UK Economic Growth collapses to -0.5% in the 4th Quarter of 2010 as the bad weather bites

Yesterday saw another leg up in the rally which has continued in the American equity market for several months now. The US Dow Jones equity index made a triple-digit gain of 108 points to 11,980 but could not quite gain the 12,000 level. There was some possible support from the International Monetary Fund for such an improvement as it raised its forecast for economic growth in the United States in 2011 from 2.3% to 3%. It is also true that equity markets often perform well after the State of the Union Address which is tonight,so maybe markets were anticipating this. Moving back to the IMF it raised it forecasts for world economic growth too in 2011 from 4.2% to 4.4% and also raised its forecast for the year just ended from 4.8% to 5%. So good news and a little fuel to the fire which has been affecting one type of economic theory which I discuss below.

Andrew Sentance challenges a key theory of the Bank of England by debunking the “output gap”

For those unaware of the situation Andrew Sentance is the member of the United Kingdom’s Monetary Policy Committee who has recently been voting for an interest-rate rise. Yesterday he gave a speech challenging the orthodoxies of his colleagues and agreeing with points I have been making pretty much since I began this blog.

So let us start with his reason for having the views that he has.

Whereas the Governor wrote only one open letter to the Chancellor (in April 2007) in the first decade of the MPC, he has written a further eight letters in the past three years. This run of letter-writing appears set to continue throughout this year, with inflation soon expected to rise to around 4% and possibly go even higher.

So he is worried about the UK’s inflation trajectory and goes on to explain the “output gap” which I put in for newer readers who may not have followed it.

The second challenge is to the notion of a simple trade-off between growth and inflation, which seems to underpin much thinking about economic stabilisation in policy-making circles. This approach leans heavily on the idea of the path of inflation being driven by an “output gap” between the current level of activity in the domestic economy and the amount that it could produce if it was operating at capacity.

Having identified what the output gap is Mr.Sentance then debunks it as being appropriate for these times.

In the analysis I have set out I have made relatively little mention of the domestic “output gap”, because I find this a rather narrow way of thinking about how the demand climate affects inflation in an open economy like the UK. The margin of spare capacity in the domestic economy, which output gap measures seek to capture, can have a bearing on inflation processes. But it is only one element of the way in which the demand climate affects inflation. The growth of domestic demand, global demand and the global capacity gap are also significant for an open economy like the UK. And looking beyond demand, the global inflation climate, the exchange rate and inflation expectations are also significant influences on our inflation rate, not just in the short-term but in the medium-term too.

In case the point might be missed then Mr.Sentance hits harder to emphasise his point.

The downward impact on inflation of spare capacity in the domestic economy is likely to be most noticeable in the recession or immediately after it. However, we have not seen much evidence so far that the margin of spare capacity is bearing down significantly on UK inflation………………..And many business surveys – such as the CBI Industrial Trends Survey – suggest
that the margin of spare capacity within firms is already back in line with historical norms.

And finally we get his policy prescription for the UK.

But when it is clear that global inflationary pressures, coupled with a substantial decline in the exchange rate and reasonably healthy growth of domestic demand are all contributing to a sustained period of above-target inflation, then the time has come to act. As I have argued in recent months, if we do not start to raise UK interest rates gradually soon, we risk having to do so more aggressively in the future.

Comment

The views expressed here are much more in line with mine than those expressed by the majority of the Monetary Policy Committee although I would add that Mr.Sentance trails me by a year and in monetary policy the timing of what you do can be as important as what you actually do. However. I wholeheartedly welcome his abandoning of the “output gap” mantra which has dominated the thinking of the MPC in spite of the fact that reality has plainly not followed the theory. I also welcome his attack on the use of the phrase one-off  by saying “but it would be a mistake to label all the global factors affecting inflation as one-off short-term disturbances”. You see that is exactly what many of his colleagues on the MPC have been doing.

A little more of this and the MPC would be in danger of getting a grip on events.

