Fraser Nelson is no fan of the Monetary Policy Committee’s decision yesterday to increase the level of quantitative easing (QE) by a further £50 billion.

Writing in yesterday’s Daily Telegraph, he argues that, at the very least, Mervyn King and George Osborne should come clean about the effect on pensioners because it is their policy that has driven annuity rates so low.

As ever with economics, it is not that simple. To understand, why requires a bit of theory. Paul Krugman has set this out in a recent blog; but here is the main line of argument.

Interest rates are determined by the supply of savings and the demand for funds for investment. At any point in time, there is a level of the interest rate that will result in savings equalling investment at full employment.

The problem right now – because of deleveraging – is that this level of interest rates is negative. But interest rates cannot fall below zero (because people would simply keep their savings in cash). The result is that, even with interest rates effectively at zero, there is an excess supply of savings and insufficient demand in the economy.

 Krugman’s solution is more government spending (or tax cuts). In the UK, this option has been ruled out by the Chancellor.

 The alternative, therefore, is quantitative easing:crudely put, printing (electronic) money to buy government bonds and so lower long-term interest rates. This can support demand in the economy through a number of channels.

Lower bond yields mean lower mortgage rates. Lower yields on government bonds will also lead to lower yields on corporate bonds and higher share prices because the investors who sell government bonds to the Bank will want to invest the proceeds in other assets.

This makes it cheaper for companies to raise funds. And lower yields will also tend to make sterling less attractive to international investors and help to hold it down against the currencies of our key trading partners, particularly the euro.

Do debtors gain from this as Nelson argues? Yes they do. For example, if there was no QE, rates on fixed rate mortgages would be higher. Do savers lose out? Yes they do – but only up to a point.

While the yield available for anyone buying a government bond today is historically low, anyone who has been holding bonds in recent years will have seen their value appreciate significantly.

Similarly, anyone buying an annuity today will get what appears to be a low pay-out. But the value of their pension pot will be so much greater thanks to QE, particularly if it has been invested largely in government bonds, as most advisers would recommend for those close to retirement.

 In any case, it is wrong to put all the blame on Mervyn King and George Osborne for any transfer of wealth from savers to debtors.

Through QE they are implementing what the market cannot achieve. The overall economic situation – an economy in which output is currently almost 4 per cent lower than at its peak four years ago – requires lower interest rates, which also favour debtors over savers. But rates cannot go any lower; QE is the alternative.

 Fraser Nelson likes thought experiments: he starts his article with one. Here’s another one. Imagine George Osborne were to stand up in the House of Commons and declare that, despite the risk of a new economic crisis, he had ordered the Bank of England to end its policy of quantitative easing because of its effect on annuity rates and the income of pensioners.

Furthermore, interest rates would in future always be maintained at a level of 2 per cent or above. And no, he would not be relaxing fiscal policy because maintaining the UK’s credibility and credit rating was still of primary importance.

As a result, he might add, business and consumer confidence was expected to collapse, there would be a sharp increase in mortgage rates and the Office for Budget Responsibility is now forecasting a deep recession and youth unemployment of 1.5 million in 2013. This seems grossly unfair on the current generation of school and college leavers, but the alternative is poorer pensioners and that is unacceptable.

 QE is not perfect, and I am one of those who think that relaxing the pace of deficit reduction would be sensible while interest rates are at the zero bound and growth is turning out far weaker than expected. But it surely has a role to play in helping to ease the economy out of its current predicament.

 In one respect, Nelson is right: this is a big experiment and we cannot be sure of the outcome. But such is life. Unlike in the scientific world, there are no laboratories in which new economic policies can be tested out before they are used in the real world.

Sometimes the situation is so bad that policy makers have to experiment on the real economy. In the current circumstances surely that is better than the alternative of doing nothing.

See also:

• What does QE3 mean for the real economy – Ben Fox, February 10th 2012

• Quantitative easing is stimulating commodity training, not the real economy – Josh Ryan-Collins, February 9th 2012

• We’re all economists now, part one – Ben Mitchell, February 4th 2012

• Will quantitative easing work this time? – George Irvin, October 9th 2011

• Quantitative easing: The latest windfall from us all to “country London” – Ranjit Sidhu, October 8th 2011

The UK economy may be back in recession, on the technical definition of two consecutive quarters of declining real GDP. UK Gross Domestic Product contracted by 0.2 per cent in the final quarter of 2011 and many economists think that it will contract again in the first quarter of this year.

The chancellor said the drop in output in the final quarter of 2011 ‘was not entirely unexpected’ and this is true in the sense that economists have been predicting it for the last few months.

But just six months ago, there were very few forecasters expecting the UK to return to recession.

It is convenient for the government to blame the deepening euro zone crisis for this development, and it has probably had some effect on consumer and business confidence, and thus on investment spending and hiring.

But exports have been relatively resilient and weak domestic spending is the main problem. This is due to the squeeze placed on household spending power by higher commodity prices, the increase in VAT and the government’s cuts in public sector employment.

Provisional figures show the UK economy contracted by 0.2 per cent in the final quarter of 2011.

As a result, growth for the full year was 0.9 per cent. Growth over the four quarters to the final quarter of 2011 was 0.8 per cent, though this figure is flattered by comparison with the final quarter of 2010 when output was hit by bad weather in December. Underlying growth over the last four quarters was probably as low as 0.3 per cent.

