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.