Just to link this story there has been a recent change in “output gap” theory which goes as follows. Even some of its adherents can see that it is not working in the UK so they have moved onto the world as a whole. This links with my mention of the IMF growth figures above as the world overall is recovering well from the credit crunch. Accordingly some think that here the output gap theory gives an explanation for some of the commodity price rises we are seeing. In essence they are arguing that the world as a whole has seen its output gap decline and accordingly prices are rising. This leads me to two thoughts. Firstly this is a more realistic proposition than applying it to the UK alone. And secondly never underestimate economists ability to recycle (failing) economic theories!

UK  Economic Growth or GDP Figures

This mornings figures were estimated a week or so ago by the National Institute for Economic and Social Research or NIESR and they forecast this.

Our monthly estimates of GDP suggest that output grew by 0.5 per cent in the three months ending in December after 0.6 per cent in the three months ending in November. These estimates suggest the economy expanded by 1.6 per cent in 2010. 

Unfortunately for them they got the 0.5% bit right but forgot to put a minus sign in front of it as the official figures have shown this morning that UK GDP contracted by 0.5% in the last quarter of 2010 rather than grew! There is a small crumb of comfort in the fact that output was 1.7% higher than a year before. But according to the Office for National Statistics we saw this on the quarter.

Output in the construction sector decreased 3.3 per cent.Output in the service industries decreased 0.5 per cent.

Ouch! One factor that needs to be taken into account is the unusually cold weather and snow which disrupted the UK in 2010 and the ONS has some thoughts on the effect of this.

The change in GDP in Q4 was clearly affected by the extremely bad weather in December last year. The disruption caused by the bad weather in December is likely to have contributed to most of the 0.5 per cent decline, that is, if there had been no disruption, GDP would be showing a flattish picture rather than declining by 0.5 per cent. We should emphasise that this assessment of the effect of the bad weather is the best we can make it at this stage, but is still inevitably uncertain………..weather creates more uncertainty than usual and increases the chance that the GDP estimate will be revised.

We also see the fall in GDP due to the bad weather expressed in terms of the individual sectors of the economy which the ONS feels caused the drop.

Construction -0.1 Services -0.4

In terms of estimating the breakdown of the services sector the ONS estimates that the main areas affected were hotels and restaurants,transport and recreation.

Comment

These figures came this morning as pretty much a complete surprise. Yes 0.5% was expected perhaps but not the minus sign in front of them. I feel compelled to point out that I have often argued that these numbers can be unreliable and we never actually ever know that they are correct, so a dose of caution is required. After the bad weather of December this point is likely to be particularly true.

Another potentially ameliorating point is the fact that if we look further back into 2010 we saw “upward surprises” to growth in the second and third quarters. The numbers then were unexpectedly strong being initially reported at 1.2% and 0.8% respectively. I wonder if some of the growth unexpectedly reported then has dropped out of the figures in some way giving us a surprise in the reverse direction.

Also as there will no doubt be some shock headlines in the mainstream media we should remember that many of the other indicators for the UK economy have been recording more optimistic numbers than this which again suggests that there may be something of an aberration in these figures. An example of this was that the latest figures for manufacturing and industrial production which covered the period up to the end of November rose on a quarterly basis by 1.2% and 0.8% respectively. Also it is worth remembering the figures for world economic growth from the IMF which were revised upwards for both 2010 and 2011 only yesterday.

In the end, in my view, you also have to take the figures on face value to a degree as I do not feel you can pick and choose the ones you accept. Should they turn out to be accurate then the situation may be worse than the stagflation scenario I have feared and written about. So let us hope the weather had a big impact and roll-on the 25th of February when we get a revision of these figures!

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19 thoughts on “UK Economic Growth collapses to -0.5% in the 4th Quarter of 2010 as the bad weather bites

  1. Firstly, how can the chancellor say it is fine to see negative growth as the report says it was down to snow? Without snow the report says that GDP would be flat, how is this not scary with cuts coming? Plus the report does not state we will make up the loss in GDP. Surely, it is dishonest of the chancellor to suggest the report excuses itself.

    Now to attack the ONS.

    They use a different method to calculate the GDP this quarter due to bad weather. Given experts thought there was growth, the question is whether the best data for 2 months and then the ONS trying to account for snow is better than the estimates all the experts have made on all the data.

    The ONS put a very dodgy argument about statistics at the back of their report. Average error is 0.07 and average total error is 0.19. Firstly the technique used is different, but are they really suggesting they would still expect only a 0.2 change on average.

