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The IoD states that the GDP outlook could present the Chancellor with serious fiscal difficulties.

Elephant at the table 

IoD chief economist Graeme Leach said that the Chancellor tweaked his GDP numbers in his Budget and that borrowing rose by £20 billion.

“The elephant sitting at the table is what happens to borrowing if the economy undershoots the Chancellor’s optimistic GDP forecasts. There is no slack whatsoever in the fiscal rules and so will the Chancellor be forced to raise taxes or cut spending in the middle of a downturn?” Leach added.

With regard to GDP growth the IoD argues that 2 factors suggest the UK will experience a soft as opposed to a hard landing.

First, whilst CPI inflation at 2.5 per cent is above target and likely to deteriorate further over the coming months, the inflationary threat is not as great as that seen in the early 1990s when headline inflation nudged double digits.

The UK was also in the ERM during the last recession and this severely limited the ability to reduce interest rates.

Oil prices have hit $110 per barrel and producer input price inflation is at a record high, but there is also evidence that a significant proportion of these pipeline pressures will be absorbed on margins.

More aggressive reductions possible 

The inflation constraint prevents an aggressive US style monetary easing but it does not preclude modest further interest rate reductions.

Moreover, if the economic outlook were to weaken more than expected (and inflationary pressures as a result) more aggressive reductions in interest rates would become possible.

Second, the corporate sector is in a relatively strong position as we enter the downturn. At the start of the 1990s the corporate sector was running a large deficit.

This time around the corporate sector is running a surplus in excess of 2 per cent of GDP. Consequently the pressure for a labour market shake-out is much reduced.

Worst of the financial crisis 

The IoD also acknowledges, however, that the downside risk to the forecast is significant.

The IoD uses an analogy of the UK economy walking along the top of a mountain ridge, with a gentle slope (soft landing) on one side and a precipitous decline (hard landing) on the other. In addition, the ridge is narrowing and so we are getting closer to the edge.

Leach observed that we still don’t know whether the worst of the financial crisis is behind us or in front of us.

“We’re certainly not telling our members to put on their lifejackets but it might be a good idea to remember where they are,” he warned.

The IoD states that recent UK economic indicators clearly point towards a soft landing but that the deterioration in the US economy together with the knock-on effects of the financial crisis are what drive hard landing scenarios.

Turning point in the cycle

The uncertainty is highlighted by the fact that many individual financial institutions cannot fully gauge their exposure at present and so aggregating the impact of the financial crisis across the whole economy is impossible.

Over the past 15 years the UK has probably experienced the most stable period of growth in its economic history, but we are now at a clear turning point in the cycle and the uncertainty is intensified by the ongoing financial crisis.

For the UK the key danger signal of a prospective hard landing would be a shake-out in the labour market with an upward shift in unemployment and sharp drop in house prices.

Household savings levels are low and indebtedness is high and so any shift towards precautionary behaviour would very quickly slow the main engine of growth, consumer spending.

Total employment expected to increase 

Thankfully, the IoD points out that there is little evidence of any widespread labour market threat at present. A recent survey of IoD members suggested that total employment was expected to increase in 2008.

Leach said that if one looks at the UK economy in isolation recession fears appear misplaced.

He explained that there is an inflation constraint but in the event of a significant downturn in the economy the MPC could ease policy and put a floor under growth.

“We can’t look at the UK alone, however, as factor in the US situation and the impact of the financial crisis and the picture becomes decidedly murky. We still think a recession can be avoided but our level of confidence has fallen,” Leach concluded.

IoD Economic Forecasts – Spring 2008

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Related links

• Institute of Directors