Bill Jamieson: a cut in interest rates can't be counted out

A triple whammy of troubling news has brought us close to an inflection point for the UK economy. A rate cut could now prove the big surprise of 2016 '“ and in due course a 10 per cent devaluation of sterling '“ whichever way the EU referendum turns out.

As data shows the economy weakening, a cut in interest rates cant be counted out

A growth slowdown has been evident for some time. But the breadth and extent of the downturn came sharply into focus last week.

First came worrying pointers from construction and manufacturing. The latest Markit Purchasing Managers Index for Construction has hit a three-year low while the Manufacturing PMI has now fallen to 49.2, below the critical 50 level and signalling contraction.

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Until now comfort was taken in the resilience of the much larger services sector. But last Thursday came news that the PMI for services showed weakening optimism. The services business activity PMI has fallen to its lowest since February 2013 when Europe was gripped by dire economic downturns in Greece and other southern Mediterranean countries, threatening the survival of the European single currency.

This index has fallen to 52.3. And while this is still above 50, it is well below the 55.2 average over the past 20 years. Some dismiss the Markit PMI readings as little more than measures of business confidence – a volatile measure reflecting media and newspaper coverage that can quickly change.

But the PMI readings go back 50 years and enable us to compare present trends with long-term past performance. And there is a close correlation between the PMI readings and subsequent movements in UK GDP. The likelihood is that if the PMIs are pointing to poorer business confidence readings, the real economy is likely to experience a downturn as well.

Markit chief economist Chris Williamson says the slowdown makes for “a triple whammy of disappointing news on the health of the economy at the start of the second quarter. The surveys are collectively indicating a near-stalling of economic growth, down from 0.4 per cent in the first quarter to just 0.1 per cent in April.”

Now in recent weeks it has become commonplace to blame the run of weak activity on uncertainty caused by June’s EU referendum. But worries were already surfacing about weakening UK economic growth in the second half of last year. As Oxford Economics points out this weekend: “With the economy slackening well before the referendum date was announced, it is difficult to believe that this is the only story.”

A continuing global slowdown, concerns over the health and pace of China’s economy, the strength of the US dollar and, at home, the introduction of the national living wage and its knock-on effect on business costs are likely to have exercised at least as great an influence.

Now all eyes will be on the next set of economic growth figures due in July. Barring a dramatic improvement in sentiment in the next six weeks, they are likely to make uncomfortable reading. And both the UK Treasury and the Bank of England will come under pressure for a policy response.

It has been assumed until now that the central bank was set on a rise in interest rates – the policy debate being not on the direction of rate travel but the timing of a rise. But now the prospect of a rate cut has come into view. “One thing that is clear”, says Oxford Economics, “is that the possibility of a cut in interest rates is looking ever less outlandish.”

The latest signs of weakness in the economy, it adds, will strengthen the hand of those MPC members leaning towards a cut in bank rate. Both the bank’s chief economist, Andy Haldane, and Gertjan Vieghe, an external member of the Monetary Policy Committee, have mooted this possibility in recent months. Most believe the bank will stay put on rates for now – but a cut could well be the big surprise of 2016 if the economy does not stabilise.

Given the poor outlook for the second quarter it looks most unlikely now that GDP growth will reach 2.2 per cent in 2016. Global Insight economist Howard Archer has cut his UK forecast to 1.8 per cent (Scotland is likely to see a lower figure). The MPC is almost certain to follow suit.

Meanwhile, the UK’s burgeoning current account deficit has prompted speculation of a 10 per cent sterling devaluation at least. This has spiralled from 2.2 per cent of GDP in 2000 to 7 per cent last year. The UK has long run a persistent trade deficit in goods and services, so what’s new? The net primary income account – largely investment income – has moved from a surplus of nearly 1 per cent of GDP in 2000 to a deficit of 1.9 per cent.

Economists Douglas McWilliams and Scott Corfe, of the Centre for Economics and Business Research, say their simulations “suggest that to sort the UK’s current account we would need a 10-15 per cent devaluation” and to allow for investment flow issues “the devaluation would need to be over 20 per cent”.

A devaluation would see a quick revaluation gain. But, says the CEBR, “one should be careful not to imagine that one can get away with persistently devaluing the assets of inward investors without antagonising them in such a way as to create outward capital flows … Our conclusion is that despite the potential assistance of the international account and capital flows, sterling is likely to have to be devalued in the coming years… a devaluation of at least 10 per cent of sterling’s trade weighted value is likely to be necessary to significantly improve the UK’s international financial position.”