Brace yourself - the economy is worse than we thought

If you thought the age of a gloomy UK economy was coming to an end, think again. A slow and subdued economic recovery was the key message delivered by Bank of England governor Mervyn King when he presented the latest Inflation Report on Wednesday.

As King embarks on his last year as governor (he retires next year) he has dropped the niceties and is willing to face the facts straight on. At this press conference he virtually admitted that the UK’s economy is dismal, he doesn’t know when it will get better and the tools the Bank has been using since the financial crisis began four years ago have not been working.

The BoE’s growth forecasts for the next two years have been cut dramatically: The original estimate that growth could be as high as 4% next year has been scrapped; it is more likely that growth will expand at a fairly dismal 1% a year for the next two years. However, even that low rate of growth could be optimistic.

So why does our economy keep failing to recover? King says that it’s down to the rest of the world also experiencing weak growth making it hard for our famous economic re-balancing act to get started. Now that the financial sector is showing signs of weakening and our export sector is suffering from problems abroad there isn’t much left to fire up our economy.

He also laid the blame on sterling. There is one thing that King does not like and that is a strong pound. You have to feel sorry for him - even though he has created £375 billion of extra money over the last three years through the BoE’s quantitative easing programme, it hasn’t had any effect on the pound, which is up nearly 15% on a broad-based basis since the beginning of 2009. This is causing King to lose his patience as the strong pound is making our exports even harder to sell to our neighbours who are ravaged by a sovereign debt crisis.

Double trouble

The Inflation Report delivered a double whammy: Not only will growth be weak, but our incomes are more than likely to be eroded by persistently higher prices.

The BOE now expects inflation to run at 2.5% at the end of next year, a little bit below the current rate of 2.7%. However, price rises won’t fall back to the Bank’s target rate of 2% until 2014. And the Bank can’t even say this will happen with much confidence – instead King said that the risks were broadly balanced that inflation will fall by 2014.

Prices remain elevated thanks to high energy and food costs. Since we are unlikely to stop eating or driving any time soon, get ready to feel the pinch. But high inflation doesn’t just hit the bill at the end of a food shop; it has ramifications for savers and debtors alike.

High inflation actually erodes our debts in real terms, since money is worth less when inflation is higher. That’s great news – we can borrow our way to recovery? Not that fast, right now banks don’t really want to lend as they concentrate on repairing their own balance sheets, and we are also being told to live within our means. Borrowing our way to recovery seems out of the question.

So we should save then? Yes, but with interest rates so low what is the point of putting money in a bank. Interest rates are only 0.5%, and many savings products offer rates lower than that.

The end of optimism?

King left the optimists clutching at straws. Although unemployment fell further in September to 7.8% from 7.9% in August, we have seen the number of people claiming unemployment benefits rise in October. The pace of job growth has also slowed down over the last three months, which could weigh on October’s unemployment data when it is released in December.

Added to that, some people have started to question the UK labour market’s ability to defy gravity. Some argue that companies haven’t been laying people off because they are getting cheap money from the Bank of England and paying extremely low interest rates on their debts. Thus, the private sector is acting a bit like the state – it is keeping people in jobs even if demand is drying up.

There is a concern that some companies may be paying people to turn up even though there is not as much work for them as there was pre-2008. This may have kept the unemployment rate down in recent years, but it could have long term negative ramifications for the economy.

Firstly, the cheap money may be keeping companies afloat that otherwise should be allowed to go bankrupt and, secondly, if workers have got used to being less productive and the economy does pick up in the future then companies may not be able to get their workers’ to work harder. This will mean that companies need to hire more staff, which could add to their cost base and make them flabby and inefficient in the future.

The one piece of good news from this Inflation Report may not be delivered until the 5th December when Chancellor Osborne delivers his Autumn statement. Since the BoE seems out of options to try and boost the economy it makes it more likely that the Government will delay fiscal reform and ease the pressure on public sector spending cuts.

Some will argue that is the wrong thing to do, that it delays the inevitable and threatens our triple-A credit rating. But George Osborne better get ready as Mervyn is coming round the bend and is ready to hand the baton to his Chancellor.