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28 May 2014

UK balancing act

Simon Wells

by Simon Wells

Chief UK Economist, HSBC

UK balancing act

The economic recovery has so far been driven by consumer spending

The strengthening momentum in the UK economy means we have revised up our 2014 growth forecast to 3.1 per cent from 2.9 per cent while revising down our inflation forecasts because of the strong pound, sluggish wage growth and a supermarket price war. We now expect 1.7 per cent inflation at the end of 2014, well below the previous estimate of 2.3 per cent.

Consumer confidence has returned to pre-crisis levels. But the economic recovery has so far been driven by consumer spending and real household incomes have been largely flat over past years, meaning higher expenditure has come from lower household savings rates.

Despite the apparent strength of the recovery, the Bank of England will be worried about stifling it by raising interest rates

With wage growth still disappointing and limits to how far savings rates can be reduced, we expect growth to peak in the second quarter of 2014. Despite now expecting 3.1 per cent growth for the year, our 2015 forecast is unchanged at 2.5 per cent.

Productivity remains the UK economy’s biggest puzzle. Output per hour contracted in 2013 despite overall growth of 1.7 per cent. Productivity growth remains well below its historical average of 2.2 per cent and we expect productivity at the end of 2015 still to be 2 per cent below its pre-crisis peak. So unless we see a very rapid recovery in 2016 and 2017, the UK will have had a lost decade of productivity growth.

Combining these conservative productivity numbers with our growth forecast means the pace of fall in unemployment will slow. The UK rate should reach 6.5 per cent by the middle of 2014 but stay stuck at 6.1 per cent for all of next year.

But despite the apparent strength of the recovery, the Bank of England will be worried about stifling it by raising interest rates. The Bank is also expressing concern at the risk of a housing bubble. UK property price inflation is double digit on some measures and we expect central banks globally will increasingly meet low consumer price inflation and rapid asset price inflation with macroprudential policy.

But some perspective is required: UK house prices are not yet a nationwide problem. London prices are 30 per cent above their pre-crisis peak, but outside of the capital they are just approaching 2008 levels. Price-to-earnings ratios outside London are drifting up only gradually, despite rising fast in the capital.

So we are not yet seeing a huge debt-fuelled housing boom and, in turn, the banking system’s vulnerability to a housing crash is not rising rapidly. These factors reduce the urgency for policy action on financial-stability grounds.

Given that the Bank of England has been clear that interest rates are the last line of defence against housing market excesses, macroprudential measures such as tightening lenders’ capital requirements need time to take effect. While we do not think they are a substitute for higher interest rates in the face of broad-based inflationary pressure, the Bank is not about to tighten because of the housing market.

However, macroprudential measures are likely to be controversial too. Central bank officials influencing who can get a mortgage and who cannot could suck it further into the political arena.

This research was first published on 21 May 2014.

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