwards direction, although the Q1 figure was revised significantly downwards.
The UK is now one of the last major economies to be still showing negative growth. China and India were never in recession, while Germany, Japan and France all showed positive GDP figures in the 2nd quarter. The US has officially resumed positive growth in the 3rd quarter, publishing a growth figure of 0.9 per cent for this period.
Why does the UK seem to lag behind other world economies in returning to positive growth? This seems surprising, as earlier this year Britain seemed to be suffering less than other big countries. Germany and Japan were both badly affected by the decline in world trade. However, now that global trade starts to recover their economies are picking up.
It has been suggested that the high level of household debt is the reason that the UK is still contracting. Due to the comparatively high level of indebtedness (UK households are one of the most over-borrowed in the G7) consumers are refraining from spending more. Another contributing factor is our high dependence on the financial services sector. UK banks have been among the worst hit by the financial crisis due to a heavy reliance on wholesale funding rather than retail deposits and insufficient capital to support over-extended lending.
However, even though we may lag behind, even the most pessimistic forecaster is expecting the UK to return to positive growth by the beginning of the next year.
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The FSA has recently outlined proposed tighter rules on mortgage lending. Self-certification mortgages, which made up almost half of the mortgage market in 2007, will be banned and other measures include banning lending when potential borrowers show a number of risk factors, for example high loan-to-value combined with a poor credit history.
The intention of the reforms is to prevent excessive lending leading to dangerous house price bubbles. Necessarily this will mean less people are able to borrow for house purchases in the future.
In the short term, it does not appear that restricted lending is constraining house price growth. Although the value of mortgage lending is significantly down on the peak in the boom period, house prices are currently growing. Supply-side restrictions of houses for sale are driving this. Although the value of new lending for house purchase remains low, it has increased 120 per cent in the last year. The value of new lending for remortgaging remains very subdued, although this may be due in large part to borrowers moving to low SVRs rather than remortgaging.
In the longer term, were the FSA proposals to be enacted, house prices and house purchases must be affected. Changes in the structure of UK owner-occupation are possible. At present around 70 per cent UK dwellings are owner-occupied. This is some way above the large Eurozone counties of France and Germany, but comparable to the US. Tightening mortgage lending criteria could reduce owner-occupier rates in the UK.
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In previous eInsights we have discussed the expected trends in unemployment as we work through the recession and eventually return to growth. Based on the conventional wisdom, unemployment is a lagged variable that continues to increase for some time after a recession is over. We have also noted that in this recession unemployment has been lower than we might expect because weak wages growth has absorbed much of the output falls that would otherwise translate into unemployment.
The data continues to confirm our argument. The unemployment rate has flattened at 7.9 per cent for the past 2 months, and in level terms has actually fallen by one thousand people. Although this is expected to be only a temporary blip, and over the longer term unemployment will continue to rise, the non-typical stabilisation of unemployment during a recession highlights some of the unique features of the current downturn. In particular, subdued wage growth has absorbed some of the contraction that would otherwise play out as job cuts.
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The pound has performed weakly compared to the dollar and the euro this year. After a slight uplift in May, UK exchange rates are again on the decline - and with the UK economy still being in recession, the pound remains under pressure.
Reasons for this are that interest rates are likely to be kept low by the Bank of England, as there are no signs of increasing inflation. It is also possible that the quantitative easing scheme will be extended in November, following a surprise extension in August by £50 bn. This additional quantitative boost was followed by a weakening of the exchange rate, and it is likely that the pound will be pushed even lower if further prolongations of the scheme are announced. The UK's weak fiscal position with its large and growing public sector debt is another factor in the continued low level of the pound to other currencies.
A weak exchange rate is often considered to be a problem, but this time it could be solution to encourage exports while domestic sources of demand are still weak. Increasing UK exports will also be an important part of the wider correction of worldwide trade imbalances that lead to the build up of cheap credit in developed economies prior to the crash.
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The consumer prices index, the measure of inflation targeted by the Bank of England, has reached its lowest level in five years, now standing at 1.1 per cent. Producer prices are looking low compared to the recent past, and the RPI (which take account of mortgage interest payments) has been at an incredible low for the past 6 months. Even when we strip out the effect of interest rate cuts on mortgages, by using the RPIX, inflation still looks low at 1.3 per cent.
When we turn to the measure of core inflation, RPIY, which strips out mortgage payments and indirect taxes (i.e. the effect of the VAT cut) we see that core inflation remains reasonably high at 2 per cent. Given the amount of spare capacity we would expect during a recession, this is interesting. One explanation, however, is the weakness of sterling keeping import prices high.
