EY ITEM Club Spring forecast 2014: Long low inflation expansion on the horizon

14 April 2014

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London 14 April 2014: The UK is set to experience a long period of low inflation expansion as the economic recovery moves on to a firmer footing, according to the latest quarterly forecast from EY ITEM Club.

EY ITEM Club’s Spring forecast says the UK will see growth of 2.9% this year as favourable labour market factors create “decent but unspectacular growth” underpinned by low inflation.

Consumer spending will continue to lead the recovery boosted by wage increases of 1.7% this year – overtaking forecasted inflation of 1.6%. The report predicts that earnings growth will continue to steadily pick-up as the demand for labour strengthens and skills shortages appear in some sectors. At the same time, slowdown in the emerging markets will put downward pressure on commodity prices. The forecast predicts growth exceeding inflation on a sustained basis, after six years of falling real wages.

With inflation under control and a stronger pound, the forecast predicts that the Monetary Policy Committee (MPC) will keep interest rates on hold at 0.5% until the third quarter of 2015 – at which point rates will rise very gradually.

Two main suspects in classic UK inflation drama not on the scene

Peter Spencer, chief economic advisor to EY ITEM Club comments: “Until now the recovery has been financed by a fall in the amount households save, but it appears to be moving to a firmer footing.

“The consumer upturn will be given a boost from real wages and rising employment, while investment is finally kicking in. We are set for a long period of low inflation as pressures from commodity prices and the labour market – traditionally the two main suspects in the  UK inflation drama –- remain largely absent.

“This will allow the MPC to leave interest rates on hold until after the election, helping to stimulate further investment growth and limiting household spending on mortgage payments.”

Mortgage Market Review keeps lid on housing market

The simmering housing market will also be dampened as caution by lenders, tighter lending criteria and an increase in house building will cool prices, preventing an unsustainable boom. The forecast predicts prices will rise by 7.4% this year and 7.2% next year, easing back to 4.2% in 2016 as the mortgage guarantee scheme ends.

Crucial to keeping the lid on the market, the report argues, will be the role of the Financial Conduct Authority (FCA). EY ITEM Club warns that the FCA must use their recently gained macro-prudential tools to ensure that the income multiples of borrowers do not become too stretched. The forecast predicts their policing of income multiples in London, which remains the main constraint to purchases in the capital, will help avert a housing bubble. This will work alongside new construction orders to help prevent house prices overheating. 

Spencer continues: “The housing market is not experiencing a typical debt-fuelled recovery. Gross mortgage lending has increased but this has largely been financed by an increase in repayments by existing borrowers. New mortgage lending remains at rock bottom while Government initiatives such as the ‘Help to Buy’ (HTB) schemes will be having little impact on prices in London, where activity is fuelled by cash rather than mortgage borrowing.

“The FCA will assume crucial importance to ensure multiples do not become too stretched and that affordability is scrupulously checked. If these controls are rigorously applied this will eventually constrain London prices, particularly in hotspots like Hackney, and head off problems when interest rates rise.”

UK close to toppling Germany for highest employment in G7

While the MPC has dropped the explicit link with unemployment in its forward guidance, the report forecasts the UK will come close to meeting the Chancellor’s target for the highest rate of employment in the G7. The forecast predicts that the employment rate will increase from 71.2% of 16 – 64s in work last year, to 73.7% in 2017. This might be enough to put the UK at the top of the G7 table, which was topped by Germany at 73.3% rate last year.

The report predicts the unemployment rate will continue its descent, falling to 6.5% by the end of the year and 6% by the end of 2015, down from 7.1% currently. 

Spencer continues: “The Chancellor’s target is in sight, helped by increased labour market participation. We estimate that the labour supply will be boosted by another 700,000 over the next two years, as a result of immigration, older workers working for longer and Government reforms to move people from welfare into the workforce.

“Despite the Chancellor’s reform of the annuity system in the Budget, the economics of early retirement remain unfavourable and we expect this trend to persist. This performance might not be quite enough to put the UK at the top of the G7 league tables but it will not be far off.”

Business investment strikes back

Business investment is also set to strike back, with growth hitting 9.1% this year, helped by the low cost of capital, high levels of cash in company coffers and growing confidence in boardrooms. Business investment – which will boost productivity and support real wage growth – will increase by 9.1% followed by 8.3% in 2015 with growth rates of around 7% by 2016.

Alongside business investment, opportunities for exporters will also improve – shown by predicted growth in export volumes by 5.3% this year, followed by 5.9% in 2015.

Mark Gregory, EY’s chief economist, says businesses face a difficult balancing act in the new high employment, low inflation environment:

“The low inflation environment presents a difficult challenge for businesses with a drive towards downward pressure on prices. It makes it difficult for businesses to put up end user prices and should force a reassessment at what growth assumptions and pricing strategies are in place.

“Meanwhile in a growing labour market, private sector wages are improving and shortages are appearing, particularly in sectors such as manufacturing. This presents an opportunity for businesses to ensure they have they got their people strategy and business investment right.”

Bears still lurking in the woods

Spencer concludes that despite only moderate levels of growth, the UK’s recovery will be achieved without the risks associated with excessive credit:

“Though the return to positive real wage growth is undoubtedly good news, we’re not going back to where we were prior to the financial crisis. The pickup in earnings will be slow and steady, while austerity remains on our shoulder with the 1% cap on growth in most working-age benefits and more welfare cuts to come in 2015.

“These pressures should not stop consumer spending increasing but, while consumer spending growth will be healthy compared to recent years, it will remain short of the 3.6% annual rates seen in the decade prior to the 2008 crisis.”