Why I was right to predict a GDP contraction

 
Andrew Lilico
TODAY’S GDP figures took almost everyone by surprise. The snowfall obviously added uncertainty to the December numbers, but this was expected to show in later revisions.

Instead, underlying output was softer than thought, and the Office of National Statistics chose to make an early guess at a large negative effect of the bad weather.

But we probably shouldn’t have been as surprised as we are. We knew the service sector was contracting even in October, well before the snow.

And I and others had for some time been forecasting the likelihood of a quarter of contraction in GDP in either the last quarter of 2010 or first quarter of 2011, because every recession since quarterly records began has involved at least one in the recovery phase.

This quarter’s contraction has little to do with the coalition’s spending cuts – yet. The key drivers of the fall were construction, and business services such as consultants or outsourcing. But the VAT rise this month could cause another quarter of contraction to start 2011.

It’s very important now that the government does not backtrack on the spending cuts. What has been announced is already barely adequate and “rear-loaded”, so many of the cuts do not take effect for some years.

On tax rises, matters can be a little more flexible if needed. The VAT rise is already done, but with the Budget coming up there is the option of raising the income tax threshold a bit more than expected. That shouldn’t be done just on the basis of a bad statistic because of a bit of snow, but if the first three months of 2011 continue to look weak, income tax cuts should be an option.

I and others have been urging more quantitative easing for some time, and this GDP contraction strengthens our case. Inflation is well above target and will go higher: Citi has forecast CPI of five per cent, and I am still less sanguine – I think it likely to reach six per cent in 2012. That means we will have to raise rates very aggressively from the end of 2011 into 2012, potentially to above 5.25 per cent to keep CPI inflation to only a six per cent peak. But that is next year’s story.

It’s quite normal to have a quarter or two of contraction at this point in a recovery from a recession. It would have been a surprise not to see it after as deep a recession as in 2008/09.

But from the middle of 2011, barring calamities, I believe we will see very strong investment-driven growth.

For now, we should not panic, but we should be flexible where appropriate – on QE and on taxes.

Dr Andrew Lilico is a director at economic consultancy Europe Economics.