Various explanations for this poor performance have been put forward and most economists believe some combination of them is to blame. They include: the fact that recoveries from recessions caused by the bursting of asset bubbles tend to be weak, the effect of high food and energy prices on households’ spending power, the euro zone crisis and the speed with which the government is choosing to cut its deficit.

What happens next appears to depend primarily on developments in the eurozone. At best, growth in the UK economy during 2012 will be a little better than in 2011 (i.e. better than 0.3 per cent over the year to the fourth quarter) as lower inflation eases the squeeze on households.

At worst, a deepening of the euro zone crisis could lead to a renewed credit crunch and reversal of recent increases in business confidence, turning what could be a mild recession (if it is a recession at all) into something more serious.

These increases in business confidence – in manufacturing and in the service sector – are intriguing. Despite a collapse in consumer confidence and no let up in the gloom coming out of Europe, they suggest companies have started 2012 in a more optimistic frame of mind. This is certainly not consistent with the notion of the economy being in recession.

1. GDP declined by 0.2 per cent in the fourth quarter: Preliminary figures show real GDP was down 0.2 per cent in the final quarter of 2011. Output of production industries contracted by 1.2 per cent, construction was down 0.5 per cent and service sector output was unchanged.

Few details are available but it is likely that destocking by manufacturing companies was the main factor behind the fall in GDP. Over the last year, excluding the bounce back from last December’s bad weather, growth has been just 0.3 per cent.

2. Retail sales volumes have improved as inflation has eased: The volume of retail sales increased by 1.1 per cent in the final quarter of 2011 (making it unlikely that lower consumer spending was a factor contributing to the fall in GDP), while the value of sales was up 1.7 per cent.

Despite low wage inflation and rising unemployment, households are still willing to increase their spending on the high street and the internet.

The increase in prices – 0.6 per cent – in the final quarter was lower than recent experience, so this extra spending converted into the strongest quarterly growth in sales volumes since the second quarter of 2010.

3. Consumer confidence is at a near record low: Consumer confidence is at near record low levels, reflecting worries about rising unemployment and the euro zone crisis and a deteriorating outlook for the housing market. On previous occasions when confidence has been this low, the economy has been in recession.

4. Business surveys improve in January: Contrasting with the gloom among consumers, business confidence started 2012 on a more buoyant note. The purchasing managers’ survey of manufacturing recorded a jump in confidence, output and new orders in January, lifting the overall index to 52.1, which suggests the sector is expanding again.

The latest CBI monthly survey showed a similar picture. Meanwhile, the service sector index rose to 56.0 – a ten-month high. In the past, confidence around these levels has been consistent with the economy growing at around its trend rate – about 0.6 per cent a quarter.

5. Manufacturing output is weak: Manufacturing output fell by 0.2 per cent in November and was 0.6 per cent lower than a year earlier. The trend in output has been flat to lower for several months. Performance has become mixed across sub-sectors, with output down in seven and up in six over the last year.

6. Modest increase in employment: Employment in the latest three months, to November 2011, was 18,000 higher than in the previous three months and 26,000 higher than a year earlier. However, the number of employees fell by 93,000 over the last year, while the number saying they were self-employed increased by 138,000.

It is not clear whether some of this increase in self-employment represents hidden unemployment. There are also over 1.3 million people working part-time because they cannot find a full-time job.

7. Unemployment reaches 17-year high: On the Labour Force Survey (LFS) measure, unemployment is now 2.68 million – the highest level since the three months ending in August 1994 – and the unemployment rate is 8.4 per cent – the highest since the three months to November 1995.

Over the last quarter unemployment increased by 118,000. The claimant count measure has gone up for ten consecutive months, though in recent months the scale of the increase has been falling and in December it was just 1,200.

8. Price inflation eased to 4.2 per cent: Consumer price inflation fell back from 4.8 per cent in November to 4.2 per cent in December (and from 5.2 per cent to 4.8 per cent on the retail price measure).

There will be a further big fall in January when last year’s increase in VAT drops out of the calculation and cuts energy charges will help push inflation even lower in coming months. By the end of 2012 consumer price inflation could be below its two per cent target rate.

9. Wage inflation stuck close to 2 per cent: Average earnings increased by 1.9 per cent and regular pay was also up 1.9 per cent over the year to the three months ending in November 2011. Regular pay in financial and business services was up 3.5 per cent, while pay in other sectors only increased by around 1.5 per cent.

10. Government borrowing is below last year’s path: In the first nine months of the 2011/12 fiscal year, public sector net borrowing (excluding financial interventions) was £103.3 billion, down from £114.6 billion a year earlier. It appears that borrowing for the whole year is set to come in lower than in 2010/11 despite weak economic growth.

This is the result of discretionary fiscal tightening by the government, but higher price inflation will have helped. The OBR’s latest forecast for borrowing in the full year 2011/12 is £127 billion; this may be undershot.

11. Interest rates remain at 0.5 per cent; QE at £275 billion: The Monetary Policy Committee left interest rates at 0.5 per cent in January and the scale of quantitative easing at £275 billion. With the economy possibly back in recession and inflation now falling, there is speculation that the MPC will increase the scale of quantitative easing, perhaps as soon as at its February meeting.

12. Government bond yields close to historical lows: The 10-year UK government bond yield rose a little in January, but remains not far from 2%. This reflects the poor outlook for growth and the improving outlook for inflation, Bank of England buying of bonds to implement quantitative easing, and the ever-receding prospects of higher interest rates in the UK.

