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Economics Weekly

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Uncertain outlook for UK economy

Tue, Oct 21 2008, 07:02 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Financial market turmoil makes economic forecasts even more uncertain than usual...
The prospects for UK economic growth have deteriorated sharply in the last two months. The main reason for this relate to the higher than expected level of price inflation which has hit consumer incomes and company profits badly and so is leading to weaker consumer and investment spending. In addition, the intensification of the credit crisis - the loss of confidence in financial markets that is reflected in sharp falls in share prices and housing markets - is adding a more worrying twist to the outlook. This makes forecasting economic variables and outcomes even more fraught than usual. In a recent Weekly, we looked at how projections of economic growth 1 year ahead performed in the last decade and noted that the average error in predicting gdp growth was 1 percentage point, see table 1.

...and a single view for the year ahead is almost certainly likely to prove incorrect
Point estimates in the current period of extreme uncertainty and market turmoil are far less likely to be accurate, or useful, than even the usual 1 percentage point error, which itself is an average. For this reason, using a range of possible outcomes is likely to be better than any point estimate, and these are likely to have very similar probabilities attached to them as well. In other words, instead of being much more confident about a central outlook than any other possible outcome, it may be that a significantly different forecast can have a very similar confidence attached to it. The reasoning is that, given how great volatility is, the central view could be quite different from the view of a month earlier that at the time seemed most likely.

This is true for a range of key UK economic variables...
What does this view imply for forecasts of some key UK economic indicators for 2009? The range of outcomes for economic growth in 2009 is broad, between +1.5% and -1.9%, with an average of -0.2% for the full year, based on consensus economic forecasts made in October. This range is outside the 10- year average error of 1 percentage point - based on a central forecast of -0.2%, any outcome between +0.8% and -1.2% is equally likely – but, given the huge uncertainty currently, one would expect this to be the case. Indeed, it could be argued that the forecast range in October is not wide enough. In this regard, it is worth noting that the directional accuracy was only correct 77% of the time and that the actual accuracy of the point estimate over the 10 year period we looked at was zero, see table 1. In short, at no time in the 10 year period did the consensus forecast correctly predict the actual outcome.

Other variables in the forecast for next year are equally subject to this uncertainty. In the charts below we show the standard deviation of economic growth, household consumption and consumer price inflation. These show that private sector consumption may rise by 0.5% or fall by 0.5%. Also that price inflation could fall back below 2% before the end of 2009 or it could end the year above 3%. It should be remembered that there is also a 23% chance, or nearly 1 in 4, that the direction of the forecasts for next year is wrong as well. This leaves a huge range and implies that the outcome for interest rates in 2009 is equally wide, from a range of 2.5% to 4.5%. With all the current uncertainty, point estimates in our view are simply not very useful and a range of possible outcomes would serve analysis best going forward, especially for financial planning purposes, as what seems plausible or implausible now could easily switch around next month as conditions change.

...making a better approach to have a range of most likely outcomes as the basis for planning
Hence, our views about the most likely outcome for the UK next year should be seen in this light; it is just what seems like the single most likely outcome now, but other outcomes are also almost equally likely at this time of such huge turmoil and uncertainty. Nevertheless, there is clearly a lot of pessimism about the UK economy and this is reflected in the consensus forecast of -0.2% gdp growth in 2009. This suggests that output will fall but not as deeply as in the early 1990s. We would tend to concur with this view, but expect a slightly stronger number on the basis that the authorities seem prepared to use fiscal, monetary and regulatory instruments to ensure that a deep recession does not occur. For this reason, we believe that interest rates are likely to be cut to 4% by the end of the year, possibly in November. (Why wait? If the authorities are prepared to act to prevent a fall in output, the sooner they do the better).

In conclusion, expect considerable variability in actual outcomes in 2009 compared with forecasts
For us, this would mean that the UK economy may experience a technical recession - six months of falling output – for the first time since the early 1990s. However, it may be that there is only 1 quarter when growth falls but the economy stagnates for up to nine months, both are consistent with modest economic growth in annual terms. So, either economic conditions improve in the next few months, and we avoid recession or they do not and the economy contracts by up to 1% in 2009, see chart d. This would clearly give a different outcome for interest rates and exchange rates. In that scenario, Bank rate would be cut to 3% in 2009. If not, we expect that it stays at 4% for most of the year. This may mean that sterling could fall even further below our end 2009 central forecast of $1.58, which is based on base rates of 4%. But the key point is that a number of very different outcomes are very possible for 2009 and forecasts are particularly prone to be wrong, however plausible they may seem at the moment.

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Published on  Tue, Oct 21 2008, 07:16 GMT