Entries Tagged 'economics' ↓

Recent data suggests that the UK’s long record of unbroken economic growth may, at last, be coming to an end. The latest snapshot of the UK economy presents a relatively good economic situation; however, this mask a variety of data suggesting the economic situation is sharply deteriorating.

The Bad News on the UK Economy

• Falling disposable incomes due to rising oil and energy prices
• Falling house prices. Falling house prices reduce consumer wealth, consumer confidence and the ability to remortgage. Rising house prices have long sustained UK economic growth, but, now prices are falling, the opposite is occurring.
• High Street Sales slumping. M&S has reported a series of disastrous results. Food sales fell by 4.2%, clothes sales by 6%. The problems of M&S are revealing because M&S targets the luxury end of the food market. It appears that price is becoming the important factor in consumer shopping. The likes of Netto and Aldi are likely to do fine in a recession as they target the best value, rather than selling the most expensive organic food at any price.
• Rising Mortgage Costs, despite base rates staying the same. The credit crunch is forcing up the cost of fixed rate mortgages.
• Rising inflation could even force the MPC to increase interest rates, a sure way to make the downturn worse.
• High Levels of Consumer Debt. For several years we have benefitted from high consumer confidence which has encouraged record levels of consumer debt both secured and unsecured. As confidence in the economy falls, consumers are likely to try and increase their savings ratio, leading to a fall in consumer spending.
• Government Borrowing is likely to increase to £60 billion, well above the governments target, leaving no room for expansionary fiscal policy.

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This is a question I sometimes ask my economics students. - If you were the Bank of England governor what would you do?

To be fair, the MPC have quite a few difficult choice to make. The decade of low inflationary continuous growth seem to be over. The current economic situation includes the unwelcome development of both higher inflation and lower economic growth. This deterioration in economic prospects comes against a backdrop of falling house prices, a shortage of credit in the banking system and record levels of personal and government debt.

In one regard, the MPC have a simple target - keep inflation between 1-3%. However, although the government only set an inflation target, it is assumed they will be sensitive to other issues such as economic growth and unemployment.

Recently, the Bank forecast that inflation will rise to 4% by the end of the year. This is not unreasonable given rising food and energy prices. In normal times this would require higher interest rates to reduce the inflationary pressure. However, these are not normal times.

This inflation is caused by rising costs and not rising demand. The rising costs are squeezing living standards and consumer spending. Furthermore, falling house prices are discouraging consumer spending. With this ‘double whammy’ of rising living costs and falling house prices, the last thing the MPC should do is to be increasing rates. Higher rates at this stage of the economic cycle could tip the economy from sluggish growth into a full blown recession.

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According to the government’s official statistics, inflation is currently 3%. But,many people in the UK, would probably say that they feel prices are rising much faster than this official figure. Is the government method wrong? Are people right to be sceptical of official figures. What is the real Rate of Inflation?

CPI (Consumer Price Index).

Firstly the CPI rate excludes many factors. CPI excludes mortgage interest payments (so the recent rise in mortgage costs are excluded). CPI also excludes council tax rises (which are once again above inflation.

The old method of inflation is the Retail Price index RPI. This does include housing costs and council tax. The current RPI gives a higher inflation rate (4.3%) and has done for a long time. It is argued, with good reason that CPI underestimates inflation.

RPI and CPI Inflation

source: ONS

Input prices

Input Price Inflation is rising at 15%. Materials and fuel inflation is approaching 30%. Input prices are often a lead indicator. i.e. because input costs are rising now, we can expect higher inflation in the future. ONS

Some Goods Are Rising Much Faster than inflation

Petrol prices are rising very rapidly. Nearly 30% increase in the past few months. This takes a big part of people’s spending and is a very visible figure. If you drive anywhere, you can’t help but notice the rise in petrol. Therefore, there is a constant reminder of this important barometer of prices.

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The Key Economic statistics:

• Inflation 3%
• Economic Growth 2.5%
• Unemployment 5.3%
• Interest Rates 5%
• Current Account deficit 4.2%
• Government borrowing 2.8%

• These statistics taken from National Statistics online. [link]
• Note many forecast a deterioration in economic growth. These statistics tend to be backward looking; i.e they reflect what has happened in the past.

Snapshot of UK House Prices

• Halifax House Price Index May 08 average house Price - £184,111

Halifax House prices Monthly change - 2.40%

Halifax Annual House price change (last 12 months -3.80%)

• Land Registry Monthly Report April 08 average house price £183,626

monthly change - 0.20%

Annual Change in house prices 2.70%

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Recently, the Governor of the Bank of England indicated that the UK faced the prospect of recession. He pointed out some of the factors that are slowing the UK economy down.