13. Sterling little changed in January: There was little movement in any of the main exchange rates during January.

See also:

• We’re all economists now, part two - Ben Mitchell, February 5th 2012

• We’re all economists now, part one - Ben Mitchell, February 4th 2012

• Look Left – Wonga’s student ‘scam’ comes unstuck - Shamik Das, January 13th 2012

• Economic update – January 2012: Outlook not all bad - Tony Dolphin, January 9th 2012

• “We are spiralling into a prolonged and ghastly depression”: The economy in 2012 - Ann Pettifor, January 6th 2012

Tony Dolphin is the chief economist at the Insitute for Public Policy Research (IPPR)

Growth in the UK economy in the decade up to the financial crisis and recession was dominated by large companies and institutions. In the private sector, big banks grew rapidly and major food retailers increased their market share. Meanwhile, in the public sector there were large increases in employment in the health service and in education.

The next decade will be very different. The problems facing the banks as they seek to repair their balances sheets and restructure in response to the Vickers Commission’s recommendations (assuming these are implemented in full by the government) are well known.

At the same time, if growth in future is driven less by debt-financed consumer spending, the major retailers are likely to find the going tougher. And in the public sector, financial constraints mean that it is more likely that employment across the health and education sectors will contract than expand.

In this environment, if the economy is to grow at a healthy pace small businesses will have a vital role to play. Dynamic small companies will have to help generate the growth and create the jobs that are needed for the economy to return to full employment.

But this will only be possible if they can attract the finance they need. Entrepreneurs need funds to establish new businesses; and small firms need funds to expand and to allow them to take on more employees.

Project Merlin – the deal between the government and the five major UK banks – is supposed to deliver some of this finance.

The banks were committed to lending £76 billion to small and medium-sized enterprises in 2011 (more if demand exceeded this level). In the first three quarters of the year, Bank of England figures show lending amounted to £56 billion, suggesting the banks were just about on course to meet the full-year target.

But anecdotal evidence gives a very different impression. There are frequent complaints from small firms that credit is often not available, and that when it is, it is only at a high price or on very restrictive terms. The government needs to listen to these complaints and find a way to make the banks offer more support to the small business sector in 2012.

But obtaining bank finance is not the only problem small companies face. As they grow, they also look to equity finance to back their business expansion plans. But they find investors are more interested in seeking short-term gains from large companies, than they are in investing for the long-term in smaller companies.

IPPR has just published a research paper by Gervais Williams, an asset manager at MAM funds, arguing that tax changes are needed to promote long-term responsible investment in smaller companies at the expense of short termism.

His analysis shows how an outflow of investment from the small companies sector over the last decade has weakened its ability to respond to the challenges it now faces and he argues that this outflow needs to be reversed.

Institutions, such as pension and insurance funds, should be encouraged to invest less in large companies and in overseas equity markets and more in smaller companies in the UK market.

In a low growth world, where dividend payments are likely to account for a bigger proportion of the returns from investing in equities, backing high-yielding small companies – which tend to outperform the equity market over the long-term – might just make good sense.

See also:

• Obama puts manufacturing top of the agenda – time for Cameron to do the same? – Tony Burke, January 27th 2012

• Mandelson weighs in behind National Investment Bank – Alex Hern, January 27th 2012

• Design agencies face a second year of talent exodus in 2012 – Rachel Fairley, January 3rd 2012

• Will quantitative easing work this time? – George Irvin, October 9th 2011

• Debunking the banking lobby’s scare tactics – Joe Cox, September 1st 2011

Real GDP in the UK fell by 0.2 per cent in the final quarter of 2011 according to figures released today by the Office for National Statistics.

Growth in 2011 as a whole was 0.9 per cent. Growth over the four quarters ending in 2011 Q4 was 0.8 per cent, though this figure is flattered by comparison with the final quarter of 2010, when output was hit by particularly bad weather. Underlying growth over the last four quarters may have been as low as 0.3 per cent.

In the final quarter of 2011 output of production industries fell by 1.2 per cent, probably as a result of large-scale destocking (there are very few details available at this point). Output of construction industries was down 0.5 per cent, while output in the service sector was unchanged.

The recovery from the 2008/09 recession continues to be slow and uneven. Real GDP has increased by 3.5 per cent since the second quarter of 2009. Over comparable periods after the last two recessions, real GDP increased by 7.1 per cent in the 1980s and by 8.8 per cent in the 1990s.

There are various explanations for this poor performance.

First, this is a different type of recession and recovery. Economists have shown that recoveries after recessions that are caused by the bursting of debt and asset bubbles tend to be relatively slow. The present UK experience is adding another case study to their collection.

Second, higher commodity prices during 2011 squeezed households’ spending power and reduced domestic demand growth.

Third, the government’s belief that it could cut its deficit aggressively because the private sector would fill the gap has proved wrong, as the latest employment figures show. While public sector employment fell by 67,000 in the latest quarter (to September), the private sector created only 5,000 net new jobs.

Unsurprisingly, despite the government’s optimism, the more the government talked of austerity, the more reluctant companies have been to step up recruitment or make new investments.

Fourth, the euro zone crisis has also affected business confidence, particularly of exporters. Again, this will have been bad for jobs and bad for investment.

In the short term, as I have been warning for some time, things are unlikely to get much better.

