The UK economy’s increasingly unbalanced growth

The UK economy currently seems in fine fettle. GDP expanded last year by 3%, the fastest rate of growth seen since 2006 and double the average seen during the post-crisis 2010-2013 recovery period. And while the UK economy’s growth rate slowed earlier this year, it has subsequently picked up pace once more.

 Certainly, business confidence is high at present, and consumer confidence especially so. Indeed, households’ plans to purchase “big-ticket” consumer durables are at a multi-year high, as are plans to buy a home.

 The macro-economic fundamentals are also reassuring as far as the near-term growth prospect is concerned. Company profits are growing robustly, and corporate balance sheets are in good shape; the banking system is increasingly willing to lend, employment growth is strong; the property market is buoyant; commodity prices are weak. Against such a backdrop, business investment, housing investment and consumer spending all seem set to remain upon an upward path.

 Unfortunately, though, the UK economic upswing is looking increasingly “unbalanced”, with resurgent domestic demand rather than exports doing the “heavy lifting”. After a protracted period of post-crisis retrenchment, the UK household sector has begun once more to spend beyond is means, as shown by the drop in the savings ratio to pre-crisis levels. Companies are beginning to behave in similar fashion. Home prices are rising far faster than income, and traditional value metrics suggest that the housing market is increasingly overvalued. As a result of these developments, the size of the UK’s current account deficit – the difference between what we spend and earn as a nation – has reached a fresh high as a percentage of GDP. In these critical regards, the current UK economy is beginning to look ominously like its late-1980s former self when the economy boomed, but at the cost of serious domestic macro-imbalances developing which resulted, eventually, in the protracted recession of the early 1990s which resulted in a return to double-digit unemployment.

 Faced with such developments, it is frankly surprising that the Bank of England’s Monetary Policy Committee hasn’t yet begun the process of “normalising” short-term interest rates. Instead, the Bank’s key lending rate remains stuck at 0.5% -– the level to which it was reduced as an “emergency” response to the financial crisis in March 2008. Nor are there any indications whatever that the Monetary Policy Committee is currently contemplating a near-term rate hike, with the markets expecting one no earlier than March 2016.

 Arguments in favour of keeping rates at rock-bottom levels include currently low inflation ( both in terms of consumer prices and pay settlements); an assumption that the economy still possesses ample spare productive capacity( despite the fact that GDP was 4 ½% above its pre-crisis cyclical peak in Q1 2015); the need to avoid further upward pressure upon the exchange rate in the face of the European Central Bank’s adoption of QE and continuing uncertainty about the future of the Euro project, for fear of the damage this would inflict upon the UK’s export competitiveness; a desire to rely upon macro-prudential measures rather than the “blunt” instrument of higher interest rates to restrain financial excesses and sustain financial stability.

 Such arguments, however, are not as powerful as generally assumed. It seems very likely, for instance, that the economy is currently close to full capacity (it’s worth noting, in this connection, the past propensity of UK policy makers to over-estimate economic “slack” at a similar stage in the business cycle.). In addition, there is the very real risk that the current ultra-low interest rate regime is encouraging households to take on debt beyond their means to service, let alone repay, when interest rates are eventually raised. There is also a growing risk of super-low interest rates fostering wasteful “mal-investment. As for the risk of the beginning of interest rate “normalisation” pushing up sterling to increasingly uncompetitive levels, such pressure could always be offset by determined foreign exchange intervention ( a traditional policy instrument the possible deployment of which isn’t even being discussed at the moment).

 A further reason why UK monetary policy makers are content to keep interest rates at historically low levels (even during the 1930s “cheap money” period from 1932 onwards the official rate was 2% compared with the current 0.5%) is doubtless that the new Conservative government’s intended fiscal stance is currently uncertain. The previous government’s fiscal “austerity” -– as measured by the government’s cyclically-adjusted fiscal stance––ceased altogether during the twelve months prior to the recent general election – just as the dictates of the political business cycle would have predicted beforehand. By the same token, one would expect the new government to tighten its fiscal policy stance at the very beginning of its 5-year term, in the expectation that it will be able subsequently to loosen up once more ahead of the 2020 election. The suspense concerning what is in store austerity-wise in coming years will ,of course, be relieved very soon, with the delivery of the government’s first Budget.

 Ian Harwood has worked as a City economist for over thirty five years and is a Non-Executive Director of Accent