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Why rises in interest rates and population could spell more economic woes ahead

It was good to see a thoughtful comment piece the other week by the Business Editor, picking up on my suggestion that, despite recent encouraging economic data, this is not the time to start turning cartwheels of elation.

We should leave that to the remarkable Commonwealth Games gymnasts.

Essentially - without wishing to be an unduly dismal scientist - there are two key points about our economic situation and outlook which require emphasis. First, despite the UK and Scottish economies having now recovered to the point where aggregate output has overtaken the previous peak, we are still very much in negative territory as compared to where we would have been without the debacle of the 2008 collapse. Second, the recovery underway is not yet sufficiently balanced and broad-based for sustainability to be assured - particularly as we approach a time when a rise in UK interest rates is becoming inevitable. (The only questions are when rates start rising and how far and how fast they are increased.)

The latest data tell us that Scottish GDP passed the 2008 peak in the first quarter of this year and UK GDP did the same in Q2. That is encouraging, but we should note that as recession struck UK GDP declined by 7 per cent in just over a year; while re-capturing that loss has taken us six years.

Further, we may now be back where we were, but we are still way below where we should be. The recovery has been dramatically slow. RBS economists calculate that if recovery had 'followed the path of a typical post-World War II recession' then GDP would be a full 10 per cent higher than it is now. That is a phenomenal loss of output - and I stress that is calculated on the basis of 'typical' recovery from recession. If our comparator was no recession and growth continuing around trend (say 2 per cent- 2.5 per cent per annum) from 2008 to now, then the hypothesised loss in output would be far greater than 10 per cent. Also the welfare loss associated with the years when output was below the 2008 peak cannot be recovered.

Allow me two further points to underscore this conclusion. First, the data above are in terms of overall GDP - total output across our economy.

For some sectors, including crucially manufacturing and also (unsurprisingly) financial services, recovery to the past peak has by no means been achieved.

Then there is the small matter of population growth. Official statistics show that the UK population in 2008 was 61.8 million, growing to 64.1 million last year and (my estimate) c.64.5 million this year. Thus our population is over 4 per cent higher than at the time of the last peak in aggregate GDP. Hence GDP per head has not yet recovered to that past peak but remains 4 per cent + lower. Even given a fair wind it will be 2016 before GDP per head (a far better proxy for welfare that overall GDP) is back to its 2008 level.

That inevitably leads me back to the critical question of whether that wind is set fair for continued growth. There is some evidence that the balance of growth is recovering, but I remain unconvinced. The level of business investment (critical to productivity, competitiveness and hence sustained growth) has hardly budged upwards since 2008. Analysis by Fathom Consulting shows UK business investment to be under 9 per cent of UK GDP as compared to nearly 13 per cent in the USA. Compared to a base of 100 in 2005, US productivity (output per hour) has risen to around 110; in the UK it has fallen to just over 95.

These data may help to explain the (welcome and continuing) rise in employment, but do nothing to instil confidence about future competitiveness. This is especially the case while sterling remains unduly strong against the dollar, in particular, but also the euro. This sterling strength is associated with expectations that the Bank of England will be first in its peer group of central banks to start raising interest rates.

The consumer remains critical to our growth surge, and here further evidence from Fathom points to everything turning around after the 2013 Budget, which deliberately encouraged the housing market, consumption, growth in consumer debt, etc. Further, increases in interest rates, when they come, will result in a slowdown in retail sales growth and the level of mortgage demand. We have already seen a hit to consumer confidence in anticipation of rate rises.

Interest rate rises could also lead to further sterling strength (especially if the Fed and the ECB do not follow suit) and run the risk of placing real pressure on those who have taken on, indeed were encouraged to take on, high levels of mortgage and other consumer debt while rates remained in negative territory. That will cause strains among households and economic deceleration - especially if investment and exports remained subdued.

One final thought is that we have a UK General Election next May. The Governor of the Bank of England and members of the Monetary Policy Committee would find themselves somewhat unpopular in UK Government circles if they were seen to be tightening monetary policy significantly in the run up to that event! But consumption and house price increases alone do not add up to a healthy economy - we have proved that in the past! To date the MPC has voted unanimously to keep rates on hold. That unanimity is set to come under increasing strain. Governor Carney will earn his pay package if he can work his way through the economic and political stresses and strains of the next nine months.

Jeremy Peat is visiting professor at the University of Strathclyde International Public Policy Institute

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