Deluge of bad economic news must not swamp belief in strong recovery

Published on Saturday 8 November 2008 16:43

LOWER interest rates but no money to lend; cheaper houses but no confidence to buy them; recession deepening and no evident recovery. How on earth do we get out of this?

So heavy was the torrent of appalling bad news last week – plunging service sector activity, fresh falls in manufacturing, a blistering International Monetary Fund warning and appalling company announcements – there was barely time to absorb one jaw-dropping announcement before another came along.

From plunging profits at Toyota and BA through to a 30% slump in construction activity and dire news from the retail sector: surely the Bank of England's dramatic 1.5 percentage point cut in interest rates would have halted the stock market slide?

On the contrary. After a brief rally last Thursday the market plunged further to take share prices down almost 6% on the day.

The mood is no better in America. On the morning after Barack Obama's momentous victory, a leading political pundit phoned me to insist that Wall Street would rally strongly on the euphoric mood of change and hope. I tried to warn him that futures trading pointed to an opening fall. But nothing could have prepared either of us for the extent of the tumble, with the market closing 5% down.

Orators may have their moments of soaring political poetry, but Wall Street is driven by matters much more prosaic – mounting evidence of an economy getting worse by the day.

Figures showing an awesome slump in manufacturing orders deepened the gloom. But that was only one of a series of pointers that the world's biggest economy had taken a nose-dive in October. A sharp rise in unemployment is another.

But this news flow is part of the problem. It is focused on immediate events and near term forecasts. That makes it virtually impossible to form a more considered view.

There is certainly very good reason to be deeply gloomy about immediate prospects. But equally there is every good reason to expect that by this time next year the mood will be different.

A unique convergence of favourable developments for the economy will have changed it. These include a sharply lower pound to help exporters; the near total absence of inflation, which should help boost real incomes; a Government pushing through public spending projects, and interest rates cut to record lows.

Ask any economist to write a dream ticket for a stunning growth performance and – barring big cuts in tax – you would struggle to improve on this list.

Of particular note was the emphatic signal sent by the Bank of England that it is fully alive, not just to the immediate problems facing business and households, but to the deflation threat. And it has shown it will not be held back by custom and precedent in taking the action it deems necessary. The full extent of the cut was not at all expected by the market and indeed may have brought a shock realisation as to how serious the current downturn is.

But the risks of acting too boldly are more than outweighed by the risks of doing too little, and in my view this dramatic move by the Bank is all the more to be welcomed. It has also had the desired effect on the London Interbank Offered Rate (Libor) which dropped from 5.56% to 4.49% on Friday, its lowest rate since 2004, triggering a spate of mortgage rate cuts by leading banks. I thus take more comfort from the audacity of the MPC than from Obama's "audacity of hope".

However, since we are now 'almost there' with this recovery ticket, why is there so little hope and so much despair – in business, in households and in markets?

Three factors help to explain this apprehension. First, as I indicated earlier, is the sheer volume of the bad news flow. Of course it is news that has to be reported and fully taken on board. But it does act to compound the gloom, creating a negative feedback loop in the markets. Consideration of the longer term effects barely gets a chance. And this bad news flow is set to intensify.

Second, it takes time for the Government support for the banks and for interest rate cuts to work – 12 to 18 months is the rule of thumb. It also takes time for prices to adjust to the post-credit crisis world. Even now, there are reports of house sellers being reluctant to accept that they have to cut their asking prices, convinced that falls in value only happen in faraway streets.

And third, unemployment is rising in the interim – and as well as the immediate personal blight that it causes, it impacts on the housing market and on consumer spending. And as employment is a 'lag' indicator, it may be 18 months or so yet before companies consider new hirings.

All these may give the impression that the measures taken so far are not working, or indeed have failed barely days after their announcement. But that there is no immediate turnaround is no reason to believe there will not in time be one. Every recovery takes time to unfold.

And not every commentator has thrown in the towel. This, from the monetary policy think-tank Lombard Street Research: "The Bank of England's swift reaction and sterling's immediate adjustment should make this correction less severe. Tumbling inflation will boost real incomes, bringing the needed rise in the household savings rate faster."

The headline inflation rate, says Lombard economist Diana Choyleva, is set to plummet, reaching 0% by the end of 2009, boosting real incomes. The excess borrowing this time round has been concentrated in the household sector. Hence we should not expect higher real income to lead to a quick consumer spending revival. But it should help bring about the necessary increase in the savings rate.

Currency depreciation, she adds, is also one of the benign routes to solve an excess debt problem. "Weak global growth does mean that the adjustment will initially have to come primarily through import substitution. The UK has to start consuming less and producing more."

But once we have endured 2009, and as the economies not suffering from excess debt perk up , the UK can reply on exports to pull it out of the doldrums. With exports representing 30% of output, sterling depreciation, she adds, can achieve a lot more "bang for the buck" in boosting domestic incomes. "After a cyclical hit to profits and the consequent slashing of investment, non-financial firms will be in a good position to start expanding. But households are to see a revival last, suggesting a 'feel bad' recovery in 2010."

We are going to have more – lots more – bad news in the coming weeks and months. We will need more interest rate cuts – and it may yet require a cut in taxes. And we are critically dependent on how other countries and governments respond. But much has been done and will continue to be done. A year from now we should have cause to share "the audacity of hope".

MPC moves

On Wednesday, when the Bank of England's Monetary Policy Committee (MPC) sat down to discuss the interest rate decision to be announced the following day, the atmosphere would have been tense as further signs emerged that the UK was heading into recession, writes Rosemary Gallagher.

Since 1997 the Bank of England's Monetary Policy Committee has been setting interest rates with the primary aim of ensuring the UK's inflation target is met. Its announcement last week of a 1.5 percentage point cut marked a departure from its normally hawkish approach of making relatively small, cautious changes to the base rate.

As the nine MPC members perused the data on everything from plummeting house prices to rising unemployment, the doves, led by David Blanchflower, above, would have increased the pressure on the hawks for a drastic rate cut.

Last month Blanchflower said the Bank should have been aware of the threat of recession earlier. Last week he would have told the doves around the table, including Paul Tucker and Tim Besley, that it was time for aggressive decision making.

The performance of the UK economy in the next few months will show whether or not the action the MPC finally took on Thursday was too little, too late as the scale of the recession becomes clear.

The MPC members are Governor Mervyn King, the two deputy governors Charles Bean and Sir John Gieve, and Kate Barker, Tim Besley, Blanchflower, Spencer Dale, Andrew Sentance and Paul Tucker.