    The average 0.07 suggests more that growth is miss placed in different quarters, the numbers went large positive to negative where as it may turn out to be two small positive quarters of growth.

    I love how ONS advertises the well-being survey given only financial institutes read the report. Maybe that was what Cameron meant by measuring well-being —we need to look after bankers well-being, yes they are rich but they are hated by the public at large which is not easy- and a politician would know.

    I have to slightly disagree with how you describe Sentence’s speech. He only spends a paragraph attacking UK output theory, contrast this to Posen who seems to attack other MPC members’ views.

    I do not think Sentence will completely agree with you: he does not regret past MPC decisions, he still thinks QE was needed and interest rates should not have been risen until recently. Also I thought he defends global output gap theory in his speech with which you seem to disagree.

    Regards,

    Fletch

    • When the Governor of the BoE begins and ends a talk with a discussion about happiness, then I think we are allowed to worry. His way of softening the Growthless inflationary recovery.

  2. Has anyone else seen this in the FT paper, when one banker told the newspaper that investors have been buying the bonds issued by the EFSF, “Investors love these bonds because they offer the safety of a triple-A credit, while at the same time they provide a bit of extra yield over German bunds.”

    I thought bankers didn’t like the EFSF issued bonds? Do they now think that roses are springing up in Euro land? Or is it just opportunists trying to make a quick buck?

    Robert

    • Hi Robert
      The sale went well because it allows investors to have something effectively backed by the German taxpayer but at a higher yield than German debt. The risk is slightly higher but at a time of low yields I guess it found some buyers. Also as it was the first issue some bought anyway for example Japan had promised to buy 20% of it.

      If you missed out don’t worry there will be plenty more to come! I suspect in the end it will be taxpayers who do not like these bonds rather than bankers……

  3. I have learned from experience that all ONS data published more recently has to be taken with a pinch of salt. The ONS has become unreliable, their statistics manipulated, and they have become an effective political bureau. They have lost all sense of true neutrality.

    The other issue which I feel is never made entirely clear with their published data is whether specific parameters like supposed “growth” are inflation adjusted and if so on what basis? Any parameters which are affected by real inflation but which are not computed on a real inflation adjusted basis are completely useless to everyone except politicians. It is not statistically realistic to purport to compare unlike with unlike in any case; so to change the basis of any statistic for comparison in any month or year is deliberately misleading, just as changing the datum for supposedly measuring inflation at any point is completely and intentionally misleading.

    Everything today seems to be about tricks, and smoke and mirrors. Many of those purporting today to be able to quantify elements critical to economic prosperity ought perhaps to stick to conjuring, where their evident skills might be applauded.

  4. On the output gap theory: surely it depends whether there is demand for the products of your “spare capacity” – i.e. spare capacity in construction and real estate services isn’t going to help very much with supply of food, energy, clothes, manufactured goods, etc. etc.

    I can see Sentance being beaten over the head with “-0.5% growth” in the next MPC meeting, which is a tragedy.

    Couldn’t the imminent winding down of the SLS and renewed housing slump have something to do with the contraction in the construction and retail sectors? I still see the MPC fretting over the housing market at least as much as inflation, due to their “financial stability” mandate. Call me a cynic, but I think output gap theory is just a fig leaf.

    • Hi Graeme_b, I don’t understand that the MPC has any mandate or authority relative to “financial stability”! (That is in any case a somewhat subjective term; what does it actually mean? It could be interpreted to mean almost anything you wanted it to mean at any particular time.) I think you will find that it is only the BoE who are charged with any responsibility in that regard.

      Have a look at the written remit of the MPC, which is embedded within the BoE web site as a totally separate document. Their remit and authority is in fact extremely limited, and more recently they have acted totally outside that remit, but no sanction has been exercised against them as one might have expected in a properly controlled structure.

