Economic outlook. Clouding over

The gloomsters are wrong but the Bank looks too optimistic about growth

SINCE the election, there has been a spate of bad economic news. Manufacturing output plunged in March by 1.6% from its level in February. Retailers reported the worst trading conditions in April for at least ten years. This has prompted some loose talk about recession.

The fears are over-egged if the Bank of England is right about the outlook for the economy. It paints a broadly reassuring picture in its quarterly Inflation Report published on May 11th. The economy, it says, will grow at a bit above 2.5% a year over the next two years.

Indeed, compared with its report in February, the Bank offers some relief to hard-pressed industrialists and retailers. It takes about two years for a change in interest rates to have its full impact on inflation. Three months ago the Bank was forecasting that if interest rates stayed at 4.75%, consumer-price inflation would rise above the government's target of 2% by early 2007. This suggested that rates were likely to have to rise again. In March and April, two members of the Bank's nine-strong committee that sets rates voted in favour of a rise to 5.0%.

Inflation recently rose from 1.6% in February to 1.9% in March, close to a seven-year high. The Bank now expects that inflation will rise above the target over the next few months. But, more important, it is forecasting that inflation will be just below 2% in two years' time. This implies that interest rates have peaked, which should help to boost business confidence.

The easing in the outlook for inflation two years ahead reflects the cumulative impact of a downward revision in expected GDP growth compared with February. Even so, the change is not a drastic one. The Bank has trimmed rather than sheared its growth forecast.

Is it being too optimistic? Presenting the report, Mervyn King, the Bank's governor, acknowledged that the risks to output growth were “slightly on the downside”. They stemmed, he said, from “possible weakness in activity abroad and consumer spending at home”.

A continuing consumer slowdown is the main threat. Household-consumption growth has powered the economic expansion of the past few years. That makes it all the more worrying that consumers now appear to have gone on strike. In the final three months of 2004, household consumption grew at a quarterly rate of only 0.2%. The slowdown appears to have persisted in the first three months of this year, when retail sales grew in real terms by just 0.3%. Gloomy reports for the retailing sector suggest that consumers continued to shun the shops in April.

The Bank thinks that this will turn out to be a temporary pause in consumption growth. It argues that employment and earnings growth appear to have picked up and that the housing market is stabilising. This should lead to a revival in consumer spending, even though it will grow somewhat more weakly than in recent years.

However, the Bank does accept that this benign scenario may not materialise. “It is also possible,” says the report, “that the deceleration in house prices and the cumulative impact on highly indebted households of past increases in interest rates may be associated with a more prolonged slowdown.”

Quite so. The downturn in the housing market has been abrupt. A year ago, house prices were soaring but now they have stalled. Housing-market transactions in the first quarter of this year were 35% lower than in the first three months of 2004. This is likely to result in more downward pressure on house prices, argues Sabina Kalyan of Capital Economics, a consultancy. This suggests that it may be premature to talk about the housing market stabilising.

The economic prospects are by no means as bad as recent news has suggested. But it is too early to have much confidence that the economy will behave in as orderly a fashion over the years ahead as the Bank suggests.

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