Tuesday 25 January 2011

UK economy stalls: time for a rate hike?

The worst of times for the UK's economic policy makers seems to be upon us. Following last week's news that CPI inflation reached 3.7% in December, and with the certainty of further price increases in early 2011, this morning brought news that GDP unexpectedly fell 0.5% in the final quarter of 2010. To be honest this has happened a full quarter earlier than I had thought possible. It seemed certain that the increase in VAT announced for early January would pull some consumer spending forward into late 2010, giving growth an artificial and very possibly unsustainable lift. In the event, the exceptionally bad winter weather across the UK through most of December took a severe toll, though the Office for National Statistics estimates (very tentatively) that even without this factor, the economy would have been close to flat for the quarter.

What happens next? I am regularly vexed by media commentators and business lobbyists who talk about output being "lost" as a result of events like train strikes, when all experience shows that the "lost" production is quickly recovered through overtime working and so on. The same applies, to some extent, with bad weather. Construction activity, one of the bright spots in the economy in the first half of the year, fell 3.3% in Q4. This certainly squares with anecdotal experience: building workers in my own area, by no means the worst hit by the weather, simply downed tools and sloped off for an early Christmas in about mid-December. They're all back on the job and trying to catch up now, so it would be logical to expect construction to bounce back quite strongly in Q1/2011.

Normally you'd expect something of the same thing in retail spending, another Q4 weak spot. After all, if people are planning to go out and buy a microwave but then see it snowing outside, they don't decide to do without a microwave for the rest of their lives. They just wait until the snow stops and then head down to the shops. On this particular occasion, though, spending may not bounce back so readily, because the VAT increase in early January may have come along before some people managed to catch up on their weather-delayed spending.

Policymakers need to think carefully about what may be holding the consumer back. Opposition politicians (hello there, Ed Balls, newly-minted Shadow Chancellor) are arguing that it's the coalition government's spending cuts that are the problem. That seems highly improbable. For one thing, actual spending cuts haven't happened yet, and for another, it's not government austerity that real people seem to be blaming for their reluctance to spend. On a talk show this morning I heard one gent state that he'd cut his weekly grocery spend at Tesco from £60-80 in the past to £40 now -- in order to keep filling his two cars with fuel. That's perverse in two senses. Obviously it's plain daft to starve yourself in order to feed your Ford, but in addition you have to wonder how closely this gent is checking his bills. Sure, fuel has gone up by 10-15% in the past year, but that's absolutely dwarfed by the rise in a lot of quite basic foodstuffs.

As a professional economist (no tittering at the back there!) I'm supposed to look beyond anecdotal evidence and focus on the hard facts. But right now I'm finding it difficult to believe that inflation is as low as the 3.7% the ONS is reporting. One example: crusty rolls at my local Waitrose were sold at 4 for a pound this time last year. Then they were 3 for a pound. Now they're 47 pence each, no discount for quantity. That's an 88% rise in a year, and there's lots more examples like that. It's well and good to point out that CPI includes less frequent purchases like television sets -- very tasty cooked in a tagine, I believe -- whose prices have fallen almost 10% over the past year. However, when people are seeing much larger leaps in prices every week than the official data suggest, they can hardly be blamed for believing their own eyes rather than the ONS survey data.

I've somewhat belaboured this point because there was something strange and disturbing in the December retail sales numbers that appeared last week. Overall spending was weak in December, yet consumers appear to have maintained their Christmas purchasing plans by cutting back on....food! The volume of food sales fell more than 3% in the month. This is not a bad thing in itself. People overbuy food so extravagantly at Christmas that a small cutback like this mainly translates into a welcome decline in the amount of wasted food being sent to landfills in January. However, people clearly perceive that they are being squeezed by soaring costs for necessities, whether that means food, fuel or railway season tickets for the daily commute. There's obviously a limit to how far spending on those things can be cut back, so unless that perceived squeeze ends soon -- extremely unlikely -- spending in other areas will have to fall.

And here, finally, we get to the policy implications of all the recent data. Much of the early media commentary on the Q4 GDP data is suggesting that prospects for a Bank of England rate hike have been pushed back indefinitely. Under most circumstances this would be logical. However, if what's holding the consumer back is a fear that inflation is on the point of getting out of control, then the Bank will be taking a huge risk with both growth and inflation if it sits idly by and watches CPI head up to 5% by mid-year. There was a strong, if mainly symbolic case for raising rates in mid-2010, when the economy was moving ahead smartly. Growth seems to have slowed dramatically (though I'm guessing the underlying picture is not as bad as the Q4 GDP data suggest), but the need to do something about inflation has arguably gone past the symbolic stage.

Oh, and one more thing. Can we stop talking about a "double dip recession" please? The economy has grown for four straight quarters, so the previous slowdown is fading into history, at least statistically. If the UK really does head back into recession now, it should be regarded as a whole new cycle, because to be sure the causes seem to be quite different.

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