Global Insight Perspective | |
Significance | Growth is now below trend and likely to slow significantly further over the coming months in the face of serious headwinds. |
Implications | Extended below-trend growth should eventually significantly dilute underlying inflationary pressures. However, the current elevated inflation levels and risks mean that the Bank of England is likely to be very cautious in trimming interest rates further. |
Outlook | Global Insight forecasts GDP growth to moderate from 3.0% in 2007 to 1.6% in 2008 and 1.4% in 2009. Furthermore, we see downside risks to these forecasts, particularly in 2009. |
The Office for National Statistics (ONS) has confirmed that GDP growth moderated to 0.4% quarter-on-quarter (q/q) in the first quarter of 2008. This was the weakest q/q growth rate since the first quarter of 2005. Furthermore, it was below trend growth (widely believed to be 0.6-0.7% q/q). GDP growth had previously slowed to 0.6% q/q in both the fourth and third quarters of 2007 from 0.8% q/q in the second. Meanwhile, annual GDP growth slowed to a two-year low of 2.5% in the first quarter of 2008 from 2.8% in the fourth quarter of 2007 and a peak of 3.2% in the second quarter of last year.
Service Sector Slows Further, While Industrial Production Contracts
On the output side, growth in the first quarter of 2008 was limited by a further slowdown in the dominant services sector. The sector grew 0.5% q/q, the weakest performance for three years and down from expansion of 0.7% q/q in the fourth quarter of 2007 and 0.8-1.0% during the first three quarters of last year. Consequently, the annual growth rate moderated to 2.9% in the first quarter of 2008 from a peak of 3.9% in the third quarter of 2007. This was largely due to a marked slowdown in growth in the business services and finance sector to 0.4% q/q and 3.8% year-on-year (y/y) in the first quarter of 2008 from 1.4% q/q and 5.2% y/y in the third quarter of 2007. Indeed, this was the weakest q/q growth since the second quarter of 2003 and largely reflected the fact that activity in the financial intermediation sector was hit by the credit crunch and financial-market turmoil. Government and other services expanded by 0.5 q/q and 2.0% y/y in the fist quarter of 2008, while there was solid expansion in distribution, hotels, and catering (up 0.7% q/q and 2.5% y/y) and transport, storage, and communications (up 1.0% q/q and 3.2% y/y).
Meanwhile, industrial production contracted by 0.2% q/q in the first quarter of 2008, limiting y/y growth to 0.6%. Manufacturing output expanded by 0.3% q/q (and was up 1.0% y/y) but this was countered by marked falls in extraction activity (down 4.6% q/q and 4.5% y/y) and utilities output (down 1.3% q/q, although up 1.7% y/y). Finally on the output side, construction output growth slowed to 0.5% q/q from 1.1% q/q in the fourth quarter of 2007, although it was still up 2.9% y/y.
Robust Consumer Spending Limits Growth Slowdown
Household spending surprisingly expanded 1.3% q/q and 3.0% y/y in the first quarter of 2008. Consumption growth had previously slowed markedly to 0.1% q/q in the fourth quarter of 2007 from 0.7-0.8% throughout the first three quarters. The strength of consumer spending in the first quarter was particularly surprising given that consumers faced mounting headwinds, including muted disposable income growth, an increasing squeeze on purchasing power from higher energy and food prices, tighter lending conditions, and a markedly slowing housing market. Indeed, there are significant doubts about the retail sales data in recent months, as expressed by the Bank of England. Meanwhile, government spending grew 1.0% q/q in the first quarter of 2008, having fallen by 0.5% q/q in the previous quarter; it was up 1.7% y/y.
Disappointingly, gross fixed capital formation contracted by 1.6% q/q in the first quarter of 2008, the sharpest drop for five years and in marked contrast to a 1.8% q/q increase in the fourth quarter of 2007. Annual growth in gross fixed capital formation slowed to just 1.1% in the first quarter, from 4.1% in the fourth quarter of 2007 and a peak of 9.6% in the fourth quarter of 2006. Total investment was limited in the first quarter of 2008 by business investment, which contracted 1.4% q/q after overall expansion of 7.9% in 2007. In addition, investment in dwellings was reported to have been subdued. Meanwhile, inventories (including the alignment adjustment) rose by a much reduced £968 million (US$1.9 billion) in the first quarter. This was down from an increase of £2.9 billion in the fourth quarter of 2007. Consequently, domestic demand expanded 0.1% q/q and 2.6% y/y in the first quarter of 2008.
Net trade lifted q/q GDP growth by 0.2 percentage point in the first quarter. However, this was only because imports contracted 0.6% q/q, while exports were flat q/q. Exports had previously fallen by 0.5% q/q in the fourth quarter of 2007, so there are signs that slowing global growth may be countering the beneficial impact of the weaker pound.
Outlook and Implications
We expect growth to lose further momentum over the coming months and to be markedly weaker overall in 2008. Despite jumping in the first quarter of 2008, consumer spending seems certain to be increasingly pressurised by muted real disposable income growth, tighter lending practices, heightened debt levels, a markedly softer housing market, and lower equity prices. Furthermore, growing concerns about the economic outlook are likely to encourage consumers to tighten their belts, while unemployment has started to rise. Probable gradual Bank of England interest-rate reductions will help the consumer, but will only partially offset these major headwinds.
In addition, business investment plans are being pared markedly in the face of the ongoing credit crunch, slowing growth, and increased doubts and fears over the economic outlook. Meanwhile, despite being helped by a softer pound, exports seem likely to be increasingly hit during 2008 by slowing global growth. Finally, weakened public finances mean that there is little, if any, scope for the government to take fiscal measures to boost growth, while ongoing inflation risks mean that the Bank of England is only able to cut interest rates gradually. Consequently, in our May detailed and monthly forecasts, we projected GDP growth to slow markedly from 3.0% in 2007 to 1.6% in 2008 and 1.4% in 2009. Furthermore, we consider the risks to the growth forecasts to be to the downside, particularly in 2009.
Interest Rates Likely to Fall Gradually
We suspect that extended muted economic activity will eventually markedly dilute underlying inflationary pressures and lead the Bank of England to cut interest rates further. However, with inflation likely to approach 4.0% in mid-2008, the Bank of England will tread extremely carefully on the interest-rate path for the time being. Indeed, it currently seems highly unlikely that the bank will be prepared to trim interest rates again until August at the very earliest; and, even for that to happen, the bank will want clear evidence that wage moderation is continuing and that reduced demand is undermining companies' pricing power. The Bank of England will also need to see that inflation expectations are being capped. Global Insight still suspects that interest rates could eventually fall to as low as 4.0% in 2009, but it will be a gradual process.