This morning the Office for National Statistics published preliminary estimates of an -0.2% fall in March quarter 2012 GDP. This follows a -0.3% contraction in Q4, so pulling the UK into a ‘double dip’ recession (the first since the 1970s). Below are some frequently asked questions, and my response.
Was the fall a surprise?
Most forecasters were expecting very modest growth in Q1, with the median estimate (according to Bloomberg) for a +0.1% increase. These forecasts were in line with most leading indicators and partial indicators, which pointed to sub-trend growth last quarter.
Though disappointed, however, I doubt many commentators (including myself) were that surprised. Preliminary GDP numbers are notoriously volatile, and there are several variables which can unexpectedly throw the result (more about that later).
Why did growth fall in Q1?
The services sector, which accounts for more than three-quarters of output, is not in recession - it rose a modest 0.1% in Q1 (a lot lower than business surveys and retail sales suggested). Industrial production fell by -0.4%, but that alone would not have been enough to produce a negative number. What dragged it lower was a -3% fall in construction output, which detracted 0.2 percentage points from the headline number. Without that fall, GDP would have been flat last quarter.
Should we believe these estimates?
Not particularly. Preliminary GDP estimates in the UK are based on less than half the data that go into the final national account estimates. The rest are extrapolated or imputed. They are frequently subject to large downward (or more commonly, upward) revisions. In a year or two’s time we could well discover there was no ‘double dip’ recession after all.
Former MPC member Andrew Sentance gave a powerful example in a March 30 blog:
In the early 1990s, the recession appeared to continue through 1992 and into early 1993. At the time, it was believed to be the longest recession that the UK had experienced since the Second World War. The most recent data show the decline in GDP coming to an end in late 1991, exactly when Norman Lamont declared he could see the “green shoots of recovery”. He was right, though ridiculed at the time.
Most economic commentators are likely to react with a degree of scepticism to today’s numbers, for three reasons. First, past GDP estimates have experienced major revisions. Second, there are serious quality concerns about some of the inputs, especially construction. Third, and most important, because these estimates are at odds with most of the other main indicators of economic activity. The numbers simply don’t gel.
So we shouldn’t be too worried?
Yes we should. There is a real risk that the headline contraction, reinforced by ‘doom and gloom’ stories the media will pump out over coming days, will weaken already soft consumer confidence and spending, discourage British business from hiring or spending, and deter foreign investment. If Britons talk themselves into a funk we could see what (to me at least) looks like a temporary soft patch into a more serious and protracted downturn. It’s all about Keynes ‘animal spirits’, as Akerlof and Shiller and others have noted.
How will the Government respond?
Calls for the Chancellor, George Osborne, to abandon (or at least modify) his fiscal austerity plans will grow. However ministers are terrified at the prospect of losing their AAA rating, and there are few signs of a ‘Plan B’ in the works. Indeed on Monday the Treasury chief secretary said he had asked Government department’s to identify another £16bn of cuts.
With the Office for Budgetary Responsibility set to downgrade its growth forecasts, larger spending cuts will be required simply to maintain the Government’s debt-to-GDP targets. So should the government cut even more, maintain its existing spending plans, or rethink its approach?
We can expect a protracted debate in the UK about whether the pace of spending cuts is too high, and hence self-defeating. It is a view forcefully made by Jonathan Portes, and even the IMF in their January 2012 World Economic Outlook Update (PDF):
Overdoing fiscal adjustment in the short term to counter cyclical revenue losses will further undercut activity, diminish popular support for adjustment, and undermine market confidence.
Today’s figures lend weight to the critics, and pressure for a ‘Plan B’ will surely grow. The Q1 fall in construction, for example, was driven by a large drop in drop in new public non-housing projects. Further spending cuts will also detract from growth.
The next few months are likely to be uncomfortable ones for Mr Osborne. Today he said in parliament “we will stick with our plans”. He also said:
The one thing that would make the situation even worse would be to abandon our credible plan and deliberately add more borrowing.
That is debatable. But there is more that could be done even within the existing tax and spending envelop to promote growth and job creation, if Mr Osborne has the wit to pursue it.
For example, Ian Mulheirn from the Social Market Foundation published a detailed proposal (PDF) in February suggesting bringing forward by four years the £15 billion of tax increases pencilled in for after 2015, and using that money for temporary infrastructure spending in those four years. Oxford’s Simon Wren-Lewis also had some observations on this on his excellent Mainly Macro blog.
There is also a need for a bolder pro-growth agenda, encouraging investment, reducing regulatory burdens and so forth. This is normally bread and butter for a Tory administration but, rhetoric aside, we’ve not yet seen many actual initiatives from this administration.
How will the Bank of England respond?
Although Bank economists can be expected to treat the latest GDP figures sceptically, as they have did back in 2008/2009 when the numbers also looked questionable, the weak growth figures will lend support doves on the Monetary Policy Committee such as David Miles who want to see further quantitative easing. However given recent higher-than-expected inflation numbers, I do not expect further QE at the May MPC meeting.
One thing’s for sure though – QE or no QE, the Bank’s official cash rate won’t be changing until 2013 at the earliest.
How did financial markets react?
Much as you’d expect. The pound, at a six month high running up to the numbers, fell by 0.3-0.4% after release and is likely to weaken further. Gilts saw a modest rally, as yields fell in light of a more disinflationary outlook.
UK stocks, by contrast, moved higher this morning - showing just how little economic fundamentals drive equity markets, at least in the short run.
So how bad will it get?
It is too early to tell. On the downside, the Eurozone recession will be a drag on growth, as will negative domestic consumer and business sentiment. Another sovereign debt market crisis could occur at any time. On the other hand a weaker pound will help exports, the US economy is perking up, and China appears to still be on track for a soft landing.
Weaker consumer spending and output lost due to the Jubilee bank holiday could see another negative quarter posted in Q2, but beyond that there is some prospect of a tepid British recovery emerging in the second half of the year. The ONS’ decision to include London Olympic tickets sales when the Games take place this summer, rather than when they were purchased, should boost the Q3 figures.
Former MPC member DeAnne Julius says “this should be one of the shortest recessions on record” (FT £). Let’s hope that she is right