U.K. Economy (Finally) Turning the Corner.

Executive Summary

Recently released data show that real GDP in the United Kingdom grew 0.3 percent (1.2 percent at an annualized rate) in Q1-2013 relative to the previous quarter, which was not as weak as some analysts had expected. The positive outturn means that the British economy has avoided a "tripledip" recession, at least for now, and it undoubtedly comes as a relief to officials who reside on Downing Street.

However, the British economy is not yet completely out of the woods. The ongoing recession in the Eurozone continues to exert headwinds on British exports; U.K. construction spending continues to nosedive and British businesses remain in hunker-down mode. The better-thanexpected GDP data take some pressure off of the Bank of England (BoE), at least for the time being, to "do something" to jumpstart growth. That said, the Monetary Policy Committee (MPC) could very well increase the size of its quantitative easing (QE) program further and/or modify its Funding for Lending Scheme (FLS) if growth remains sluggish. We forecast that the British pound will depreciate modestly versus the U.S. dollar in the quarters ahead.

U.K. Economy Averts "Triple-Dip" Recession in Q1-2013

The British economy has struggled over the past five years (Figure 1). It entered a deep recession in the aftermath of the global financial crisis (GFC), and contracted more than 6 percent between Q1-2008 and Q2-2009. It then grew at a modest rate until Q3-2011 before sliding back into a "double-dip" recession. About six months ago we wrote a report entitled "Is the British Economy Starting to Turn the Corner?" after strong GDP data for Q3-2012 were released.1 The 3.8 percent annualized rate of real GDP growth that was registered in that quarter broke the string of three consecutive quarters of negative growth, and raised some hopes that the economy was finally recovering from its "double-dip" recession. However, expectations of sustained growth proved premature as the economy contracted again in the fourth quarter.

Recently released data show that real GDP in the United Kingdom rose 0.3 percent (1.2 percent at an annualized rate) in Q1-2013 relative to the previous quarter. The good news is that the outturn was stronger than the consensus forecast had anticipated. In addition, by posting positive growth in the first quarter, the British economy (or at least the British government) avoids the embarrassment of a "triple-dip" recession. The bad news, however, is that the British economy is hardly doing swimmingly at present. Despite the modest growth rate that was registered in Q1-2013, real GDP in the United Kingdom has been more or less flat on balance over the past six quarters. Moreover, British real GDP remains 2.6 percent below its Q1-2008 peak (Figure 2). In contrast, the American economy is 3.2 percent larger today than it was when the "Great Recession" started in Q4-2007.

A breakdown of the first quarter GDP data into its underlying demand-side components is not yet available.2 However, data from the past few quarters shed some light on the drivers of economic growth. In that regard, growth in consumer spending has supported overall economic growth while net exports have been a drag. For example, growth in consumer spending contributed 1 percentage point to the year-over-year GDP growth rate of 0.2 percent that was registered in Q4-2012 (Figure 3). In contrast, net exports sliced 1.2 percentage points off of the overall GDP growth rate in that quarter. With the Eurozone, to which the United Kingdom sends roughly onehalf of its exports, in recession over the past year, the negative contribution from net exports to overall GDP growth should be of little surprise.

The breakdown of GDP data into value-added by broad industry categories suggest that consumer spending continued to support real GDP growth in the first quarter while the external sector likely continued to be a drag on economic growth. Specifically, value-added in the service sector, which is tied closely to consumer spending, rose 0.6 percent. In contrast, the 0.3 percent decline in manufacturing value-added would be consistent with continued weakness in real exports, and the 2.5 percent drop in construction value-added indicates that residential and non-residential construction likely contracted. Although value-added in the service sector now exceeds its previous peak, the manufacturing and construction sectors remain severely depressed (Figure 4).

Absent some unforeseen shock, we do not look for the U.K. economy to "triple dip." Indeed, we forecast that real GDP growth will slowly strengthen from a year-over-year rate of 0.6 percent in Q1-2013 to nearly 2 percent by the end of next year. Although slow economic growth in the Eurozone likely will continue to exert headwinds to British export growth, we look for growth in consumer spending to remain solid and for investment spending to slowly pick up some steam. We do not expect the government to back away from its avowed policy of austerity, although the GDP data in fact show that government spending has made a positive contribution to GDP growth over the past year (Figure 4).