There is some good news: energy firms are bringing down their charges and petrol prices have fallen. This will ease the squeeze on households’ spending power.

But, as the IMF warned only yesterday, when it revised its forecast for growth in the euro zone in 2012 down from +1.1 per cent to -0.5 per cent, the euro zone crisis is an increasing threat to the global economy. Meanwhile, the government is sticking stubbornly to its deficit reduction plans, meaning further cuts in public sector jobs and taking more demand out of the economy.

With public sector austerity at home and a potential crisis in the euro zone on their doorstep, it seems unlikely the private sector will step up its recruitment or investment plans any time soon.

Together, these GDP figures and the short term outlook suggest the UK economy has slipped back into recession. The feared ‘double-dip’ began in the final quarter of 2011.

See also:

• When the private sector collapses for a second time – Cormac Hollingsworth, January 19th 2012

• Manufacturers still fear a double-dip recession in 2012 – Tony Burke, December 23rd 2011

• More grim news: Economists predict UK will be back in recession in 2012 – Alex Hern, December 12th 2011

• Stories from the economy, or: The prospects for young people, and other grim tales – Richard Exell, November 17th 2011

• IMF boss repeats call for Plan B – Will Straw, September 5th 2011

Revisions to the national accounts data published by the Office for National Statistics just before Christmas show economic recovery in the UK was stronger in 2010 than previously thought.

It is quite common for the statisticians to discover extra growth in the economy in the first year of recovery – in part because they find it hard to pick up the expansion of new businesses – and this repeats the usual pattern.

The new figures show GDP growth in the whole of 2010 was 2.1% – significantly higher than the initial 1.4% estimate.

What is most interesting though is that, according to these figures, the recovery from the 2008/09 recession proceeded at the same pace for five quarters – that is from Q3 2009 to Q3 2010 – as did the recovery from the two previous recessions (those of the early 1980s and early 1990s).

At this point in the current recovery real GDP was 3.2% higher than at its lowest point, compared to 3.1% in the 1980s and 3.0% in the 1990s. This might be judged a little disappointing, given that the 2008/09 recession was deeper than the previous two, but since then things have got worse.

While the economy recorded growth of 2.7% in the following year of the 1980s recovery and 4.8% in the following year of the 1990s recovery, growth in the UK over the last year has been just 0.5%.

And if forecasts from the Office for Budget Responsibility are right and the economy does not grow at all the final quarter of 2011 and the first of 2012, then this recovery is going to lag further behind the previous two (Graph 1 below includes OBR forecasts for the period Q4 2011 to Q4 2012).

Graph 1:

It would be wrong to be too gloomy. History suggests the statisticians might find some more growth in 2011 too. But this is shaping up to be the slowest recovery in the UK in the post-war period.

See also:

• Glasman is battling over postage stamps, but growth is the priority – Cormac Hollingsworth, January 9th 2012

• Manufacturers still fear a double-dip recession in 2012 – Tony Burke, December 23rd 2011

• The south is on its way out of recession, but the north is stuck – Lewis Goodall, December 15th 2011

• Unemployment: Plan A isn’t working – Richard Exell, December 14th 2011

• Grim economic news II: OECD cut UK growth prediction. Again – Alex Hern, December 13th 2011

A year ago economists were too optimistic about the outlook for the UK economy.

They expected a drag on spending from the increase in the standard rate of VAT to 20 per cent and from public spending cuts, but most thought the economy would expand at an annual rate of around two per cent in 2011. The outturn is likely to be less than one per cent.

Economists got three things wrong:

• First, they failed to foresee how high oil prices would rise in the first half of the year. This pushed up petrol prices and heating costs and squeezed households’ spending power.

• Second, they did not expect the euro zone sovereign debt crisis to worsen to the degree that it did. This affected the outlook for businesses in the second half of the year.

• Third, they misjudged the negative effect on confidence in the private sector of cuts in the public sector. This caused companies to hold back investment spending and hiring.

Together these three factors brought the economy to the brink of recession.

Here is a scorecard of different economic indicators over recent months:

Commentary:

2011 turned out to be a grim year for the UK economy.

Growth fell well short of economists’ forecasts made at the start of the year; inflation and unemployment both ended the year higher than expected; and public sector borrowing was also higher.

Just about the only good news was that the current account deficit is likely to be smaller than forecast, though as this is largely due to weak import growth, which in turn reflects the weakness of the economy, it is no real cause for celebration.

As we enter 2012, the outlook for the economy appears bleak. Public sector austerity continues at home and the euro zone debt crisis is unresolved, creating great uncertainty for companies that have trade links with our European neighbours. International bodies like the IMF and the OECD believe the euro zone is back in recession and that the UK is teetering on the brink of following it.

The outlook is not all bad.

Oil prices, though volatile, are not trending higher as they were a year ago and global food price inflation has also eased. Forecasters, including the Bank of England think inflation will be close to its two per cent target rate by the end of the year.

This will ease the squeeze on households’ spending power. Meanwhile, interest rates are likely to remain at just 0.5 per cent, bond yields are at historical lows and the Monetary Policy Committee has increased the scale of quantitative easing to £275 billion.

A serious worsening of the euro zone crisis could lead to another credit crunch and deep recession. But, if this is avoided, the UK economy seems more likely to continue growing, albeit at a disappointing pace and one that is not fast enough to reverse recent increases in unemployment.

