Despite a shrinkage in manufacturing and widening trade deficit, the IMF have hinted that the UK economy is beginning to emerge from one of the longest periods of economic stagnation / recession on records. They marginally increased their forecast for UK growth to 0.9% for 2013. Does the recent good news give hope to the UK?

Firstly, it is worth bearing in mind:

• The UK recession lasted much longer than necessary. (To what extent did EU recession cause UK recession)
• The recovery is unbalanced and so far has relied on falling spending. (Balanced economy)

However, there are hopes that the UK economy will finally escape the 5 year long stagnation and return to some form of normal growth. At the least, the UK is in a more optimistic situation than many EU countries.

Why is the UK economy looking more optimistic than many of our European partners?

Austerity lite. On its election in 2010, the UK government embarked on a high profile ‘austerity’ campaign. It promised to slash spending and reduce the deficit. Fears over job losses and spending cuts led to a decline in confidence, and combined with many other factors, slowed down the recovery.

Ironically, for all the noise the government made about austerity, it didn’t do particularly much. (Data on UK austerity) Public investment was cut deeply. But, there was only a relatively small fall in real spending in 2011/12. However, compared to our European partners, like Italy, Portugal, Spain and Greece, UK austerity was quite mild. Still it was a tightening of fiscal policy during a recession when fiscal policy should have been counter-cyclical. But, the damage from spending cuts was relatively minor compared to continent. Countries which embarked on deeper levels of austerity, have unsurprisingly experienced a much deeper recession.

Note: Figures for 2013 and 2014 are forecasts based on OECD June 2013 forecast. I feel that the forecast recovery for Spain and Portugal looks optimistic. (It wouldn’t be the first time the OECD have under-estimated negative effects of austerity on economic growth)

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In the past few years, Central Banks have been buying bonds to

• Increase money supply
• Reduce bond yields

The aim of quantitative easing is to avoid deflationary pressure and increase economic growth. Ending quantitative easing will mean
The Central Bank stop buying any more bonds. The process will then be reversed and, in time, the Central Bank will start selling the government bonds that they have.

The implications of this will be:

Falling bond prices and rising bond yields. Q.E. has had the effect of making bonds more attractive. Demand has been boosted by the Central Bank intervention, and this has encouraged investors to buy bonds (also helped by the relative security of bonds during a recession) However, when the Central Bank sell bonds, the price will go down, and this has the effect of increasing bond yields.

It is not just the Central Bank who will sell bonds. The fear is that when the markets see the Central Bank is ending Q.E. they will sell bonds because they know the market is turning. This is shown by the fact that bond yields rose following just an announcement from Federal Reserve that Q.E. may end ‘at some time in the future’

Money supply. If banks buy bonds from the Central Bank, they will see a fall in their cash reserves, and in theory, this could lead to lower bank lending as they maintain liquidity reserves.

• However, this effect may be very limited because quantitative easing in the first place didn’t really encourage any increase in bank lending. Banks just sat on their increased reserves. Arguably we have had the wrong ‘type’ of quantitative easing – but that is another question.

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When interest rates were cut to 0.5% in March 2009, few would have expected them to remain at 0.5 until the present time. Yet, we have seen an unprecedented period of zero interest rates. There is much speculation about:

• When interest rates will rise?
• How much will interest rates to increase to?
• What will be the effect of rising interest rates on an economy, that has got used to low interest rates?

When will interest rates rise?

Essentially interest rates will rise when there are signs of a strong economic recovery, which is starting to cause the threat of demand pull inflation. The problem is that, over the past few years, the UK has seen many ‘green shoots’ of recovery which have failed to translate into a lasting recovery. In recent months, retail sales have improved – indicating some signs of recovery, but the EU recession is holding back recovery, creating a patchy picture. Policy makers will want to see annualised growth of 2.5% a year before there is greater confidence that the UK is leaving the this era of stagnant growth.

Important factors in signalling an end of zero interest rates

Signs of core-inflation. The main motivation for raising interest rates is to prevent a return of inflationary pressures. If core inflation (which strips out volatile factors) starts to increase above 2%, then there will be a strong case to increase interest rates. In Europe and US, inflation is actually falling to below 1.5%. The UK headline inflation rate is higher, but during the great recession, the Bank of England have correctly been suspicious of the CPI rate. It hasn’t a true reflection of demand pull inflation – more a reflection of cost-push factors.

Wage inflation. A key sign for a return to economic normalcy, will be an increase in real wages. Currently nominal wage growth is very weak. Many workers are seeing wage freezes. In this climate of real wage cuts, economic activity is depressed and the case for higher interest rates remains very weak.

Fall in unemployment. The US and UK have seen moderate falls in unemployment levels, but unemployment is still significantly above the natural rate (structural unemployment). Whilst there remains demand deficient unemployment, there is a case for keeping monetary policy loose (low rates). Also, there is a well-grounded fear that unemployment rates offer a slightly better picture than reality. Unemployment figures have been masked by a rise in under-employment.

Any sign of boom in the housing market. An increase in house prices could restart a round of higher spending, driven by the ‘wealth effect’ However, in the UK, house prices still look overvalued on ratios of house price to incomes. A fall in house prices may be more likely than rising house prices.

How much will interest rates increase?

This is an interesting question. Pre-crisis, ‘normal interest rates’ may have considered to have been 5% There is a widespread assumption that a return to trend rate growth of 2.5% and inflation of 2%, would see interest rates of 5% – giving us a more normal real interest rate.

However, as Mervyn King recently pointed out, many young homeowners have borrowed extensively to get on the property ladder.

A small increase in interest rates will significantly increase the cost of mortgage payments, and therefore a small increase in interest rates will have a large impact on reducing economic growth. (see more housing stats) Because we have got used to low interest rates a small increase will have a big impact on the economy. In other words, the UK is particularly sensitive to interest rates. If interest rates increased to 5% quickly, it would have a large contractionary effect – which would end the nascent recovery. Therefore any increase in interest rates to prevent inflation can be relatively small.

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