Sunday, August 02, 2015
Another milestone on the road to normality
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

An economic recovery is all about barriers and milestones. It is a story of getting over the barriers and counting off the milestones as you pass them. Britain has just passed an important milestone. It is one which suggests that at the very least talk of a lost decade for the economy, which was once very common, was misplaced.

It is two years since gross domestic product (GDP), adjusted for inflation, surpassed the pre-crisis level achieved in early 2008 but is only now - or more accurately in the April-June quarter - that GDP per head has regained its earlier peak.

These milestones do move around. As GDP figures get revised, it is quite likely that both will be seen to have occurred earlier than the current numbers suggest. We should not expect miracles, however. The economy was left weak and groggy by the crisis and was always going to take time to get back on its feet.

The barriers to recovery in recent years – from outside Britain – have been several. High global oil and commodity prices gave us high inflation in 2011, intensifying the squeeze on real incomes, a factor that did not dissipate until about 18 months ago.

The eurozone crisis, at its height three years ago, affected Britain’s economy directly through trade, and indirectly by spilling over into renewed concerns about the banking system. What may or not be its last gasp, the Greek crisis of recent months, is no longer critical, but one of its side-effects has been to push sterling up to €1.40-plus heights against the euro, which is hurting exporters.

Now China has emerged as a potential barrier to recovery, though my sense is that any negative effect from China’s stock market woes will be balanced by its effect on oil and commodity prices. Sometimes, as with last year’s sharp fall in oil prices, which has not been significantly reversed, external forces can be more of a springboard than a barrier.

Now that the GDP per head milestone has been passed, what other milestones are there? One is the length of recovery. If we define a recovery as a period of growth unbroken by two successive quarterly GDP falls, this one has now lasted almost six years. It is still in the foothills compared with the 16-year growth marathon between the autumn of 1991 and early 2008 but is catching up on the Thatcher 1981-90 nine-year recovery.

The biggest milestone of all would be if growth in coming years were strong enough to eliminate the “lost” years, in other words to make up for the ground lost as a result of the recession of 2008-9 when GDP fell by 6%.

The five years it took for GDP to get back to pre-crisis levels (seven years on a per capital basis), meant those years of potential growth – when the economy might have been expected to expand by 2.5% a year – were lost. Though growth is now above its long-run average, it is not enough above it to make up that lost ground other than at a snail’s pace. Those years of potential growth, and the rise in living standards associated with them, were largely lost for ever.

That’s enough milestones. Two questions arise. One is whether there is anything to suggest growth will become better balanced than it has been. The other is whether strong growth – the second quarter rise of 0.7% made it six out of the past eight when the economy has grown by that much or better – will be enough to persuade the Bank of England to hike interest rates.

That the recovery could do with being better balanced is not in doubt. The service sector bounced back quickly, getting back to pre-crisis levels of output as long ago as 2011. But manufacturing has yet to do so; it is 4.9% below its early-2008 levels, while construction is still 3.2% down.

Though both sectors disappointed in the latest quarter, perhaps a more nuanced picture is provided by the performance of the three sectors from their recession low points. Construction and manufacturing fell further, so had more to make up. From their respective recession low points, the service sector is up by 11.9% and manufacturing by 8.8%. Construction is actually the strongest of the three, up by 16.8% from its recession trough. But manufacturing could and should be doing a lot better.

What about interest rates? Every quarter of 0.7% growth is a quarter in which a little more spare capacity is used up. We will hear a lot more about this on “super Thursday” this week when the Bank publishes its quarterly inflation report, interest rate decision and monetary policy committee (MPC) minutes simultaneously. In the past these three events were been spread over three weeks.

Will the Bank, while acknowledging the strength of recovery, tone down its language on rate hikes because of the renewed weakness of oil and commodity prices? Brent crude oil is back in the low $50s, while broader commodity price measures dropped to a 13-year low last week.

We will see what happens. But I would be surprised if some MPC members do not vote for a rate hike this week and if the Bank’s broader message is not that people and businesses should be prepared for the start of a gradual rise in rates in the coming months.

When oil and commodity prices were high, the Bank “looked through” the temporary boost they provided to inflation, deciding instead that the economy was not ready for a hike in rates. Now prices are low, they are likely to take the opposite view; that they cannot postpone indefinitely the process of “normalising” interest rates. The new normal will, of course, be lower than the old normal.

Starting to raise interest rates will, when it comes, be a milestone in itself after more than six years in which there has been no change. It will be a milestone of the road back to normality.