Is the economy now contracting?

A composite indicator based on activity and orders indices from the purchasing managers’ surveys is at a level suggesting a small decline in GDP in the third quarter. However, the surveys extend back only to the early to mid 1990s, so their history does not encompass a full recession, implying uncertainty about the relationship. Moreover, the latest results, for July, were probably depressed by a surge in energy prices, which has since reversed. An alternative coincident indicator with a long history and a good record of signalling economic contractions is the rate of change of job vacancies. Quarterly GDP falls have historically been associated with a three-month decline of over 10% in the stock of vacancies. The three-month change in July was -8%, suggesting a stagnant or very slowly growing economy.

What is the risk of a full-blown recession?

In the recessions of the mid 1970s, early 1980s and early 1990s, the annual change in GDP bottomed at -2.7%, -4.1% and -2.1% respectively. Forward-looking indicators have yet to signal comparable weakness. For example, a monetary forecasting model – with inputs including interbank rates, credit spreads, narrow and broad money supply growth and the effective exchange rate – projects a fall in annual GDP growth to about 0.5% by the first quarter of 2009 (see chart). Based on the model’s forecasting error, this implies a 30-40% probability of a recession – defined as an annual fall in GDP – in the first quarter. The MPC’s latest forecasts are similar but slightly more downbeat: annual GDP growth is projected at 0.1% and zero respectively in the first and second quarters of 2009 assuming unchanged interest rates, consistent with an evens chance of a recession.

How do current conditions differ from prior cyclical downturns?

In terms of the monetary model, there are three contrasts with prior pre-recessionary periods. First, the interest rate “shock” suffered by the economy has been smaller. In the two years before the onset of the last three recessions, the three-month interbank rate rose by an average of 680 basis points; in the last two years the increase has been 120 b.p. Of course, some households and firms seeking to raise new funds have experienced a larger rise but interest rate changes affect the economy partly via their impact on the debt servicing burden and disposable income of existing borrowers: the average rate paid on the stock of outstanding mortgages has increased by only 50 b.p. over the last two years. Secondly, narrow money typically contracts in real terms before recessions but is currently still growing: non-interest-bearing M1 – currency plus interest-free sight deposits – rose by an annual 7.3% in June. Thirdly, the effective exchange rate has fallen by 11% over the last year versus an average 1% rise in the year before the last three recessions.

Will the economy recover later in 2009?

The MPC’s forecasts show annual GDP growth recovering from zero in the second quarter of 2009 to 1.0% by the fourth quarter, reflecting easier credit conditions, a diminishing drag from higher energy costs and a boost to net trade from the lower pound. The monetary model forecasts only to the first quarter based on current data but can be used to project further ahead assuming no change in the inputs; this also suggests a revival in annual growth. However, risks lie on the downside – the inputs may deteriorate, with monetary expansion, in particular, likely to slow further, possibly significantly.

Will inflation return to target within two years?

Base effects will be significantly favourable for headline inflation during 2009. If energy and food prices fall back, a return to 2% or even below is possible by late next year. However, the medium-term outlook will be shaped by “core” developments. Annual CPI inflation excluding fresh food and energy rose to an MPC-era high of 2.6% in July and is likely to climb further for three reasons: pass-through of recent cost increases, continuing sterling weakness and earlier monetary excess. The lower exchange rate is lifting core inflation partly via higher non-commodity import prices – manufactured import costs rose an annual 7% in June, having been unchanged in the previous 12 months – but also by reducing competitive restraints on domestic firms’ price and wage decisions. Monetary trends influence inflation with a variable lag averaging two years. Adjusted for financial distortions, broad money growth peaked in the second quarter of 2007 and is now slowing sharply, suggesting inflation relief in the second half of 2009. However, any decline may be insufficient to reverse the earlier increase and return core inflation to 2% in two years.

Will the MPC cut official rates significantly?

Aside from its own forecast uncertainties, the MPC is constrained by three factors. First, Bank Rate at 5.0% is low relative to current inflation and – more importantly – inflation expectations. According to the latest NOP / Barclays Basix survey, households expect inflation to stand at 4.8% in five years’ time. Cutting the policy rate below public inflation forecasts would risk damaging the MPC’s inflation-fighting credibility, with negative longer-term repercussions. Secondly, reductions in UK rates unmatched by a similar move overseas – as implied by current market expectations – could exacerbate sterling weakness, thereby extending the overshoot in core inflation. Thirdly, the coming Pre-Budget Report is expected to deliver further fiscal stimulus, which – together with cyclical deterioration – may push public net borrowing up to 4-5% of GDP next year. Fiscal slippage further raises the risks to credibility and sterling if monetary policy is loosened substantially.