1. GDP increased by 0.6 per cent in the third quarter: Revised figures show real GDP increased by 0.6 per cent in the third quarter of 2011, but also that it contracted by 0.1 per cent in the second.

As a result the latest annual growth rate was unchanged at 0.5 per cent. Higher inventory building accounted for all of the growth in GDP in the third quarter (an increase in fixed investment being offset by weaker net exports).

If this inventory building was involuntary, as seems likely given the deterioration in economic sentiment during the autumn, it will reverse in the final quarter, subtracting from growth. This will make it very difficult for real GDP in aggregate to expand.

2. Retail sales volumes disappoint due to higher inflation: The volume of retail sales contracted by 0.4 per cent in November, though this followed two months went sales were up 1.6 per cent in total. Over the last year, retail sales volumes have increased by a disappointing 0.7 per cent. However, retail sales values were up 4.6 per cent over the same period.

The difference is inflation on the High Street of close to four per cent. Monthly data throughout 2011 have shown annual growth in sales values of between four and five per cent, despite increases in average earnings of close to two per cent and, recently, higher unemployment.

Households have not deserted the shops, and weak sales volumes are the result of higher inflation.

3. Saving ratio stable, real incomes down: This impression of households being willing to spend but finding their money goes less far is confirmed by the latest national accounts data.

These show the saving ratio is little changed over the last year – it is actually down from 7.0 per cent to 6.6 per cemt – while real disposable incomes (a measure of households’ purchasing power, after allowing for taxes and inflation) fell by one per cent. As a result, total consumer spending, in real terms, fell by one per cent.

See Figure 1:

4. Consumer confidence is at levels associated with recession: Both the main surveys of consumer confidence in the UK show it to be at very depressed levels. The Nationwide survey actually showed confidence edged a little higher in November but worries about the general economic situation and personal finances persist.

Meanwhile, the GfK NOP poll found confidence at its lowest level since early 2009, when the economy was still in recession.

5. Business surveys improve in December: The purchasing managers’ surveys of confidence in manufacturing, construction and the service sector all showed surprise improvements in December. The manufacturing index increased from 47.7 to 49.6 – just below the crucial 50 mark that is supposed to indicate the sector is expanding.

Meanwhile, the service sector index rose from 52.1 to 54 – its highest level since July. Amid all the gloomy talk about the UK economy, these three surveys – taken together – suggest the outlook might not be quite as bad as feared.

6. Manufacturing output is no longer increasing: Manufacturing output was up 0.2 per cent in October, when it was 2.0 per cent higher than a year earlier.

However, output has not increased in the last six months. The slowdown is broad-based and not just due to the problems of one or two sub-sectors within manufacturing. Only in the transport and ‘other’ categories is output growing at a more rapid pace.

7. Employment is declining: Employment fell by 63,000 in the latest quarter (comparing August-October with May-July) and it is 14,000 lower than a year earlier. The number of employees fell by 252,000 in the latest quarter and the number of self-employed people increased by 166,000.

There are now 4.14 million self-employed people in the UK – the highest number since records began in 1992 (and in all probability the highest ever).

It is not clear whether this shift into self-employment is voluntary or the result of insufficient employment opportunities. In the three months to September, employment in the public sector contracted by 67,000 and fell below 6 million for the first time since 2003. Meanwhile, private sector employment increased by just 5,000.

8. Unemployment is increasing: On the Labour Force Survey (LFS) measure, unemployment is now 2.64 million – the highest level since the three months ending in September 1994 – and the unemployment rate is 8.3 per cent – the highest since the three months to January 1996.

Over the last quarter – to the three months ending in October – it has increased by 128,000. The claimant count measure has gone up for nine consecutive months, though in recent months the scale of the increase has been falling and in November it was just 3,000.

Alongside the business survey evidence for December, this is perhaps another reason not to get too gloomy about the economic outlook.

9. Price inflation eased to 4.8 per cent: Consumer price inflation fell back from 5.0 per cent in October to 4.8 per cent in November (and from 5.4 per cent to 5.2 per cent on the retail price measure).

Forecasters, including the Bank of England, think inflation will be close to its target rate of two per cent by the end of 2012 and, while their track record in recent years has not been good, there is nothing in the latest data to suggest an alternative outcome is more likely. This will ease the squeeze on households’ purchasing power.

See Figure 2:

10. Wage inflation stuck close to two per cent: Average earnings increased by 2.0 per cent and regular pay by 1.8 per cent over the year to the three months ending in October 2011.

Despite higher price inflation, annual wage increases have fallen slightly in recent months. Increases in manufacturing, while still lower than in the service sector, have been improving, while increases in finance and business services have fallen, though at 3.4 per cent for regular pay they remain well above average.

11. Government borrowing is below last year’s path: Public sector net borrowing (excluding financial interventions) was £88.3 billion in the first eight months of the financial year, down from £98.7 billion a year earlier.

Borrowing for the whole year is set to come in lower than in 2010/11. The OBR’s latest forecast is for borrowing in the full year 2011/12 to be £127 billion, up from £122 billion forecast at the time of the March budget, but down from £136 billion in 2010/11.

12. Interest rates remain at 0.5 per cent; QE at £275 billion: The Monetary Policy Committee left interest rates at 0.5 per cent in December and the scale of quantitative easing at £275 billion.

13. Government bond yields at historical lows: The 10-year UK government bond yield fell during December and ended the year close to two per cent.

