Strong growth – but heavily reliant on inventories

Figures released today by the Office for National Statistics show that real GDP in the UK increased by 1.2 per cent in the second quarter – slightly better than the 1.1 per cent first estimate. Most commentary so far has focused on the 8.5 per cent increase in output from the construction sector which was a major factor behind the leap in growth when it is analysed on an industry-by-industry basis. This is clearly unsustainable and suggests that growth will drop back in the second half of the year.

A similar conclusion is reached when growth is analysed by looking at its expenditure components. Over three-quarters of the growth in the second quarter came about as a result of firms rebuilding their inventories. Net trade added nothing to growth and while consumer spending was a positive factor, investment spending detracted from growth.

A look at the detailed figures shows that firms reduced their inventories for six consecutive quarters between 2008Q4 and 2010Q1 as they chose to meet some demand from existing stocks, rather than from higher output. It is unsurprising, after such a prolonged period of de-stocking, that inventories were so lean that companies felt the need to start rebuilding them in the second quarter.

But this does not mean that underlying demand in the economy is strong. True, consumer spending increased at its fastest pace since the first quarter of 2008 and, as Ed Balls claimed today this does vindicate to some extent Labour’s economic policies. In particular, its efforts to support employment helped to limit the damage to incomes and consumer confidence caused by the recession.

Balls said:

“Those figures today show that Labour’s strategy was working… They don’t say anything at all about what is going to happen in the next period.”

There is still no sign of a sustained recovery in investment spending or of a boost to growth from trade. This is a problem for George Osborne because he is banking on a rebalancing of the economy in favour of exports and capital spending to support growth while he cuts public spending.

When the provisional growth figures were released a month ago, he claimed they showed the economy was strong enough to cope with large cuts in the budget deficit. But, excluding the one-off effect of inventory rebuilding, private sector demand increased by just 0.1 per cent in the second quarter.

And all the evidence suggests the prospect of an increase in VAT and massive cuts in public spending, together with worse economic news from the US and Europe, have caused business sentiment in the UK to deteriorate over the last two months. The growth outlook in the UK is very uncertain and it still looks to be too early to cut the deficit at the pace the coalition is proposing.