The outlook for the UK has picked up over the past three months but stronger productivity and wage growth will largely determine how durable its economy is over the next couple of years. Inflation should remain fairly benign -- consistent with moderate levels of spare capacity and a higher British pound -- which suggests that the Bank of England (BoE) won’t be in a great hurry to raise rates.
In its quarterly inflation report, the BoE revised up its outlook for the UK economy. Real GDP is expected to rise by 3.5 per cent in 2014 (up from an estimate of 3.4 per cent in the May inflation report), while the outlook for 2015 was maintained at 2.9 per cent.
These upward revisions follow another quarter of solid data, with the UK economy growing by 0.8 per cent in the June quarter and the unemployment rate easing to 6.4 per cent. Over the past 18 months the economy has consistently exceeded expectations -- with the unemployment rate falling much faster than the BoE anticipated.
Weakness in the eurozone remains a threat to the UK recovery but global growth appears set to rebound somewhat following a softer-than-expected first half -- most of which was driven by the US. However, the recovery in the eurozone remains tentative at best, with a number of countries walking a fine line between recovery and recession.
Poor productivity and sub-par wage growth remain the greatest risks to the UK recovery; although at this point the BoE “envisages that they will rise over time, and … underpin a sustained expansion”.
Nevertheless, productivity continues to miss expectations and remains more than 4 per cent below its pre-crisis peak. The BoE notes that “the level of productivity is currently around 17 per cent below where it would have been had its pre-crisis trend continued”. UK productivity continues to lag behind countries such as the US and France.
In that regard, the UK has become a little like Italy -- another country suffering from a remarkably poor productivity performance over a number of years (Italy can’t blame its recession on the GFC, August 7).
A lack of investment is certainly one cause -- financial markets have performed poorly following the global financial crisis -- but inadequate allocation of capital may also be a contributing factor. The BoE notes that “resource reallocation from low to high productive uses is likely to have been impaired”.
Partly in response to poor productivity, nominal wage growth remains subdued in the UK and continues to decline in real terms. As a result, household budgets remain under pressure -- particularly given the high level of household indebtedness.
Consistent with the US and Australia, poor wage growth also reflects existing spare capacity within the labour market. The BoE estimates that the level of spare capacity is worth around 1 per cent of GDP. However, with the economy rising at an above-trend pace, that capacity is vanishing with each passing quarter.
Soft wage growth may also reflect the changing composition of UK employment. Employment growth has been centred in occupations with lower skill levels, which is weighing on productivity and wages. The BoE estimate that composition may be cutting as much as 0.5 per cent from annual wage growth.
The BoE committee believes that “inflation will remain close to, but a little below, 2 per cent for the next couple years” but will gradually trend towards the central bank’s annual inflation target of 2 per cent. A mixture of soft wage growth and a rising currency will put downward pressure on inflation and ensure that inflationary pressures remain modest over the outlook.
Overall the UK is well placed, with the economy set to expand at an above-trend pace over 2014. The BoE has taken steps to curb excessive mortgage lending -- with tentative evidence that they are having the desired effect -- and that will allow the central bank to delay a decision on rates until it is happier with the combination of wage growth and productivity.
If those two factors don’t improve then the recovery will run out of steam fairly quickly. The household sector remains a key part of any recovery but it will be difficult for household spending to maintain its momentum if real wages continue to fall -- particularly once the labour market settles at a more sustainable unemployment rate.