Sunday, January 01, 2006
Forecasters struggled in a year of three halves
Posted by David Smith at 12:00 PM
Category: David Smith's other articles

WHAT did we learn about the economy in 2005, and what does this tell us about the outlook for 2006? I will have more to say about the latter next week. In the meantime there’s plenty to get our teeth into.

Ian Harwood, global chief economist at Dresdner Kleinwort Wasserstein, lists 10 lessons from 2005. Compressing them, they are: a sharp rise in oil prices failed to give us a global recession — the dog didn’t bark. Headline inflation rose but core inflation did not. Booming housing explained America’s economic resilience, while cooling housing was the reason for Britain’s slowdown.

The dollar defied all the predictions of a fall, while in euroland there were tentative signs that the economy is not permanently becalmed. Europe may, perhaps, follow Japan’s revival, though that revival did not eliminate deflation — falling prices.

China’s extraordinary investment-led boom continued. Globally, profits accounted for a much greater share of gross domestic product (GDP). The technology sector remained highly volatile.

Here in Britain, if the Treasury is right in its assessment of what happened, 2005 was the first year in many that consumers did not drive the economy.

In every year from 1997 to 2004 consumer spending outstripped overall economic growth, the rise in GDP, as households feasted on falling interest rates and a booming housing market.

In the year just ended (calling it last year still seems a little premature) this pattern changed. The Treasury’s estimates suggest that both consumer spending and GDP rose by 1.75%. Consumers did not stop spending but they did rein back sharply. The correponding rise in 2004 was 3.75%.

A second fact worth noting is that, assuming a December rise in the claimant count — we will not get the figures for a couple of weeks — 2005 will have been a year in which this measure of unemployment rose every month. That has not happened since 1992, when the economy was slowly emerging from recession. Rising unemployment and sluggish consumer spending could, of course, be related.

A third big change was that China vaulted over Britain to become the world’s fourth- largest economy. That was going to happen anyway, though it was helped by the discovery by Chinese statisticians of some economic output they were not previously aware of. China’s economy was last bigger than Britain’s in the 19th century. The People’s Republic has Germany, the world’s third-biggest economy, in its sights.

Old-style football managers used to talk about a game being of two halves. Some still do. With Britain’s economy, however, we seem to have had a year of three halves.

The story can be told through the Bank of England’s inflation reports, published in February, May, August and November. In February, the Bank was pretty sanguine, despite early indications that retailers were finding things a struggle.

The Bank noted that the global recovery was continuing, that growth in Britain was roughly on trend and that, while it was aware of the bleating from retailers, it thought that prospects for household spending were “unclear”. As for Britain’s overall growth prospects, they remained “robust”.

That continued to be the broad view for the first three to four months of the year. The Treasury has been much criticised for its March forecast of 3%-3.5% growth, which always looked optimistic. But consensus growth forecasts, while well below the Treasury’s, did creep higher in the early months of the year. Many forecasters expected a rise in base rate.

The second phase, described by the Bank in its May inflation report, came with the realisation that Britain’s economy was facing the twin challenges of slower growth and rising inflation. The slowdown in consumer spending was more durable than first thought, the report noting it had “faltered at the end of last year (2004) and that weakness appears to have persisted into the first quarter”.

There was an accompanying problem of higher inflation, partly driven by the rise in oil prices. Inflation was now expected by the Bank to rise above the 2% target, while the risks to economic growth were on the downside, as a result of those reluctant consumers. Those downside risks gave us the year’s solitary interest-rate change, the August cut from 4.75% to 4.5%.

For a while it was a nasty time. Retailers screamed of Armageddon on the high street while some economists predicted that inflation would soon top 3%, forcing Mervyn King, the Bank governor, to write a public letter of atonement and explanation. The word “stagflation” re-entered the vocabulary.

But it was not quite so bad. While retailers were screaming, official figures suggested that there was a recovery in spending in the second half of the year. Inflation reached a peak of 2.5% and then came down. The worst of the crisis had passed. By November, when the Bank presented its report, things had quietened down, and so had calls for further cuts in interest rates — for now.

It was an interesting time. Every year I try to measure who read it well, and who got it wrong. Gordon Brown took flak over his forecast last month but it was not, in general, a great year for predictions. While almost everybody correctly took the view that the Treasury’s growth numbers were too optimistic, few got the full extent of overoptimism.

At the start of the year the consensus growth forecast was 2.5%, against a 1.75% outturn. Most thought that inflation in the final quarter of the year would be below 2% rather than above. Some expected higher base rates, which we might indeed have had if the Treasury had been right on growth.

This year’s congratulations, therefore, have to be more restrained than usual. The clear winner was Capital Economics, which was more downbeat on growth than most, and also got the balance of payments and unemployment almost exactly right. Jonathan Loynes, Capital’s chief UK economist, should treat himself and his team to a drink.

Deutsche Bank and Hermes also scored well. Both were too upbeat about growth but did well on other things. I should also mention Peter Warburton of Economic Perspectives. Normally he has been too pessimistic. This time some of that pessimism was justified, and he was the only forecaster to come in below the growth outturn.

Too many forecasters in effect exclude themselves by presenting their numbers in a way that makes comparisons difficult. The OECD did not do quite as badly as its bottom place suggests, but it excluded itself from some possible marks.

How did I do? I did not have a great year. I was too optimistic on growth (2.75%) and inflation (1.75%). The base-rate forecast was good, 4.5%, as was my prediction that house prices would rise, not fall, by between 3% and 5%. I’ll work on the other numbers in time for next week.

PS: Only a few days left to send in your responses to the Economic Outlook competitions. The quiz questions, to remind you, were:

On the basis of published figures, how many successive quarters has Britain’s economy been growing? (a) 37, (b) 45, (c) 53.

The Bank of England’s “repo” or base rate is 4.5%. How high and how low has that rate been since Bank independence in May 1997?

Ben Bernanke will soon succeed Alan Greenspan as Federal Reserve chairman. Mervyn King took over from Eddie (now Lord) George in 2003. But who preceded Greenspan and George in their posts?

The other competition was my request for high-tech economic indicators to replace the skip index, which is now looking a bit long in the tooth. Anything to do with mobile phones, the internet, iPods, iPaqs, Blackberries, blogs, robots and things I’ve probably never heard of, will fit the bill.

From The Sunday Times, January 1 2006