12 March 2017

Financial Times: Three visions of UK economy take shape on verge of Brexit talks

Scenario 1

The economy slows as household finances are squeezed by higher inflation, business investment is flat and trade gains only a modest boost from a weaker pound. The strong momentum in the economy at the turn of 2016-17 keeps growth high before a fall in the rate in 2018. Unemployment remains stable at about 5 per cent with wage increases not reflecting higher inflation.

There are ups and downs in the Brexit negotiations but nothing sufficiently significant to make people change how much they spend and borrow. Continued talk of a transition deal makes everything seem quite distant.

Assessment:

This is a mediocre outlook for the economy, better than what was thought likely immediately after the vote to leave but worse than most forecasts before the referendum.

Many economists think such a reduction in growth is necessary after sterling’s fall. “You want consumers to slow when faced with an adverse trade shock [to their incomes],” says Andrew Benito of Goldman Sachs.

Likelihood:

Most economists subscribe to a version of this view, which forms the basis of predictions by the Bank of England and Office for Budget Responsibility.

Verdict:

A typical consensus forecast. Nothing goes spectacularly wrong and nothing particularly right.

Scenario 2

Consumers continue to defy expectations — because they believe the prime minister will make a success of Brexit. Borrowing continues to grow strongly and savings drop further. As a result, spending growth continues to outpace income growth.

Unemployment falls gradually towards 4.5 per cent and wages increase in real terms.

Negotiations with the EU go smoothly. Expectations of a deal that is mutually advantageous help consumers to feel confident that their finances will not be harmed by Brexit.

Assessment:

In comments last month, Mark Carney, Bank of England governor, laid out a similar scenario — of strong growth, rising business investment and higher inflation, all of which would lead to an increase in interest rates.

Andrew Lilico, of Europe Economics, adds that since the pound has fallen so much already the downside risks to sterling are limited — which could relieve some of the pressure on incomes.

But other economists are worried at the prospect of rapid growth based on more consumption — unless productivity surges upwards to save the day.

“Can consumers borrow even more?” asks Erik Britton, director of Fathom Consulting. “Of course they can. That was the big error of judgment that ultimately triggered 2008-09. Would that be a good thing? No, it makes the crisis to come even bigger.”

Likelihood:

After the past six months, few economists are willing to dismiss the possibility of a further surprise on the upside. But few see such a buoyant outcome as their central scenario.

Verdict:

A path that suggests the second half of 2016 sets the tone for the next two years. If the future was just a continuation of the recent past, economic forecasting would be much easier than it is.

Scenario 3

As higher import prices erode consumers’ incomes they finally notice that they had little justification for increasing their spending in 2016 faster than their incomes grew. Consumption stalls as people seek to repair their finances. Government spending is also weak.

The economy keeps growing only thanks to a modest contribution from trade. Inflation weakens in line with fading demand while unemployment rises to about 5 per cent and wage growth remains stagnant. Difficult negotiations with the EU create widespread fear that the business environment will deteriorate sharply after the UK leaves the EU. Investment falls.

Assessment:

Such a pessimistic scenario — which would leave households worse off than at the end of 2016 — would require a substantial change in sentiment in business and among consumers. This has not yet been evident, but few think it impossible.

Mr Britton at Fathom Consulting argues that, with no obvious driver of economic growth, the outlook is likely to be weak — and the BoE has little ammunition to counter a downturn. “It’s down to the bottom of the barrel,” he says.

Related article Should Britain pay the Brexit bill? The question of whether the UK should pay billions of euros is taking centre stage. Outside perceptions of the UK will also matter.

Mr Benito of Goldman Sachs says international opinion was unimpressed by the Conservative party conference in October, when Mrs May denounced “citizens of the world” and ministers made clear their post-Brexit priority of clamping down on immigration.

He adds that the government later regained its poise, halting flight from Britain. “The downside scenario looks more remote now than in October, but as negotiations get under way after Article 50, this is the one to keep bearing in mind,” he says.

Likelihood:

Many economists predicted this type of outcome after the referendum. Scarred by the experience, far fewer judge today that this pessimistic scenario remains the most likely outcome.

Verdict:

The delayed reaction scenario — the idea that despite consumers’ initial resilience, the fact that Britain is leaving the EU will inevitably drag the economy down one day. The BoE finally abandoned this analysis in February. Many others say logic dictates such an outcome will come to pass. But previous forecasting failures must raise doubts about its validity during the next two years.

Full article on Financial Times (subscription required)

© Financial Times