UK: Benign Central Case Belies the Risks

David Miles and Melanie Baker | London

We end 2006 with the economy and financial markets having had another decent year. GDP has risen consistently and, for the year as a whole, at marginally above what we estimate is the trend rate. Interest rates — in nominal and especially in real terms — remain low, and the exchange rate has been relatively stable on a trade-weighted basis, though on a more volatile upward path against the dollar. Unemployment has edged up but so has employment, while stock prices and house prices have moved higher over the year. But inflation ends the year substantially higher than at the start of the year, and we expect it to rise a little further early in 2007. There is a real risk that this triggers an acceleration in wage settlements; if RPI inflation is close to 4% in the spring, then no change in the pace of earnings growth would mean stagnant real incomes. Zero real wage growth is not implausible — in fact it is quite likely. But there are obvious risks that wage rises move up and interest rates are increased to reduce the chances of above target inflation becoming persistent. Even without interest rate rises, house prices look vulnerable in the UK. However, we are not convinced that falling house prices — themselves likely at some point — need trigger a sharp slowdown in consumer spending.

Central GDP projection: solid but lacklustre

Our central projection for the UK economy is for solid, but slightly sub-trend, growth in 2007. After 2.6% real GDP growth in 2006, we project 2.3% in 2007 and 2.5% in 2008. This forecast, however, embodies two key assumptions. First, potential growth has not risen and does not rise significantly; second, export-weighted global growth slows (very moderately). On the first, we assume that the pace of immigration seen in the UK since 2004 does not continue at quite such a high rate and that productivity growth remains rather disappointing. There has been no sign of any increase in the rate of productivity growth in the UK in recent years — indeed, the evidence, if anything, is to the contrary. On the second, our global economics team regards risks to the global outlook as skewed to the downside.

Components of GDP growth: a sluggish consumer

We continue to think that consumer spending will not pick up significantly in 2007, keeping overall growth subdued. Household savings still look on the low side, debt levels and debt service levels remain high, and risks are skewed to the downside in the housing market. Arguably, the low volatility environment we’ve seen in the UK over the past decade may have helped sow the seeds for a more volatile period ahead. Less fear of sharp gyrations in the economy has likely been a factor behind households building up very high levels of debt (which may leave the economy less able to weather shocks, such as a sharp move in interest rates or deterioration in the labour market, in 2007). With slower global growth, investment spending growth may decline a touch and the contribution from net exports may be marginally negative. Against that backdrop, growth slightly below the pace of 2006 seems likely to us in 2007.

Inflation: risks on the upside

In our central forecast, we see year-on-year inflation rising into the turn of 2006 before gradually declining towards 2.0% (the Bank of England’s target). We believe it is likely that GDP growth runs slightly below potential in 2007 and that current upward pressures on inflation, from factors including electricity and gas bills, diminish and then fall out of the year-on-year comparison. However, two main factors suggest that inflation risks lie more on the upside than the downside of that profile: 1) we think there is little spare capacity in the UK economy; and 2) wage increases may become more inflationary. So far, wage growth has been very benign, but a number of factors are coinciding at an important time for wage negotiations (the turn of the year). These give us some cause for believing that wage growth risks are on the upside across a range of sectors and job types. First, RPI inflation (more important in wage negotiations than CPI) is likely to rise towards 4.0% year on year by the beginning of 2007; second, the minimum wage rose 5.9% in October 2006; third, discretionary income (the amount of money households have left after paying taxes and energy bills and after debt repayments) has been squeezed, which may persuade some to push hard for higher wages; and fourth, profit growth has been relatively strong in the UK in 2006.

Interest rates: on hold with upside risks

With a central profile of around trend GDP growth and inflation remaining above target, but gradually declining over 2007, our central (single most likely) scenario is that interest rates remain on hold throughout 2007. However, with inflation risks still on the upside, we think that the risks to this profile for rates are skewed more in the direction of further rate rises rather than further cuts. Bond yields, however, end the year at levels that seem to imply little chance of interest rate increases of all but the most minor and temporary sort. Given that situation, we believe that gilts will move lower (yields move higher) in 2007. Equity prices seem more fairly to reflect risks and stock market valuations are more robust to the impact of a possible pick up in inflation and interest rates.

Politics: Continuity, despite changes

Tony Blair looks set to step down as Prime Minister some time in the first half of the year — probably close to the 10-year anniversary of his leadership in May. It is overwhelmingly likely that his successor will be Gordon Brown, who will inherit a substantial parliamentary majority and who will, as a result, be under no pressure to call an election. (There need be no election until 2010 so, in principle, the new Prime Minister will have almost three years before needing to face opposition parties at the polls; in practice, it is likely that an election is called before 2010). Since Brown has been in charge of the overall direction of economic policy for several years, the thrust of fiscal and monetary policy — including the policy of simply ignoring the option of adopting the Euro — looks set to continue. The strategy on spending and taxing will continue to be one where expenditure rises only marginally above 40% of GDP. But that will be a very tough strategy to implement — particularly with the 2012 Olympics approaching and significant infrastructure spending still required. Keeping overall government spending contained may prove very tough.