The patient has been stabilised but a relapse is still possible - Ernst & Young - United Kingdom

The patient has been stabilised but a relapse is still possible

London 20 July 2009: The Ernst & Young ITEM Club Summer forecast released today expects UK GDP to contract by 4½% in 2009 – the largest decline in a single year since 1945 – followed by a subdued recovery of ½% in 2010. However, ITEM cautions that recent hopes of recovery are now running ahead of reality and predicts that we will not see a sustainable improvement in the UK economy until world trade starts to pick up.

Peter Spencer, chief economic advisor to the Ernst & Young ITEM Club, explains, “The economic patient has been in trauma, but thanks to the paramedics at the Treasury and the Bank of England who pumped billions of pounds worth of medicine into the economy, the patient has been stabilised for now. But it remains unclear how quick and complete recovery will be and there is still a serious chance of a relapse.”

He adds, “Unfortunately it is hard to see any very solid grounds for sustained optimism at the moment. The only ray of hope is a potential recovery in world markets, which UK exporters can exploit because of the low level of the pound.”

But overall, the short-term outlook for the UK economy is still a gloomy one, according to the forecast. This is because credit remains constrained, the current lack of competition in the banking sector means that lending to consumers and corporates will continue to be expensive and restricted with no further Government stimulus available to work its way through the system.

The Bank is swimming against a strong tide

“Capital remains short and expensive for the banks and there is currently little sign of any extra lending to either companies or consumers. Banks are saying that they will expand lending more aggressively over the next three months, but it seems most unlikely they’ll come close to meeting the demand for credit,” says Spencer.

Although the underlying rate of monetary growth has picked up a little since the Bank of England began its programme of quantitative easing (QE), corporate liquidity and borrowing remain worryingly weak, while net lending to the housing market remains close to zero.

“The Bank is swimming against a very strong tide and any short- to medium-term recovery in the economy will be anaemic – but the Bank must continue its efforts. QE is the only thing that is keeping long-term interest rates down and the money supply growing,” Spencer remarks.

Base rates pinned to the floor for next 18 months

lTEM forecasts that interest rates will be kept at 0.5% well into next year, with the significant degree of spare capacity that exists ensuring that policy will need to be tightened only very gradually after that. “Base rates will be pinned to the floor for the next 18 months,” says Spencer, undermining any recovery in the exchange rate.

Consumer still under pressure

Meanwhile the consumer recession continues to intensify due to company cut-backs in employment and earnings. However, Spencer says that the flexibility of the labour market has meant that the rise in unemployment has not been as bad as was originally feared. “Employers seem to have learnt from the recession in the 1990s that a slash and burn approach can turn out to be a handicap once the recovery begins,” he says.

Spencer adds, “Disposable incomes remain under severe pressure and consumer spending is likely to weaken further over the second half of this year, contracting by 3.2% in 2009 and by a further 0.2% in 2010, hampered by a weak housing market. This is not good news for retailers who will be trying to second-guess consumer attitudes and confidence as they assess their order books for the Christmas season.”

Just as the patient is recovering it could catch a nasty cold

All things being equal, ITEM is now forecasting weak growth in the UK economy beginning early next year. “Our recovery will really only begin when world trade starts to recover, and we should see output beginning to grow next year”, says Spencer, “just as long as the UK economy doesn’t catch a severe case of H1N1. If the worst case scenarios of the threat of swine flu are fully realised, GDP could fall by as much as an additional 3% this year and another 1.7% in 2010.”