U.K.'s Real Problem Is Nominal Growth

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Wednesday 25 April 2012/By RICHARD BARLEY/WSJ

The U.K. is back in recession: the economy shrank 0.2% in the first quarter after a 0.3% decline in the fourth. Many, including the Bank of England, seem minded to discount the Office for National Statistics data, pointing to buoyant surveys and concerns over the accuracy of construction numbers. But that doesn't mean there isn't cause for concern: inflation has fallen too, so nominal growth is slowing. That's a challenge for the government's deficit strategy.

Economists had expected 0.1% growth, and the data may yet be revised to present a somewhat rosier picture. But there was worrying weakness in the services sector, which accounts for more than three-quarters of the economy. Despite Markit's purchasing managers' index suggesting services growth of 0.7% on the quarter, the ONS pegged it at just 0.1%, with February's index of services registering a month-to-month decline of 0.4%. The U.K. economy is far from healthy: GDP is still 4.3% below its peak in the first quarter of 2008, Citigroup notes, and has effectively flatlined for the past year. Talk of recession may cause businesses and consumers to rein in spending.

Renewed recession is a political headache for Chancellor George Osborne. But even if the recession turns out to be fake, the combination of very weak real growth and slowing inflation poses a longer-term challenge to the public finances, since nominal growth is vital for tax revenues, deficit calculations and debt-to-GDP ratios. The BOE's quantitative easing has helped prop up nominal growth, albeit with a suboptimal combination of higher inflation and weak real growth. But since inflation has been above target for so long, there are limits to how much more QE can help without denting the BOE's credibility.

In the medium-term, the Office for Budget Responsibility forecasts real growth of 3% and a GDP deflator of 2.5%, giving nominal growth of 5.5%. Others are more gloomy: growth might be just 1.5% and the deflator 1.75%, Legal & General Investment Management's economists say. Mr. Osborne has already been forced to admit his plan to eliminate the structural deficit will take two years longer than expected. The sluggish U.K. economy means it might take a lot longer.

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