HSBC Monthly economic commentary - May

The electorate’s indecision is final

As the political cliché says, “the people have spoken”. Last week, unfortunately, they mumbled and the message was rather garbled. Back at the economy meanwhile, the MPC’s May meeting (delayed by four days because of the election) ended with Bank Rate left where it has been for 14 months and no increase in the QE limit of £200 billion reached in February. No other outcome was ever likely. Perhaps the political confusion is a reflection of the economic uncertainty, which has intensified in recent weeks following events in Europe.

There is now a widely held view that the last quarter will be the earliest for a rate rise, although a growing minority of economists and analysts expect rates to be left on hold for the remainder of 2010. But there is as much nervousness about inflation as there is concern about the pace of recovery, which will complicate the MPC's discussions in the coming months.

Recovery confirmed

The fact that GDP grew by 0.2% in Q1 confirmed that the recovery is still on track, although the slower rate of growth (half that of the previous three months) raised fears of a double dip. These worries are overstated. Aside from the high probability of upwards revisions in later estimates, there were good reasons for expecting a slower rate of growth at the start of 2010. Two special measures introduced last year to boost spending – the VAT cut and the car scrappage scheme – both ended in Q1. This might well have led to some spending being brought forward, thus making Q4 2009 look stronger, and Q1 2010 weaker. In addition, the bad weather depressed activity and contributed to the dip in growth.

The recent real economy data still point to a slow upturn this year, in line with Chancellor Darling's budget forecast of 1.0%-1.5% for 2010. While a marked improvement on last year's fall of 5.0%, it is well short of the trend rate of +2.5%, implying pressure on jobs and profits. The key survey numbers (the monthly PMI data), which turned upwards in the middle of last year, still point towards expansion. Even construction is now in positive territory above 50, and manufacturing is at a 15-year high.

Still weak but moving slowly upward is the message from the recent data on high street spending, house prices, mortgage approvals, consumer credit and the labour market. After a six-quarter recession of unprecedented severity, it would be surprising if the upturn was any stronger. The danger is that it could be derailed as confidence remains fragile.

Risks remain

It is clear that the authorities are not yet ready to reverse the monetary and fiscal stimuli applied to counter the recession. Interest rates will stay at or near current levels for several months. QE is as likely, in the near term, to be increased as reduced. And any incoming government will take time to make a real dent on the public sector deficit and debt – the markets may have to be satisfied with statements of intent. Yet, despite the obvious weaknesses, inflation is lurking. Not only is the CPI above the target range (and higher than expected), but so are the lead indicators of consumer prices, such as input costs and output prices. Much of this is related to the recovery in the global economy and the weakness of sterling, but the MPC may not be able to ignore the CPI edging up in the coming months however weak the domestic economy might seem.

A second threat clearly comes from the fiscal problems in southern Europe, and the threat is twofold. Even if the situation in Greece stabilises, the possibility of contagion (as with the ERM in 1992) could prolong the uncertainty with damaging consequences for the region's economy and for its financial institutions. And for the UK, the dangers of stagnating eurozone growth and/or a strengthening of sterling on the back of a loss of confidence in the euro are obvious from the fact that Europe accounts for half our exports. Without the traditional levers of government and consumer spending, the UK is even more reliant of exports to generate activity.

A sense of perspective

The Governor of Bank of England allegedly made remarks recently to the effect that whichever party won the election would have to take such unpopular action that it would be a one-term government. If true, this seems a rather naive comment from someone who has been at the centre of events for a long time. Or perhaps it was just a case of long-term memory loss. Bad as the outlook appears today, 1979 was much worse. With the economy sliding into recession, the balance of payments deficit widening, a huge fiscal deficit, unemployment on its way to three million, the UK also had inflation in double figures and moving north, interest rates not far behind and an industrial relations system that was completely fractured. It makes today's environment look positively upbeat.

After 1979, the new government took decisive and unpopular action, and was rewarded not punished by the electorate with three further election victories. Ironically, the dreadful condition of the UK economy by the end of the 1970s followed five years of a weak, minority Labour government kept in office by Liberals. Not a happy precedent.

Dennis Turner Chief Economist HSBC Bank plc 11 May 2010