In part, this reflects the UK’s position as a relative safe haven, compared to the euro zone. But the poor outlook for growth and the improving outlook for inflation, Bank of England buying of bonds to implement quantitative easing, and the ever-receding prospects of higher interest rates in the UK also help to explain why yields are at historically low levels.

See Figure 3:

14. Sterling little changed in December: Sterling was largely on the sidelines in December as the euro fell against the US dollar. As a result, it was up against the euro, down against the dollar, but little changed in terms of its trade-weighted index.

See also:

• “We are spiralling into a prolonged and ghastly depression”: The economy in 2012 – Ann Pettifor, January 6th 2012

• A word for 2012: Liquidation – Cormac Hollingsworth, January 4th 2012

• Manufacturers still fear a double-dip recession in 2012 – Tony Burke, December 23rd 2011

• More grim news: Economists predict UK will be back in recession in 2012 – Alex Hern, December 12th 2011

• Osborne proved the doommongers wrong – the economy is even worse than we predicted – George Irvin, November 30th 2011

The rate of consumer price inflation fell to 4.8% in November, down from 5.0% in October (see Graph 1), according to figures (pdf) released today by the Office for National Statistics.

Graph 1:

Retail price inflation, meanwhile, dropped to 5.2% from 5.4%.

The recent track record of mainstream forecasters (as collated by the Treasury and published on its website) has not been good when it comes to inflation.

A year ago they expected consumer price inflation in the fourth quarter of this year to average 2.8%; today’s data suggest an outturn of 4.8% – two full percentage points higher. This is a massive miss in forecasting terms. By this time next year, the same forecasters expect inflation to have fallen back to 2.2% (and the Bank of England and the Office for Budget Responsibility take a similar view).

Should we believe them?

For roughly a decade between 1996 and 2006, forecasting inflation in the UK was a doddle. Domestic inflation pressures were muted and there were few external shocks, and those that did occur were relatively small. Inflation stayed close to its target rate.

However, the last five years have seen a series of larger external shocks, particularly as a result of volatile oil and food prices. As these are largely unpredictable, so UK inflation has become almost impossible to forecast with any degree of accuracy.

Economists got their 2011 inflation forecast wrong because they did not predict the price of crude oil would increase from $75 a barrel in September 2010 to $125 in May 2011, with consequent effects on petrol and domestic energy prices.

Whether their projection for 2012 proves to be right or not will depend, to a large extent, on what happens to the oil price over the next 12 months. If it continues to drift sideways, as it has done for much of the last six months, then inflation probably will fall back to close to its target rate; if it moves sharply higher (or lower), then inflation forecasts will turn out to be embarrassingly wrong again.

What happens to inflation matters for a number of reasons. Lower inflation will ease the squeeze on households’ real incomes (assuming wage increases are maintained at roughly the current rate). This might be expected to lead to stronger growth in consumer spending and in economic growth (though what happens in the eurozone will probably turn out to be even more important in this respect).

This will affect the nature of the political debate about the economy.

The opposition are on the front foot at the moment, claiming the paucity of growth in the UK is evidence that the coalition’s policies are not working. If oil prices had stayed at $75 a barrel throughout the last year and inflation was currently 2.8% not 4.8%, then growth would be stronger and the opposition’s arguments weaker.

It is quite possible the combination of lower inflation in the UK and muddling through in the eurozone will lead to some sort of economic recovery as 2012 progresses. If it does, and if it is strong enough to at least halt the rise in unemployment, then the opposition is going to need some new arguments.

See also:

• Economic update, December 2011 – UK teeters on brink of recession – Tony Dolphin, December 5th 2011

• Osborne proved the doommongers wrong – the economy is even worse than we predicted – George Irvin, November 30th 2011

• When does economic growth benefit people on low to middle incomes – and why? – James Plunkett, November 21st 2011

• High inflation + high unemployment = misery, misery, misery… – Tony Dolphin, November 16th 2011

• Inflation is worse for the worst off – Alex Hern, November 6th 2011

The UK economy is now teetering on the brink of recession.

The Office for Budget Responsibility forecasts real GDP growth of just 0.9 per cent in 2011, followed by 0.7 per cent in 2012. But in the two quarters between the third quarter of 2011 and the first of 2012 it expects no growth at all.

The OECD is even gloomier, predicting just 0.5 per cent growth in 2012 and a very mild recession in the current and next quarters. The causes of this weakness in the UK economy are complex. Soaring food and energy prices have undoubtedly played a part, lifting price inflation well above the current level of wage settlements and so squeezing households’ spending power. January’s increase in VAT from 17.5 to 20 per cent had the same effect.

More recently, the crisis in the eurozone will have affected confidence in the UK, though exports are performing better than domestic demand.

Cuts in public spending and employment have also taken demand out of the economy

Here is a scorecard of different economic indicators over recent months:

Commentary:

The latest forecasts from the Office for Budget Responsibility (OBR) show a marked deterioration in the outlook for real GDP growth in 2011 and 2012, and in the medium-term outlook for the public finances. The government is now expected to have to borrow, in total, £111 billion more in the next five years than was previously thought. As a result, net debt in March 2015 is now forecast to be 78.0% of GDP, rather than the 70.5% expected in March.

Instead of achieving his objective of a cyclically-adjusted current balance in 2014/15, the chancellor is now expected to reach this goal in 2016/17, and then only because he has announced further real cuts in public spending for 2015/16 and 2016/17.

