Comment: Weathered economic storm but more to come?

Metaphorically speaking, the weather lady is still out with her parasol. Picture: Getty

Do we need an umbrella or will the economic weather hold good? From my early childhood in Ayrshire comes a fond memory of a Swiss chalet-style weather house gifted to us by a much-travelled aunt. The woman in the weather house was supposed to come out with a parasol when the forecast was sunny; the man with a brolly when it was set to rain.

Well, that was the theory. It was never that reliable back then and I don’t suppose it will be any more of an accurate guide now.

The good news today on the economy (though certainly not the weather this summer) is that the lady is out with the parasol. The bad news is that the man looks ready to barge past with a big umbrella.

In particular, reassuring central bank forecasts that a return to higher interest rates at the turn of the year is likely to prove slow and gentle may prove too sanguine by half.

Over the past few weeks we have had a crop of encouraging pointers. There is evidence of a pick-up in services activity UK-wide and, while the pace in manufacturing has slowed, there has been a marked improvement in industrial production. Consumer spending also looks to have been buoyant – though much of this in Scotland is more likely to have been online as poor weather kept shoppers away from the high streets.

The upshot is that preliminary figures for the April-June quarter due out on Tuesday are now expected to show growth in UK GDP rebounding to 0.7 per cent, having fallen back to 0.4 per cent quarter-on-quarter in the first three months of 2015. This would take annual GDP growth to 2.6 per cent, compared with the OBR’s forecast of 2.4 per cent in the summer budget.

However, more likely to lift household morale than an upward tick in abstract GDP statistics is the improvement in earnings. Politics may be dominated by fiery denunciations of austerity. But as Global Insight economist Howard Archer notes, “elevated consumer confidence in July and a healthy CBI distributive trades survey are expected to provide compelling evidence that the consumer is still alive and kicking”.

Average annual earnings growth hit 3.2 per cent in the three months to May. With inflation virtually dormant for now – it was zero in June – we are seeing a marked pick-up in purchasing power.

Muted oil and commodity prices should also help companies’ margins as well as supporting growth in the Eurozone, which should be beneficial to UK exports.

Meanwhile, further impetus may come from the housing market. ONS data last week reported house prices rising 0.9 per cent month-on-month in May, with the annual rate running at 5.7 per cent. The normal caveats should be applied here on “average” house price statistics, particularly as parts of the Scottish market remain subdued.

Finally, Archer notes that the July survey of business conditions by the Bank of England’s regional agents (which covered June) reported that “business services turnover growth remained firm overall” while the purchasing managers’ business activity index for services averaged 58.2 in the second quarter, up from 57.6 in the first quarter.

It is this prospect of continuing recovery, together with the marked rise (at last) in average earnings that sets a trap for the Bank of England and the Monetary Policy Committee.

Bank Governor Mark Carney forecasts that interest rate rises, when they do come, will be gradual and modest, with the new peak in rates settling at what he calls “the equilibrium rate of interest” – the rate synonymous with low inflation and full employment. This, he suggests, would be 2.25 per cent. By the standards of the past 40 years, 2.25 per cent is very low indeed. As the pre-crisis equilibrium rate was 4.5 per cent, this suggests less a return to normal than a new normal setting in.

Now this may be the case, and it would be pleasing indeed if this forecast was to prove correct. But the problem is that interest rates rarely move in an orderly or predictable fashion. This is why the forecasting record of central banks has been poor. Interest rate movements are largely driven by changes in economic conditions that are by their nature unpredictable and outwith their control.

This is the case with inflation. In the UK we are particularly vulnerable to external forces and events, as ours is a relatively open economy with imports and exports accounting for a notably higher proportion of GDP than most other European economies. We also have a currency sensitive to the vagaries of global markets, and of course a high level of government debt requiring overseas investors as confident buyers. And that, from time to time, has required higher interest rates to attract buyers than would otherwise be the case.

Once allowed to gain traction, inflation is notoriously difficult to bring back under control. For most of the 1970s and 1980s, trying to contain it was akin to chasing a tiger by the tail. Time and again earnest endeavours by governments and Bank of England governors to take effective remedial action under-estimated the strength and persistence of the underlying forces confronting them.

And often these forces were latent, seemingly inactive but subsequently erupting with considerable pent-up force when it was felt that the threat had passed. Bringing the tiger under control often involved a level of interest rates higher than, and persisting longer than, consensus assumption.

For now inflation is dormant, held down by lower global commodity prices and in particular the sharp fall in the price of oil. There seems no immediate cause for worry. But all this is helping to buoy up consumer spending and borrowing, and these, coupled with a return of a brisk real rate of increase in average earnings, point to a stoking up of powerful domestic demand in 2016 and beyond.

Interest rates may well prove more volatile than we are being encouraged to believe, and more likely to settle at a higher rate than official guidance would like us to believe. The forecast looks good. But beware the man with the black umbrella behind the lady with the parasol.