Economic performance in the United Kingdom has been surprisingly strong. However, the pace of recovery can’t be maintained without a boost in productivity.
The timing of Mark Carney’s arrival at the Bank of England as governor has proved fortuitous. Since he took the reins at the bank last July, growth has accelerated, inflation has dropped like a stone, and the economy has created over a quarter of a million new jobs. The United Kingdom is now being talked of as the fastest growing economy in Europe (see figure 1).
The United Kingdom is now being talked of as the fastest growing economy in Europe.
The bank, like everyone else, has been caught out by the pace of the recovery. Last August, the bank expected the unemployment rate to stay above 7.0 percent until the second half of 2016. Since then, unemployment has dropped sharply; it seems almost certain to fall below 7.0 percent in the coming months, two-and-a-half years ahead of the bank’s forecast just eight months ago.
In its latest Inflation Report, the bank forecasts that UK growth will accelerate to a very strong 3.4 percent this year.1 It would be the fastest rate in seven years and above the average rates seen in the decade before the financial crisis. Not only would it make the United Kingdom the fastest growing major economy in the industrialised world, it would also mean that the United Kingdom outpaces a number of developing world economies, including Brazil and Russia.
The bank’s economic forecasts tend to be fairly middle-of-the-road. Its latest, very non-consensus view, relies on a sharp upswing in UK investment and consumer spending. The bank believes that the United Kingdom is on the verge of an investment boom, and it is forecasting a 43 percent increase in UK business investment between now and 2016.
We do not think this outlandish. A host of indicators suggest that we are at a turning point on investment. Firms do not seem to have very much spare capacity. The CBI, for instance, reports that capacity utilization in small- and medium-sized firms is running at the highest level in 25 years. A worn-out capital stock and growing demand means that, at today’s low borrowing costs, returns on corporate investment are likely to be attractive.
Corporates also have the wherewithal to invest. Corporate cash levels are high, albeit heavily concentrated in larger firms. More importantly, firms are finding it easier to raise funding from banks and from capital markets. Banks report that demand for credit to fund capital spending is at the highest level in six years. Deloitte UK’s latest Survey of Chief Financial Officers found that the top corporate priority is now expansion. A record 72 percent of respondents believe this is a good time to take risk (see figure 2).2
A record 72 percent of respondents believe this is a good time to take risk.
The other factor behind the economic rebound forecast by the Bank of England is a continued recovery in consumer spending. The bank believes that after a four-year squeeze on earnings, 2014 will be the year in which consumer spending power recovers. The bank expects the growth rate of average earnings to accelerate significantly and for inflation to drift lower, delivering a boost to consumer spending power.
The UK economy’s changing fortunes had two pronounced effects on the financial market.
A recovering economy fuelled speculation that the bank could tighten monetary policy sooner rather than later. Financial markets are currently working on the basis that the bank will raise rates in the first quarter of 2015, but speculation that it could be earlier has increased.
A stronger economy has also boosted the pound. On a trade-weighted basis, against a broad basket of currencies, the pound has risen 9.3 percent in the last year and now stands at its highest level since November 2008 (see figure 3). Much of the pound’s rise reflects strong gains against the US dollar, up by 11 percent in the last year.
On a trade-weighted basis, against a broad basket of currencies, the pound has risen 9.3 percent in the last year and now stands at its highest level since November 2008.
The financial and external risks, which have buffeted the UK economy in the last six years, have abated. But the recovery also faces internal risks. Perhaps the most significant is the possibility that UK productivity remains lacklustre, hampering the recovery and fuelling inflationary pressures.
Britain’s recession collapsed output, but it had far less effect on employment. That softened the human impact of the recession, but with more people producing less, productivity plummeted. Productivity measures the efficiency of the production process. In the long run, it is a major determinant of growth and of inflation. Higher productivity is the key to sustained expansion in both average earnings and in investment. Without an upturn in productivity, the sustained recovery the Bank of England and most forecasters expect is not realistic.
EndnotesView all endnotes
- See Deloitte CFO Survey, “Unternehman erhöhen die schlagzahl,” February 2013, http://www.deloitte.com/assets/Dcom-Germany/Local%20Assets/Documents/18_ Growth%20Platforms/CFO-Services/CFO_2-2013.pdf.
- “Bank of England says the UK recovery has taken hold,” BBC News, November 13, 2013, http://www.bbc.co.uk/news/business-24926512.
- “Optimism rises at record pace among UK’s smaller manufacturers,” CBI, November 11, 2013,
- Ian Stewart, Debapratim De, and Alex Cole, “The Deloitte CFO Survey: Q3 2013,” Deloitte LLP, September 2013, http://www.deloitte.com/assets/Dcom-UnitedKingdom/Local%20Assets/Documents/Research/CFO%20Survey/uk-insights-cfo-survey-2013-q3-full-report-v2.pdf, accessed January 6, 2014.