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Economy

Pound won't save UK from recession

Written by Gary Howes

Monday, 04 August 2008

GDP growth next year expected at only 0.5%.

Roger Bootle, a leading economist at Deloitte has said he does not believe the recent fall in the pound will be followed by a period of sustained low inflation and export-led growth.

Bootle made the comments in the latest issue of the Deloitte Economic Review.

While the sharp fall in the UK exchange rate seen since last summer should eventually lead to a period of better-balanced growth like that enjoyed in the mid-1990s, it won’t prevent the credit crunch, a major housing downturn and a sharp retrenchment in corporate spending from sending the economy into recession.

The fall in the pound is a long-overdue lifeline for UK exporters who have been struggling to compete in world markets for much of the last decade. Accordingly, it will aid the long-awaited and much needed rebalancing of activity away from households and domestic demand and towards the external sectors.

Needless to say, this could have pretty strong implications for the performance of different sectors of the economy. Manufacturers are set to buck the trend of the last ten years and perform relatively well. Meanwhile, those companies which rely on the spending power of households are going to have to get used to a long period of more modest activity.

But the lesson from when the pound fell sharply in the early 1990s is that exports are unlikely to pick up sharply until global demand recovers, which in this case is likely to take some time. Accordingly, the real boost from the lower pound will not be felt for a number of years.

The lower pound will therefore not prevent the economy from slowing very sharply over the coming quarters as steep falls in house prices, the squeeze on real incomes and the credit crunch place a huge dent in domestic demand.

What’s more, the lower pound could exacerbate the downturn if it were to prompt a more sustained rise in inflation, preventing the Monetary Policy Committee from cutting interest rates aggressively.

Import price inflation is already at a 15-year high and CPI inflation looks set to rise towards 5% later this year in response to surging food and energy prices, triggering at least another four open letters from the Governor of the Bank of England to the Chancellor.

And with the recent fall in the pound having come at an earlier stage of the economic slowdown than that seen in 1992 – when it came after a major recession – the inflationary dangers of a weaker exchange rate might appear to be greater this time round.

But the economy is already slowing sharply and the structural forces bearing down on inflation are probably stronger than those in the early 1990s. Accordingly, Deloitte's don’t expect the pound’s fall to result in a sharp increase in underlying price pressures, at least not on its own.

Nonetheless, with the inflationary threat greater than it has been at any time in the last 15 years, interest rates are likely to be on hold until late this year at the earliest and a hike is not altogether out of the question.

All of this is seriously bad news for the already slumping housing market. It is expected that UK house prices to fall by around a third by the end of 2010, with severe adverse implications for household spending and investment. Household spending growth is likely to grind to a complete halt next year, while investment may fall by something like 1.5%.

Eventually, inflation concerns will ease and interest rates will fall sharply – Deloitte's still expect rates to fall as low as 3.5% in 2009. But by then it will be too late to prevent the economy from entering a deep downturn.

Deloitte's now expect GDP growth of just 0.5% next year – the slowest expansion in 16 years – and the chances that the UK economy will enter its first recession since 1991 are growing by the day. Moreover, if inflation worries prompt the MPC to keep interest rates higher for longer, things could turn out to be even worse.