Expect things to get worse before they get better

Beyond the next few months, there are reasons for relative optimism

NOVEMBER'S SHARP bounce in retail sales - up by 0.8 per cent in the month, when most had expected a further fall - was the first upside surprise on economic activity for many months.

Of course, the usual caveats about not reading too much into one month's data apply, but the figures do suggest the risks for the economy in 1999 might be a little more evenly balanced than the overwhelming gloom that dominates much commentary might suggest. A glance at forecasters' expectations suggests the same. The consensus among private sector economists is that the economy will expand by somewhere between half a per cent and 1 per cent in 1999.

This is certainly slow enough to encompass the possibility of a technical recession - two consecutive quarters of negative GDP growth. And growth this slow would probably result in unemployment rising by around half a million. But for the period of healthy growth seen since the early 1990s to end with a slowdown of this magnitude - rather than a sizeable contraction in output before a pick-up back towards trend growth in 2000 - would signal a significant break with the tradition of the last several decades.

Typically, downturns in the UK have been characterised by output falling cumulatively by around 5 per cent. Why should things be different this time? Primarily, it comes down to a question of balance. At the height of the economic boom of the late 1980s, the UK corporate sector was in financial deficit - the excess of investment over saving - to the tune of 5 per cent of GDP.

The current account - the UK's financial position with the rest of the world - was in deficit to almost the same degree. Estimates of the output gap - the level of output relative to what is sustainable without accelerating inflation - suggest it had become positive to the tune of about 6 per cent of GDP. Against this background, a collapse in output had become necessary to get the economy back on track.

At the peak of this economic cycle, things look very different. The current account is in surplus, the corporate sector in only marginal deficit, and most estimates suggest output is less than 1 per cent above trend. The economy simply does not need the sort of slowdown that has typically ended upswings.

Unfortunately, of course, what the economy needs is not always what it gets. And the forward-looking indicators have pointed to a sharper slowdown than even the most pessimistic interpretation of the economy's growth potential would imply is required. But beyond the next few months, there are further reasons for relative optimism.

First, policy is being eased at a far earlier stage of the economic cycle than has been the case in the UK's history. Second, the economy looks well placed to respond positively to low interest rates. Base rates started to fall while growth was merely slowing this time. In the early 1990s, output was already falling substantially before a clear peak in base rates was in place.

The response of the economy to lower base rates depends crucially on the health of household finances. In this respect, things look strikingly different compared to both the UK's history and to other developed economies, most notably the US. Abstracting from recent volatility, the UK saving ratio - savings as a proportion of personal income - stands at around 7 per cent. This compares to a slightly negative saving ratio in the US, although a small part of the difference may be explained by different definitions.

At the equivalent point to now in the last cycle, the UK saving ratio had fallen to around 5 per cent. This suggests UK households have some room to absorb slower income growth by saving less as base rates fall.

The housing market - the key transmission mechanism for base rates to the real economy - also suggests some room for optimism. The recent recovery in house prices has done little more than match the growth in average earnings, leaving house prices - outside central London at least - still looking relatively cheap by historical standards.

For the UK as a whole, average house prices are around four-times annual average income. This compares to around six times at the peak of the last boom in the late 1980s. A further recovery in house prices does not, therefore, need an out-of-control boom, but rather a continued recovery towards "normal" house price valuations relative to income.

So, the economy is in good financial shape and activity and asset prices are not booming to the degree they have at the peak of previous cycles; all pointing to relatively modest slowdown in growth. Yet confidence, particularly business confidence, remains depressed and short-term lead indicators suggest output may well fall in the early months of 1999. What might prompt an upturn?

The answer, of course, is further falls in base rates. And base rates should fall much further from here. December's half a per cent rate cut and, more importantly, the minutes of the meeting released two weeks later, suggest the policy-making process has changed significantly in recent months. Up to the last quarter per cent move in October, the majority of Monetary Policy Committee members clearly felt the level of interest rates was - give or take a quarter of a per cent - right.

Each monthly meeting was a matter of assessing the month's economic news and determining whether it argued for a marginal tightening or loosening of policy. But December saw a significant shift in this respect with the MPC apparently contemplating the possibility that the absolute stance of policy may simply be too tight, as real interest rates are too high. Strictly speaking, an accurate measure of real interest rates takes the current level of base rates and subtracts the level of inflation expectations. Given the difficulties in measuring inflation expectations, however, we generally assume that current inflation is a reasonable proxy for where inflation is expected to be in future.

As the chart shows, on this basis, base rates have only just moved to the right side of neutral by historical standards. Add in the strength of sterling and there is little doubt that policy overall remains tight. With the MPC apparently coming to the same conclusion, expect base rates to fall rapidly from here with a trough of 5 per cent or less in place by the summer.

All-in-all, expect news on the economy to get worse before it gets better in 1999. But with the MPC acting quickly to avert a sharper slowdown than is necessary, 1999 should, by the UK's standards, be a relatively soft landing.

Adam Cole is UK economist at HSBC Economics and Investment Strategy.