The UK looked like it was facing a tough year at the start of 2013. Some even speculated about a "triple-dip" recession. But the economy turned around much faster than expected during the summer. Lower macroeconomic uncertainty, a thawing in credit conditions, falling unemployment and possibly even good weather, combined to cause a sharp recovery in consumer confidence.
Household consumption has been much stronger than forecast and government expenditure held up well. The big questions for 2014 are whether a recovery in demand will finally tempt companies to spend some of their cash, how can the UK improve its trade performance, and will consumers continue to power growth when wages are rising so slowly.
The strong household consumption is all the more remarkable given that real wages have probably fallen by around 1 per cent over 2013. Decent growth in incomes remains some way off, so households will have to continue reducing savings or borrowing more to grow spending.
Household consumption has been much stronger than forecast and government expenditure held up well
Prospects for real pay seem better in 2014 because of falling inflation, but are hardly good, despite the return to robust economic growth. High unemployment reduces bargaining power and job vacancies are picking up only slowly. So unless output growth is very strong indeed, any cyclical-recovery in productivity growth won’t be sufficient to put it close to the pre-crisis trend.
So while the Bank of England thinks recovery has taken hold, the apparent disconnect between expenditure and output means we think quarterly growth rates will slow slightly in 2014.
Consumer confidence had signalled weak consumption growth at the start of 2013. However, it soared and housing market activity plus easier credit should ensure consumption continues to drive growth. Housing accounts for a quarter of total investment but we also expect a rebound in business expenditure. Business investment is still 27 per cent below its pre-crisis peak, so some deferred spending may now materialise as the economy recovers.
However, government spending won’t contribute much to growth and with domestic demand rising and the pound strengthening, rising imports could mean trade again disappoints, despite the US and eurozone economies improving in 2014.
Overall, we have raised our 2014 growth forecast to 2.6 per cent from 2.2 per cent. Combining that improvement with a modest cyclical recovery in productivity means unemployment may fall to 7 per cent slightly sooner than we previously thought. However, our base case is still that unemployment remains above 7 per cent until the third quarter of 2015, the threshold for the Bank of England to consider raising interest rates.
So interest rates should be on hold throughout 2014. Even if productivity fails to rise, there is unlikely to be sufficient wage or price pressure to spur the Bank into tightening and, unless incomes are rising, it won’t risk killing the recovery and squeezing households further.
There are still considerable risks to the recovery. Growth could be stronger if companies ramp up spending rapidly and credit conditions ease too quickly – or weaker if there are further eurozone setbacks or if households think they have reduced savings too far.
But even if the recovery looks entrenched in early 2015, raising rates in the months around Britain’s general election in May 2015 could prove too controversial for the Bank. We’ve pencilled in late 2015 for the first quarter-point hike.
This article was first published on 21 November 2013.