Falling House Prices. Falling house prices is an important barometer for state of economy. It affects consumer wealth and consumer confidence. IF house prices continue to fall, more will be pushed into negative equity which will reduce spending.

Rising Cost of Living. Rising food and energy prices is increasing the cost of living and making people less able to spend on other things.

Slow Down In Other Economies. Both the US and EU face lower growth. If our main trading partners slow down it will affect our exports.

Credit Crunch. Shortage of credit is making it more difficult to borrow, not just for mortgages but also firms wishing to invest.

How Will Recession Affect Housing Market?

• A recession in the UK, would lead to falling demand for houses. If unemployment rises then less people will wish to buy houses; there would also be a rise in home repossessions, which would reduce the demand for housing.
• Interest rates? Usually in a recession interest rates fall. But, the Bank of England are worried about rising inflation. They point to CPI reaching the governments target of 3%. Therefore, they are reluctant to cut rates. Therefore, if a recession is accompanied by inflation then it becomes more difficult to cut rates and makes the downturn more serious.

 Prospects of Recession in UK

On my Economics Blog, I wrote a piece trying to explain the current economic difficulties in the US.

The worrying thing for the UK, is that we share many similarities with the situation in the US. Although a UK recession is still less likely there are several similarities between the two economies.

Boom and Bust in Housing Market.

US house prices increased much faster than incomes. This was due to various factors such as, speculative buying, ‘unsuitable mortgage lending’ and unreasonable expectations over future house prices. Since 2006, US house prices have  fallen by 10%. UK House prices have increased even more (300% in past 10 years) than in the US , therefore, there is a similar scope for house price falls in the UK. Falling house prices would push the UK economy into recession as consumers see a decline in their wealth.

• However, I feel the UK housing market is less prone to a crash than in America. This is because house price rises are primarily due to shortage of supply, rather than speculation. Also in the UK, mortgage defaults are not as big a problem as in the US. I think it is more likely we will see a stagnating housing market in the UK. But, whatever happens to house prices it will definitely have a big impact on the economy. Continue reading →

There is an article here about the prospects of recession in the US

Basically, a combination of falling house prices and financial instability is likely to cause significant falls in US consumer spending and a recession seems hard to avoid. However, I am impressed by the way the US monetary authorities are trying to deal with the difficult circumstances. They seem to have no hesitation in cutting interest rates to boost spending. The organised rescue of Bear Sterns may leave investors unhappy, but compared to the debacle of Northern Rock, it has many merits; maintaining confidence in the banking sector is vital to avoid any financial meltdown. With these attempts to inject liquidity into the banking sector, I would expect the US to limit the extent of the forthcoming recession. The main danger is if house price deflation continues to decelerate and consumers become insensitive to interest rate cuts. There is also a fear that there may be more ‘Bear Sterns’ in the background.

Recession in UK?

The UK is further away from a recession. House prices, key to the economy, are currently stagnating rather than falling. However, like the US, the UK has a very low savings rate and high rates of borrowing. This makes the UK vulnerable to the credit crisis which is pushing up interest rates for borrowers.

Unfortunately, the UK needs to rebalance the economy. It needs to reduce its borrowing and excessive spending (illustrated by current account deficit). This rebalancing is likely to involve lower consumer spending. The uncertain question is whether the downturn will be moderate and managed or escalate into a full blown recession. At the moment, the MPC certainly seem less keen to cut rates to increase demand for money.

Problems of personal debt in the UK 

Many had predicted the fall in house prices would precipitate significant cuts in interest rates to bolster the economy. However, it appears the UK may be experiencing the worst of both worlds. Not just slower growth but also higher inflation.

Factory gate inflation (the price of goods leaving the factory at wholesale prices) is at a 15 year high. This usually feeds through into higher consumer price inflation.

Rising food, energy and oil prices. Growth in demand from China and India plus constraints on supply mean that oil prices and food prices have been rising, this increases the general cost of living

Maybe house prices will not fall after all. A prediction for house prices today suggests that house prices may rise by 3% this year.

Another factor is the devaluation in the Pound. Since autumn the Pound has fallen 10% on its trade weighted index. A devaluation makes imported goods more expensive and boosts Aggregate Demand increasing inflationary pressure. Continue reading →

Looking at Economics fundamentals, it is hard to understand why the Pound rose so much against the dollar in recent years. I think the main reason for the Pound’s strength is that it offered an easy alternative to the dollar, but, in looking for an alternative to the dollar the merits of the Pound has been exaggerated. With the UK economy predicted to slow down, it is highly likely we will see a general devaluation in the Pound, not just against the dollar, but also against other currencies such as the Yen and Euro.

The Dollar’s weakness has been well documented, but unfortunately many of the reasons for the Dollar’s weakness are shared by the Pound.

Why Pound is Overvalued Continue reading →