All the chancellor’s room for manoeuvre has now been used up.

On the current rules, any further increase in the borrowing forecasts – whatever its cause – will necessitate more spending cuts or tax increases otherwise debt will not be falling in 2015/16. If the eurozone crisis escalates in the next few months, the chancellor will have to announce a further tightening of fiscal policy in March.

The chancellor is sticking stubbornly to his ‘Plan A’ for deficit reduction because, he argues, to not do so would risk the confidence of bond markets, and it is a fact that bond yields in the UK are close to record lows.

It is, however, debateable whether that is due to the chancellor’s fiscal policy or to the deteriorating outlook for growth, the recent increase in the scale of quantitative easing and the vanishing likelihood of an increase in interest rates in the foreseeable future. Certainly, the price to pay for low bond yields appears to be almost every other economic indicator turning red.

1. GDP increased by 0.5% in the third quarter: Preliminary figures show real GDP increased by 0.5% in the third quarter, and that it was also up 0.5% over the last year. The composition of this growth was, however, worrying. Consumer spending was unchanged from the previous quarter; business investment and exports were down.

Growth was driven by a 0.9% increase in government spending and a 0.7% contribution from inventory building. If this inventory building was involuntary, as seems likely, it will reverse in the final quarter, subtracting from growth.

2. Retail sales volumes being held back by inflation: Over the last year, retail sales values have increased by 5.4%, but retail sales volumes are up just 0.6%. The difference is inflation on the High Street of 4.8%. Given that average earnings have increased by around 2% over the last year and employment has fallen, the increase in sales values could be described as surprising.

It suggests households are switching spending from services to goods and that, despite low levels of confidence, they are not completely withdrawing into their shells. The latest month shows how lower inflation – just 0.1% in the month – can boost sales volumes, which were up 0.6%.

See Figure 1:

3. Consumer confidence is at levels associated with recession: Depending on which survey you choose to highlight, consumer confidence in October was either close to or at its lowest level since records began in the 1970s. On the previous occasions when confidence has been this low – in 1990 and in 2008 – the UK economy was going into recession.

Households are particularly worried about the general economic situation, less so about their own finances.

4. Business surveys mixed in November: The purchasing managers’ survey of manufacturing dropped again in November and is well below the crucial 50 mark, indicating output in the sector is now contracting. Orders – both domestic and overseas – slipped and are at their lowest level since the middle of 2009.

Surprisingly, service sector activity was stronger, with the purchasing managers’ index rising to 52.1, from 51.3 in October. However, job losses in the service sector were running at a faster rate than at any time since August 2010.

5. Manufacturing output is no longer increasing: Manufacturing output was up 0.2% in September, when it was 2.0% higher than a year earlier. However, output has not increased in the last six months, reflecting weaker demand at home and overseas. The slowdown is broad-based and not just due to the problems of one or two sub-sectors within manufacturing.

Only in the transport and ‘other’ categories is output growing at a more rapid pace.

6. Employment is declining: Employment fell by 197,000 in the latest quarter (comparing July-September with April-June) and it is 109,000 lower than a year ago. The latest breakdown of employment in the public and private sectors is only for June, but it is likely that private sector employment is still expanding, though no longer at a fast enough pace to offset the speed of contraction in public sector employment.

Surveys suggest private sector employment might also start to contract the in coming months as employers cut back recruitment plans.

7. Unemployment is increasing: On the Labour Force Survey (LFS) measure, unemployment is now 2.62 million – the highest level since the three months ending in September 1994 – and the unemployment rate is 8.3%, the highest since the three months to January 1996. In the last three months (to July-September) it has increased by 129,000.

Youth unemployment exceeds 1 million for the first time since comparable records began in 1992.

The claimant count measure has gone up for eight consecutive months, though in recent months the scale of the increase has been dropping – one modest bright spot in all the gloom.

See Figure 2:

8. Price inflation eased to 5.0%: Consumer price inflation fell back from 5.2% in September to 5.0% in October. Recent increases in domestic energy prices should now be fully reflected in the published data, so inflation has probably peaked. Forecasters expect it to drop sharply over the next year and, barring any further large increases in energy prices, it could be back in line with its 2% target rate by this time next year.

No doubt this will be a great relief for the Monetary Policy Committee. It will also ease the pressure on household incomes.

9. Wages fail to keep up with prices: Probably the main reason domestic demand in the UK has been so weak over the last year – and that growth has therefore disappointed – is the failure of earnings growth to keep up with inflation. Over the last year, to September, regular pay was up just 1.7%, while total pay, which also includes bonuses, increased by 2.3%.

See Figure 3:

10. Government borrowing is below last year’s path but above target: Public sector net borrowing (excluding financial interventions) was £68.3 billion in the first seven months of the financial year, down from £78.7 billion a year earlier. Borrowing for the whole year is, therefore, set to come in lower than in 2010/11.

The OBR’s new forecast is for borrowing in the full year 2011/12 to be £127 billion, up from £122 billion forecast at the time of the March Budget.

11. Interest rates remain at 0.5%; QE at £275 billion: The Monetary Policy Committee left interest rates at 0.5% in November and the scale of quantitative easing at £275 billion.

12. Government bond yields close to record lows: The 10-year UK government bond yield remained close to its record low level throughout November and at one point was below the 10-year German yield. This reflects the deteriorating outlook for growth, the additional QE announced by the MPC and the ever-receding prospects of higher interest rates in the UK.

