Economic outlook 2012: will quantitative easing lead to stability and growth?

The economy is still in turmoil more than one year since the recession ended, with low growth and high inflation among the challenges faced.

Key points

"This is the most serious financial crisis we have seen at least since the 1930s, if not ever," said Mervyn King, the Governor of the Bank of England, on 7 October 2011. One year earlier, he had warned that "after a financial crisis, the hangover lasts for a while", but many had expected to see more signs of recovery in 2011, rather than continued economic turmoil.

Gross domestic product (GDP) had expanded by 1.1% in the three months to the end of June 2010. This growth was not to continue - by the first quarter of 2011, GDP growth was 0.4%, dropping further to 0.1% for the second quarter of the year. Although it has picked up to 0.5% for the third quarter, according to the latest figures from the Office for National Statistics (ONS) (PDF format, 84K) (external website), such growth is not expected to continue for the fourth quarter.

While GDP has fallen, inflation has headed in the opposite direction and the all-items retail prices index (RPI), the measure preferred by wage-setters, now stands at 5.6%. ONS figures (PDF format, 117K) (external website) also show that the consumer prices index (CPI), the Government's preferred criteria, is 5.2%, edging towards triple the 2% target.

Consumers are feeling the pressure - the combination of higher prices, zero-to-low pay rises and increasing unemployment means that incomes are suffering in real terms and there are very few stimuli to get the economy off the ground. In our economic outlook this time last year, we noted the risk of a double-dip recession - one year on, this risk remains.

Interest rates cannot go much lower, continuing to stand at the 0.5% level they have been at since March 2009. In a bid to escape the current doom and gloom, the Bank of England's Monetary Policy Committee (MPC) took the decision on 6 October to inject money into the economy through further quantitative easing (QE) (on the Bank's website).

Although there was opposition to this throughout 2011 (several MPC members spoke out against this move, with only one member of the nine voting for further QE between October 2010 and September 2011), QE was seen as a key (and possibly only) route to stability as the economic situation worsened (QE was described by the Economist's Buttonwood blog as "the last game in town" (external website)). The second round of QE (QE2) involves injecting £75 billion into the economy through asset purchases. According to the Bank of England, this should take four months to complete.

Gross domestic product to rise in 2012

Output has been extremely low this year, and while the MPC's August Inflation Report (PDF format, 608K) (external website) forecast that GDP should gradually pick up after two years of low growth, by October the MPC was saying that "there had been significant downside news about the factors influencing the outlook for demand in the two months since the August Inflation Report had been published".

Relevant factors include a slackened pace of global expansion and the indebtedness of several eurozone governments and banks. In September's MPC minutes the forward indicators for the fourth quarter suggested that growth could be zero. Meanwhile, economists at Barclays Capital predict quarter-on-quarter growth of 0.3% in the third quarter and just 0.1% in the fourth quarter.

Earlier in the year, several one-off factors were considered key to the second quarter's minimal GDP growth rate of 0.1%, as productivity and spending fell. These ad hoc factors include the additional bank holiday for the royal wedding and the after-effects of the Japanese tsunami but, as the months have passed, these events can no longer be blamed for the continuous poor growth in output throughout 2011. Admittedly, third-quarter growth was higher, at 0.5%, but many economists continue to predict negative growth for quarter four.

The International Monetary Fund, in September's World economic outlook (external website), forecast 1.1% GDP growth for the UK in 2011, increasing to 1.6% in 2012. The National Institute of Economic and Social Research's (NIESR) predictions in its quarterly Prospects for the UK economy (PDF format, 80K) (external website) point to a fall in GDP growth from 0.9% this year to 0.8% in 2012.

Treasury figures are higher for next year - the October 2011 comparison of new independent forecasts (made in the past three months) puts average GDP growth at 0.9% for 2011 and 1.3% for 2012.

Forecasters are reacting to the external challenges that lie ahead. In September 2011, Goldman Sachs' UK Economics Analyst reported: "The direct effect of weaker global growth on UK exports, and the indirect effect of the eurozone sovereign debt crisis on UK investment (via higher bank funding costs and greater uncertainty) now clearly skew the risks around UK GDP growth to the downside." Goldman Sachs' preliminary estimates put quarter-on-quarter GDP growth at 0.6% to 0.7% in the third quarter.

In its August MPC minutes, the Bank of England warned that there are "substantial uncertainties" around the outlook for output growth, with the eurozone's financial condition considered to be the greatest risk.

Sectors experience varying levels of growth

While GDP growth is slow, some sectors have seen a recent rise in output, according to the ONS GDP Preliminary Estimate Q3 2011 (PDF format, 51K) (external website). For instance, output for the production industries (which include manufacturing) increased by 0.5%, compared with a 1.2% decline in the second quarter and a fall of 0.1% in quarter one.

