Buoyant UK economy double boost for Ireland, but rates there may rise soon

The UK economy is growing at a pace which is not only rapid but also well ahead of that generally expected at the turn of the year, prompting a scramble from analysts to revise up economic projections and a reassessment by the market on the likely timing of the first interest rate increase, which is now seen early next year or even before the end of 2014.The unexpected strength of economic activity has also left the Bank of England’s monetary policy strategy is disarray, as it had sought to guide rate expectations with reference to the unemployment rate , with a pledge to keep rates unchanged until the former fell below 7%, which to the Bank did not seem likely till 2016. The unemployment rate is now 6.5% and the Bank  has changed stance, rendering its initial foray into forward guidance somewhat of a embarrassment. None of the nine members of the MPC, which sets the BoE’s policy rate, has yet to vote for a rate increase but it may not be long before we see some advocating tighter monetary policy, particularly as house prices are also rising at a heady clip.

The UK economy experienced a severe recession from early 2008 ,as did most developed economies, although the loss of output was smaller than that recorded in Ireland (7.2% against over 12%) and the duration shorter (5 quarters versus Ireland’s 8). The  UK recovery was also much slower than seen in the past, with falling construction and industrial production offsetting an early rebound in services. All sectors are now growing again and GDP in the UK has risen for 5 consecutive quarters, with the last four seeing remarkably steady growth of 0.7% to 0.8%. That left the annual rise in GDP at 3% in the first quarter and the level of output just  below the previous peak so if q2 growth emerges as expected (around 0.8%) real GDP will have marked a fresh high ( Ireland, by comparison,  is still some 5% adrift of the 2007 peak). Moreover, the UK data has yet to be revised to incorporate the new 2010 standard for national accounts, which will no doubt lead to upward revisions to the level of GDP.

The strong pace of growth has had a significant impact on the labour market; employment rose by almost 1 million, or 3.1%, in the past twelve months, taking the employment rate to a record high, while the unemployment rate has tumbled to 6.5%. That support for household incomes has helped to boost consumer spending (which has risen for 10 consecutive quarters) while business investment has also picked up sharply and is growing at a double digit pace. The external sector is not contributing to growth but otherwise one might say the economy  is booming, although few in the UK would use that phrase. One key reason for that is the absence of any significant growth in pay (indeed annual wage inflation was just 0.4% in May) which has prompted cries of a ‘cost of living crisis’ as inflation, although lower of late, has consistently exceeded the 2% official target. Household incomes as a whole have risen ( given the rise in employment) but real incomes have been squeezed and the increase in consumption has been financed through a fall in the savings ratio, which is now under 5% from a 8% in 2012.

Fiscal policy has also been a drag on the economy in general (although not in 2014) with steeper cuts in government spending earmarked for the next few years, while credit growth , although picking up, remains limp by normal standards. Those factors may have an impact on the BoE’s thinking but it is currently wrestling with the issue of how much spare capacity there is in the economy. Most in the MPC  believe it is still around 1% but there is disagreement , with the persistence of weak productivity adding to the uncertainty about the economy’s  potential growth rate. Moreover, asset prices in general have risen and house prices nationally are increasing at a double digit pace and have scaled new heights, with London clearly in boom territory. Central banks now generally believe that they can prick housing bubbles with macro-prudential tools and the UK authorities have already sought to affect mortgage lending but other  argue that a higher cost of borrowing is the most foolproof safeguard.

Stronger growth in the UK have proved a double boost for the Irish economy. Some 16% of  total Irish merchandise exports go to  the UK (the share of services is higher at around 19%)   but it is  a much more significant market for Irish indigenous firms, taking over 36% of food exports , for example. and so growth there is a boon for Irish firms. In addition, the prospect of higher rates has led to an appreciation in sterling, with the euro rate falling to 79 pence, again a welcome support for Irish firms selling into the UK market, although to put that in historical context that  would be parity in terms of the punt/ sterling, hardly a rate seen as very advantageous for Ireland. Nevertheless, sterling’s relative strength is positive for Ireland and the UK currency may have further to rise given the differing outlooks for monetary  policy in the UK and the euro area.

€10.7bn boost to Irish GDP improves Budget outlook

I recently questioned the timing of calls for a strict €2bn fiscal adjustment in the 2015 Budget (‘Irish Fiscal Adjustment-too soon to know‘, in part based on the simple observation that the first quarter GDP data had yet to be published, with the additional caveat that the CSO figures would incorporate substantial revisions to previous data, reflecting the adoption of a new international standard of accounts. The figures have duly emerged and were a major surprise, both in terms of past revisions and in relation to growth in the first quarter of the year.

The level of Irish GDP  has been revised back to 1995 and is now substantially higher than previously published; the 2013  figure was initially estimated at  €164.1bn but is now put at €174.8bn, in large part due to the inclusion of R&D spending as investment (some illegal activities are also now estimated). The revision might be seen as just a statistical quirk in the arcane world of national accounts but it has an important implication- Ireland’s debt and deficit ratios are now lower than previously thought. The debt ratio in 2013, for example, was over 123% but is now 116.1% thanks to the higher GDP denominator. The annual deficits are also affected but the impact is less dramatic ; the 2013 deficit falls to 6.7% from the initial 7.2%.

The revisions to GDP did not have a huge impact on real growth rates, although last year’s marginal contraction in the economy (0.3%) is now seen as a modest gain of 0.2%. Growth did pick up sharply in the first quarter of 2014, with real GDP expanding by 2.7%, thanks to a strong contribution from net exports and to a substantial rise in inventories. GDP had fallen sharply in the first quarter of 2013 so that also dropped out of the annual comparison, leaving real GDP 4.1% above the level a year earlier. Consequently, the consensus growth figure for 2014 as a whole ( currently around 2%) is likely to be revised up , probably to well over 3%.

In fact the data revisions also incorporated reclassifications to external trade, with the result that exports and imports are  also now higher than previously published. The broader picture of an export-led recovery has not changed as a result however, with domestic demand still contracting over six consecutive years from 2008 to 2013. Indeed, the positive news on first quarter growth must be balanced against another  decline in domestic spending with all three components recording falls. Consumer spending is up marginally on an annual basis, albeit by only 0.2%, and at this juncture the 1.8% rise forecast by the Department of Finance looks unachievable, with deleveraging proving a stubborn offset to the positive impact of employment growth on household incomes.

Export prices are falling, as is the deflator of government spending, so the annual rise in nominal GDP in q1 was not as strong as the volume increase. emerging at 2.8%. Nonetheless it seems reasonable to assume a 3% or so rise in nominal GDP for 2014 as a whole which would yield a figure around €180bn, or a full €12bn higher than recently assumed by the Department of Finance, and result in a deficit ratio of 4.4% instead of the 4.8% currently projected, assuming the actual deficit emerges on target.

For 2015, the Department forecast a 3.6% rise in nominal GDP , to over €174bn, but on the same growth rate the implied level of GDP is  now over €186bn, given the higher starting point..As things stand the 2015 deficit is projected at €5.1bn, predicated on a €2bn adjustment, but that would now deliver a deficit ratio of 2.7% of GDP and as such well inside the 3% limit imposed under the excessive deficit procedure.Of course the deficit may diverge from expectations over the second half of the year and GDP may disappoint (including revisions!) but at this point the news today from the CSO is clearly positive for the economy and the Budget outlook, with the implication that a €2bn adjustment may not be required if a 3% deficit remains the target.