13. Sterling little changed in October: Sterling’s exchange rate against the euro barely moved during November despite all the turmoil in the eurozone. Both sterling and the euro did, however, fall a little against the US dollar. Exchange rates generally remain surprisingly stable despite big swings in equity prices and bond yields.

See also:

• Look Left – Does Labour need its own Plan B? – Shamik Das, December 2nd 2011

• “We’re all in this together” – when ‘we’ means the bottom 80% – Will Straw, November 29th 2011

• Who is paying for the chancellor’s announcements? – Richard Exell, November 29th 2011

• How Osborne’s locked in to making the bad times worse – Tony Dolphin, November 29th 2011

• Osborne proved the doommongers wrong – the economy is even worse than we predicted – George Irvin, November 30th 2011

The Coalition now finds itself into a position where its economic policy is going to be ‘pro-cyclical’ – if the economy picks up it can stimulate it further, but if it continues to stagnate, the chancellor will be forced to further slam the brakes on. How have we ended up in this position?

 At first the government’s position looks tenable. The Office for Budget Responsibility’s new fiscal forecasts show that the Chancellor is still on course to meet his two fiscal rules:

1.      To achieve a cyclically-adjusted current balance by the end of the rolling, five-year forecast period

2.      To have public sector net debt (as a percentage of GDP) falling by 2015/16

At the time of the March 2011 Budget, the OBR judged that he was on course to achieve both of these objectives one year early (i.e. in 2014/15).

Its latest forecasts show this is no longer the case. The cyclically-adjusted current balance only moves into surplus in 2016/17 and net debt starts to fall in 2015/16.

 The Chancellor is only still on course to achieve his first objective because the end of the five-year period has been rolled forward from 2015/16.

A cynic might point out that by setting himself a rolling, five-year target the Chancellor never actually has to achieve a cyclically-adjusted current balance, he only has to appear to be on course to do so. This rule is turning out to be as flexible as Gordon Brown’s ‘Golden Rule’ that the current balance should average zero over the economic cycle.

 There are two important implications of these forecasts.

First, more deficit reduction will be required in the first two years of the next parliament. Previously, the Chancellor had created a bit of room for a pre-election giveaway in March 2015; that has now disappeared. Rather than the next election being fought over how to spend the benefits of growth, it will be fought over where spending should be cut.

Second, there is virtually no more room for manoeuvre on the debt rule: the OBR forecasts it falling from 78.0 per cent of GDP in 2014/15 to 77.7 per cent in 2015/16. This means that any future upgrading of the borrowing forecast for 2015/16 – whether cyclical or structural – will have to be offset by further cuts.

 This is very important. If the euro zone crisis deepens, leading the OBR to further downgrade its growth forecasts for 2012 and 2013 and to increase its borrowing forecasts out to 2015/16, then it will also be forecasting an increase in debt after 2014/15.

Unless, the Chancellor is prepared to relax his second rule, he will have to cut spending or increase taxes more than currently planned to get back on track.

 In other words, from here on fiscal policy will be pro-cyclical. Weaker growth will lead to fiscal tightening!

See also:

• “We’re all in this together” – when ‘we’ means the bottom 80% – Will Straw, November 29th 2011

• OBR confirm Osborne will borrow more than the Darling projection – Daniel Elton, November 29th 2011

• How the OBR’s growth projections have fallen – Will Straw, November 29th 2011

• Whatever Osborne’s growth forecasts today, the reality is probably worse – Daniel Elton, November 29th 2011

• Osborne’s stimlu-lite is more pork for vested interests – Alex Hern, November 29th 2011

If anyone was inclined to get excited about the news real GDP in the UK increased 0.5 per cent in the third quarter of this year – and few were – today’s release from the ONS (pdf) detailing the composition of that growth will make them think again.

In the third quarter, consumer spending was unchanged from the previous quarter, business investment was down 0.2 per cent and exports were 1.0 per cent lower. No sign here of the rebalancing of the economy the government is hoping for, though the fall in exports does provide some cover for the government to blame disappointing growth in the UK on the eurozone crisis.

Instead, growth was driven by a 0.9 per cent increase in government spending, which is now up 2.9 per cent over the last year, and by a 0.7 per cent contribution from inventory building, which went from £452 million in the second quarter to £2,907 million in the third.

If this inventory building was voluntary, then there is nothing to worry about. More likely, though, given the recent weakness in final demand in the UK economy – and in our main export markets – it was involuntary. Producers and retailers were probably expecting higher sales, and when these failed to materialise they were left with unwanted stock.

If this interpretation is right, then the outlook for the final quarter of the year is gloomy.

Business and consumer confidence indicators and anecdotal evidence from the High Street (with Arcadia announcing today it is planning to close 260 stores) suggests final demand will remain weak. And producers and retailers are likely to cut back production in an effort to reduce inventory levels.

A fall in real GDP now looks the most likely outcome.

See also:

• When does economic growth benefit people on low to middle incomes – and why? – James Plunkett, November 21st 2011

• UK not performing too well in the GDP growth championship – Ann Pettifor, November 17th 2011

• New LSE report says Labour’s economic record was “strong” and “not due to bubbles” – Will Straw, November 15th 2011

• Osborne has put Britain in an economic death spiral: Here’s how to break out – William Bain MP, November 14th 2011

• UK set for among slowest growth in EU – Will Straw, November 11th 2011