While the services sector has largely experienced growth over the past year, this has been minimal, ranging between 0.2% and 0.7%, with a decline of 0.4% in the final quarter of 2010. Looking ahead, there are few signs that fortunes will improve - the CIPS/Markit services sector index showed that confidence fell in September 2011 for the second month running and reached its lowest level for two and a half years.

The construction sector is also having a tough time - output for quarter three decreased by 0.6% despite increasing by 1.1% in the previous quarter.

No let up in inflationary pressures

One challenge restricting growth is inflation. Certain sectors are suffering the effects more than others - the highest price rises have been seen in gas and electricity with wholesale energy costs per customer rising by £115 to £605 for the year to October 2011 (a 24% rise), according to Ofgem.

The knock-on effect for the consumer is an average annual dual-fuel bill rise of £175 between June to November, taking the average November retail bill to £1,345 (per year). The ONS says that in the month to September 2011, the average gas bill increased by 13% while the corresponding figure for electricity was 7.5%.

Clothing and footwear prices have also jumped, rising from a 3% increase between June to July 2011, to 4.4% between August and September. Although the figure to September is extremely high, in 2010 the corresponding figure was 6.4%. Both these rises are higher than any other increases between these two months since 2002.

Inflation has hit the headlines throughout 2011, with many reporting that the CPI measure, which increased from 4.5% in August to 5.2% in September, has been at least double the 2% target since January 2011. RPI increased from 5.2% in August to 5.6% in September.

By the end of 2012 (the fourth quarter), CPI should drop to 2.1%, while RPI drops to 3.5%, according to the CBI's August economic forecast (PDF format, 48K) (external website). Barclays Capital estimates a drop to 2.1% CPI and 3.2% RPI.

However, there will be some tough months before we reach this point, with CPI hitting 5.2% in September 2011. It can be argued that this was expected, with the Bank of England stating (in its September MPC minutes) that an imminent, albeit temporary, rise to more than 5% was likely when the sharp price increases of gas and electricity suppliers started feeding into CPI inflation.

Barclays Capital thinks that RPI is likely to rise closer to 6%, saying: "The ongoing squeeze in households' real incomes is the worst since the mid-1970s and a major source of consumer disgruntlement."

The consensus among XpertHR's panel of leading forecasters is that RPI inflation will average 5.2% in 2011 and 3.5% in 2012 (see chart 1).

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Interest rates could remain at 0.5% for years

One way to address rising inflation is to increase interest rates, but caution remains over doing this at a time of low GDP growth with a fragile economy that needs to be stimulated. While three out of the nine MPC members wanted to raise interest rates in April 2011, by autumn all nine MPC members voted to maintain the 0.5% interest rate (in both the September and October MPC meetings).

In the last couple of months, the predicted date when rates are likely to rise has been pushed back considerably. In April, NIESR forecast a rise in interest rates at the end of the third quarter of 2011 - this has now been pushed back to June 2012. Meanwhile, in mid-August 2011, a Reuters poll of analysts (external website) predicted that the first rise would take place in October 2012. This date has been pushed back several times this year - in February the same poll found that most economists thought rates would rise by the third quarter of 2011 (on the Reuters website).

Many others are looking much further ahead with predictions of 2013 for the first interest rate rise. In its October 2011 forecast, the Centre for Economics and Business Research (Cebr) stated: "Interest rates now look set to remain on hold until mid-2013." Before QE2 was announced, some economists predicted rates would not rise until 2014.

Pressures from abroad

Before looking at earnings and employment figures, it is worth considering why forecasts for the coming months are so pessimistic, even when compared with just a few months ago.

External problems have grown, which in turn have had a bigger impact on the UK economy. As reported on XpertHR's blog, debt crises in both Europe and the US were described by justice secretary Kenneth Clarke as "economic icebergs" in July, while on 11 August, Chancellor George Osborne said that "a huge overhang of debt makes this the most dangerous time for the global economy since 2008". Osborne added that the UK economy is in for "a choppy and difficult time" and that "the [global] recovery will take longer and be harder than hoped".

We are continuing to hear that things will get worse before they get better. As the eurozone debt crisis intensified in early October, Goldman Sachs stated: "The deterioration in global growth prospects and banks' funding conditions has continued since the MPC's meeting ended on 8 September."

Deutsche Bank has reiterated the UK's exposure to these crises, pointing out that more than three-quarters of the UK's goods exports are destined for Western Europe or the US, and noted: "The correlation between UK and US economic growth has been rising over the past five decades." In early October, it forecast "a mild recession [in Europe] over the next six months" and like many economists, predicted a second round of QE to help stabilise the economy.

