Economic data picks up but the Bank must clarify its position on inflation

 
Andrew Lilico

THIS week has seen a further significant pick-up in the economic data. The Markit/CIPS purchasing managers’ index (PMI) showed services output in July rising at the fastest pace since the boom-times of 2006. The “composite PMI” (which includes manufacturing and construction as well as services) rose at its fastest ever recorded rate since the index began in 1998. The British Retail Consortium says July was the best month for retail sales since 2006.

So, how fast could the UK economy grow over the next couple of years – say, out to the time of a General Election in the second quarter of 2015? Traditionally, it was believed that the long-term growth rate for the UK economy was about 2.5 per cent per year. If we considered the decade from the second quarter of 2005, if growth to 2015 were to get us back to a 2.5 per cent trend, that would mean we are currently about 13 per cent below trend output and could sustainably grow at 2.4 per cent per quarter for the next two years. No-one believes that’s going to happen, alas.

According to Europe Economics’ models, the long-term sustainable growth rate in the UK dropped in the 2000s, and by 2005 was around 1.5 per cent per annum for the forthcoming decade (out to 2015). That would imply UK GDP is currently over 6 per cent below trend, and we could grow at a little over 1.1 per cent per quarter for the next two years, implying annual growth in 2013 of 1.8 per cent and in 2014 of closer to 4.5 per cent (similar to 1994) – a true boom.

However, it is possible that the financial crisis and the policy response to it has damaged potential output. Some estimates suggest a one-off loss of 4 per cent, implying a current output gap of a little over 2 per cent, not 6 per cent. That would imply we could grow at 0.6 to 0.7 per cent per quarter for the next couple of years (about the same rate as in the second quarter of 2013, the most recent official data released), with GDP rising 1.4 per cent in 2013 and 2.6 per cent in 2014.

For what it’s worth, my guess is that the sustainable quarterly growth rate could be closer to 1 per cent than 0.6 per cent for the next couple of years (absent some further flaring of the Eurozone crisis, a widening of war in Syria, or a hard landing in China). But if growth reaches that level, it is likely to race beyond it into an inflationary zone.

Business investment has been greatly suppressed since 2008 – even a modest recovery is likely to stimulate considerable catch-up, and investment can spike dramatically. For example, investment in the first quarter of 1973 was 25 per cent higher than in the same three months of 1972, driving a wildly unsustainable 10 per cent annual spike in quarterly GDP. Even a modest echo of that in 2014 could see growth well above expectations. Wage inflation has been suppressed since around 2005, and real wages have dropped significantly in recent years, especially during the inflationary spikes of 2008 and 2011. Broader economic recovery is likely to trigger a widespread demand for catch-up on past foregone wage rises.

With broader economic recovery, bust banks that have been reluctant to lend out the vast cash injections they have received from the Treasury and the Bank of England may suddenly find lending attractive, driving a rapid acceleration in monetary growth.

Against all of this, there will be no expectation that the Bank of England will act. Indeed, today we are expected to have “forward guidance” from the Bank about why it will not raise interest rates to get inflation down as the economy grows – as if the experiences of 2008 and 2011 had not already convinced everyone that the Bank of England’s inflation target imposes no constraint and is there only to be breached.

The key “forward guidance” we really need is an indication from the Bank as to how much inflation would force it to tighten policy rapidly, even at the expense of some growth. We know from 2008 and 2011 that 5 per cent isn’t high enough. What would be? Consumer Price Index of 8 per cent, like in the early 1990s? More?

No-one believes that the Bank of England would pay the price of extra recession to meet its notional/fictional 2 per cent target. It has made that abundantly clear. But having no credibility to its promises could be costly when it finally does try to get inflation down. Getting inflation down in the 1980s involved 3m unemployment for 51 consecutive months. Can we avoid something similar in the late 2010s?

Andrew Lilico is the chairman of Europe Economics.