London emerges from the fog

It’s easy to be optimistic about UK prospects in light of the country's first-quarter GDP print, despite an effective lack of growth over the past six years.

The UK recovery strengthened in early 2014 and with the labour market improving and inflation contained there is reason to be optimistic about the economy’s prospects this year. But with real GDP still below its pre-crisis peak the recovery still has some way to go.

Real GDP rose by 0.8 per cent in the March quarter, narrowly missing expectations, to be 3.1 per cent higher over the year. It marks a new phase in the post-crisis recovery, with growth returning to its pre-crisis trend.

Growth was driven by services (up 0.9 per cent in the March quarter) and production (up 0.8 per cent), with construction rising by only 0.3 per cent. Services contributed 0.7 percentage points to growth in the March quarter.

By comparison, agriculture declined by 0.7 per cent in in the quarter and has fallen by 7.5 per cent over the past three years.

Graph for London emerges from the fog

Despite the strong growth, the UK economy remains 0.6 per cent below its pre-crisis peak. It highlights the depth of the recession and the ill-timed austerity measures to see that the economy has effectively not grown in six years. Real GDP per capita – a measure of living standards – remains well below its previous peak.

Nevertheless it is easy to be optimistic about the UK’s prospects. Labour market conditions have improved significantly over the past year, with the unemployment rate falling to 6.9 per cent over the three months to February.

But as always the unemployment rate fails to tell the full story. The key is that the unemployment rate has declined while workforce participation has increased. By comparison, the US has experienced a similar fall in its unemployment rate but this has been partially driven by retirements and discouraged workers leaving the work force.

Graph for London emerges from the fog

Obviously the recovery is still in its early stages but it is certainly not as fragile as it once was. The unemployment rate can plausibly drop another 1.5 percentage points before inflationary pressures build, while participation may climb a little further but is unlikely to hit its pre-crisis level.

With plenty of slack remaining in the labour market, inflation remains contained and sits a bit below the Bank of England’s target. As with other recovering economies, the key indicator will be domestic wage pressures and on that basis the BoE has little present concern. It will be happy to leave rates unchanged for now and realistically we are unlikely to see a move on rates until early 2015.

Growth among the UK’s major trading partners has generally strengthened in early 2014. The eurozone is taking tentative steps and while the recovery remains fragile at least it is occurring. The US has shrugged off early concerns about poor weather and is now back on track.

In the minutes of its April 8 board meeting, the BoE acknowledged some concern regarding the Chinese economy, noting that a slowdown in China might have a larger impact on the UK than implied by its 4 per cent share of UK exports. The implication is that a slowdown in China would have spillover effects that would impact economies globally even if they don’t trade extensively with China.

For now though the UK economy is in a sweet spot. The labour market is improving, growth has returned to its pre-crisis trend, and both inflation and inflation expectations remain well anchored. There are obviously some concerns – fragile eurozone recovery and China slowdown among them – and the recovery still has a long way to go. But for now the BoE can sit back and relax.

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