Will Monetary Policy Be Eased Further?

The better-than-expected GDP data in the first quarter take some pressure off of the BoE, at least for the time being, to "do something" to jumpstart the moribund economy. Since March 2009, the BoE has maintained Bank Rate, its main policy rate, at only 0.50 percent, which effectively is about as low as it can go. The vast majority of analysts, including us, do not look for the MPC to reduce Bank Rate further.

However, the BoE has not used up all of its "ammunition." Like the Federal Reserve, the BoE has turned to unconventional policies to support the economy. The BoE steadily increased the size of its QE program from £75 billion in March 2009 to £375 billion in July 2012, where it has subsequently been maintained. In the past three policy meetings, three members of the MPC voted to increase the size of the BoE's QE program by £25 billion whereas six members voted to keep the size unchanged at £375 billion. In light of the GDP data for the first quarter, we doubt that two "no" votes will switch sides to the "yes" camp, at least not at the next policy meeting on May 9.3

The elevated rate of CPI inflation in the United Kingdom has been an argument against the case for further QE. At 2.8 percent, CPI inflation at present is above the 2 percent rate that the government mandates the BoE to achieve in the medium term (Figure 5). Although the government recently affirmed the BoE's 2 percent inflation target, it also indicated that it may be more tolerant about the length of time that inflation can depart from target. Therefore, the case for further QE is not necessarily dead, at least not later in the year, if incoming data show that the economy is not accelerating.

Threadneedle Street, and he may be even more willing than Sir Mervyn to experiment with policies that could potentially be growth supporting. That said, Governor Carney will not necessarily have free rein. Even if he wants to push the envelope in terms of unconventional policies, he may be held somewhat in check by other members of the MPC who fear that accommodative monetary policies could lead to rising inflation expectations.

Not only has the BoE engaged in QE, but it has also sought to facilitate credit expansion directly through its Funding for Lending Scheme (FLS) that it announced jointly with HM Treasury this past July. The FLS essentially provides subsidized funding to eligible financial institutions, generally banks and building societies, if those institutions increase their lending to businesses and households. The results of the FLS have been mixed as overall lending growth to the private non-financial sector remains anemic (Figure 6). Outstanding loans to households have edged up a bit since the FLS was implemented in August 2012, but loans to businesses, especially to smalland medium-sized enterprises (SMEs), continue to contract. The amount of outstanding loans to large businesses has declined 1.0 percent (not seasonally adjusted) since August, and loans to SMEs have skidded 4.3 percent over that period.

Therefore, the BoE and HM Treasury announced some modifications to the FLS on April 24. First, the scheme will be extended by one year to January 2015. Second, loans by eligible financial institutions to SMEs will be subsidized even more. Third, certain financial institutions, such as financial leasing companies and factoring companies, will now be eligible for FLS funding because these types of financial companies can be important sources of financing for SMEs. Further modifications to the FLS could occur in the future if U.K. economic growth remains weak.

Where is Sterling Headed?

The United Kingdom experienced a sharp depreciation of its currency during the GFC. Between its high in July 2007 and its low in March 2009, Britain's real effective exchange rate fell more than 25 percent (Figure 7).4 Not only did sterling weaken significantly against the U.S. dollar during the GFC as investors moved into the safe-haven of the greenback, but the British pound also depreciated vis-à-vis the euro.5 This real exchange depreciation undoubtedly played a role in boosting real exports of British goods and services, which rose more than 6 percent in 2010 and nearly 5 percent in 2011. However, export growth has stalled over the past year. Although the real exchange rate has trended a bit higher over the past three years - not only has the nominal value of the British pound made up some lost ground but inflation has generally been higher in the United Kingdom than in most of the country's major trading partners - the renewed downturn in the Eurozone has had a depressing effect on British exports.

Looking forward, we project that the greenback will strengthen modestly vis-à-vis sterling in the quarters ahead. Rates of return on U.S. assets likely will be higher than returns in the United Kingdom due to superior growth prospects in the United States. That said, we do not look for runaway dollar strength versus sterling either. Although the Bank of England will not be in a position to tighten monetary policy anytime soon, U.S. monetary policy probably will remain extraordinarily accommodative for the foreseeable future as well. Rather, we look for the dollar to grind higher vis-à-vis the British pound over the next few quarters.