      • Hi Graeme,

        Thanks for confirming what I pointed out to you, in that it is stated on the BoE web site that it is the BoE who have been given the responsibility amongst things to attend to “financial stability”, whatever any particular individual interprets that to mean, and that it is not in the MPC’s remit to do so. In my opinion 4% inflation now clearly rising significantly in no way can be interpreted as “financial stability”; indeed quite the reverse! That is Economic instability

        It is not “difficult” to find that the MPC has no responsibility or authority in respect of “financial stability”. All you have to do is to read their remit which is clearly stated in the document on the BoE web site. The MPC does not “belong to the BoE”. Its members are appointed directly by the UK Chancellor of the Exchequer and it consists mainly of supposedly independent members who are not directly employed by the BoE, with the governor of the BoE as its chairman.

        The purpose of a remit is to define the responsibility and authority of an individual or body. If anything is not in a remit then they or it have no responsibility nor authority to act in respect of it! That is pretty basic.

      • Drf: OK, my apologies once again for not reading your reply carefully enough. I am sure you are right about the MPC’s written remit and independent status. What is your explanation for their behaviour though? Incompetence?

      • They have 4 out of 9 members who are independently put there by the Chancellor.

        2 voted for a rise.
        1 to print money.
        1 to do nothing.

        Rise in interest rates wins.

      • Hi Graeme, I believe the main reasons the MPC has not responsibly met its simple remit (and thus has become an expensive white elephant) are:

        1) Most of the MPC members and governor of the BoE were deliberately selected by Brown for their left wing semi-neo-Keynesian views;

        2) When the housing market ran away out of control they failed to increase base rate, which they should have done according to their remit, to head off potential inflation;

        3) They have continuously acted outside their remit and have never been sanctioned, so they became bolder and bolder delusionaly eventually believing that they were responsible for fiscal control of the UK Economy, rather than the Chancellor of the Exchequer! They then implemented completely irresponsible and reckless semi-neo-Keynesian policies to attempt to avoid the natural Economic correction which was in fact inescapable;

        4) It suited governments to allow them to continue with these essentially illegal policies so as to generate inflation which would write-off a significant amount of the Public debt..

  5. Re: interest rates
    Have a look @ Google + Roger Bootle, the economist who 4 told this mess coming in the early part of the Noughties. The headline says it all: MPC Members must stop up their ears: even a small rate rise could be fatal. 23 jan ’10 Telegraph, sorry no link do 2 old n95’s limitations but i assure u it is easy to find and should turn the argument for interest rises onto it’s head. My gut instinct as a hobby economist has been hold. I feel he is optimistic in saying 2 yss bad then growth but we’ll see.

  6. Does anyone else think it’s interesting that the narrative appears to be changing. All of a sudden doing something to stimulate economic growth is flavour of the month (and the message is that recovery depends on it) and Mervyn King, at least, has noticed that wage deflation is leading to a collapse in spending and has become drag on growth (and on the devaluation of debts).

    This seems to me to a belated realisation that “getting the deficit under control at all costs (and letting it be known, with a nod and a wink, that price inflation will be tolerated in order to reduce the debt)” isn’t going to cut it.

    Specialist subject “stating the bleeding obvious”.

  7. Chris, many ppl myself included knew we were in this mess for the long haul and it amazes me to think ppl expect this problem to be finished quickly by a few actions. We got some smart clues at the start of this crisis ‘worse than the 30’s great depression’ that was said of job losses in America 2yrs ago, we follow them and as i studied the great depression as a child (my parents went thru it & i was curious) u’ll know most of us havn’t seen real pain yet. There is no point blaming, imho u have to trust as this is long term strategy not a quick fix. Many of us have been going down this road for years and why many of us voted out Labour to get the tight Tories in. Medicine btw isn’t supposed to be nice but in the end we are probably going to lead the way out. I wish we hadn’t bailed the banks cause we have many companies to fall, many homeowners to default; in short what we saw in America plus more tho i think we are kinder with it again imho so our banks are in for a hammering, i hope we let them fail this time with the government quick to compensate the public.. We have a long tricky 20yrs ahead of us imho. Thank god we have ppl now in power who care and will take us where we need to be.
    At the end of the great depression of the 30’s opportunities abound; please be patient & lets all learn from this that as a country we can never be rich if we have debt.

    • Thank god we have ppl now in power who care and will take us where we need to be.

      Shaun likes to keep things non political. In any case I think you are deluded.

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