QE2, which increased the size of asset purchases by £75 billion to £275 billion, was announced in October 2011, at least a month earlier than most commentators predicted (Deutsche Bank and Barclays Capital thought that the rise would come in November, while the Royal Bank of Scotland felt that the decision was most likely to be made in February 2012, in order to give European policymakers more time to solve the eurozone debt crisis). The volume of asset purchases also surprised most economists as the consensus was that £50 billion would be injected into the economy, rather than £75 billion. Explaining the timing, the MPC October minutes said: "There were clear arguments for acting quickly and decisively now that the need for further monetary stimulus had become clear."

It is hoped that QE2 will spur the UK economy, making it is less susceptible to the continuing crises in the US and the eurozone. These not only affect the UK's export volume, but are also a key influence on employment.

Private sector job creation fails to outweigh public sector losses

The rate of unemployment has hit a 15-year high (PDF format, 107K) (external website), having jumped 0.4 percentage points to 8.1% on the ILO measure in the three months to August 2011. The last time the employment rate was higher was in the three months to July 1996. Another sign demonstrating a weakening labour market is the increase in the claimant count, which hit 1.6 million in September, up 129,000 on one year earlier.

Responding to these labour market statistics, Dr John Philpott, chief economic adviser at the Chartered Institute of Personnel and Development (CIPD), said: "These labour market figures are truly horrific, with the economy shedding almost 15,000 jobs each week between June and August.

"With 5.6 unemployed people for every job vacancy, the labour market is back to where it was in the depths of recession in 2009 and the underlying problem is getting even worse given that one in three unemployed people have now been without work for over a year. Many more months like this and we're likely to see the re-emergence of the kind of 'gissa job' economy that scarred Britain in the 1980s and 1990s."

While Cebr chief economist Scott Corfe forecast in mid-September that the unemployment rate would rise above 8% in the coming months, this happened sooner than expected. NIESR predicted that unemployment would rise to 8.3% in 2012. However, it could reach that level by the end of this year. The CBI (PDF format, 47K) (external website) had expected unemployment to peak at 2.5 million in the fourth quarter of 2011 (7.8%). By the second quarter of 2012 it expects a drop to 7.7%, falling to 7.6% by the fourth quarter of next year.

A key reason for the increase is that public sector job losses are not being balanced by private sector job creation. Barclays Capital warned in September: "The labour market is likely to deteriorate further as private sector employment growth will be insufficient to offset job losses in the public sector."

As part of his reaction to the figures released in October, Philpott stated: "The quarterly rise in unemployment is reminiscent of an economy in recession rather than any kind of recovery and confirms that the private sector just isn't creating enough jobs at present to offset public sector job cuts."

The Institute for Public Policy Research (external website) stated in September 2011 that between 1.5 million and 2 million jobs need to be created to return the employment rate to its pre-recession level of 73% (it is 70.4% at present (on the ONS website)). It has called for the Government to introduce measures to support employment growth, such as cutting corporate tax rates.

Another area of concern is that the number of unemployed people aged between 18 and 24 is increasing rapidly. It now stands at 785,000, having increased by 70,000 in the three months to August. There are calls for the Government to address this issue and the CIPD has warned that it expects youth unemployment to top one million (external website) when figures are released in mid-November.

The scrapping of the default retirement age, which came into effect in October 2011, adds further to the pool of available labour. The rise in the number of part-time workers demonstrates that people will take positions that offer fewer hours than they would like to work. ONS Labour Market Statistics (PDF format, 107K) (external website) for the three months to July 2011 showed that the number of people working part time because they could not find a full-time job increased by 70,000 on the quarter to reach 1.28 million, the highest level since records began in 1992.

Earning increases remain subdued

For those in employment, wage growth has remained subdued. XpertHR data for the year to 31 August 2011 shows a median basic pay award of 2.2%.

Explaining the challenges faced when it comes to pay-setting, Sheila Attwood, XpertHR's pay and benefits editor, said: "From the employer's perspective, while the UK is technically no longer in recession, business volumes have failed to pick up to pre-recession levels and budgets remain constrained. From an employee's perspective, however, pay rises have been negligible - or nil - for a couple of years, and the cost of living is rising rapidly."

The MPC September minutes stated: "There was little to suggest that higher inflation expectations were feeding through into wage-setting behaviour." NIESR also came up with the same conclusion, having analysed market data.

ONS data for the three months to August 2011 shows that average earnings for total pay (including bonuses) grew by 2.8%, while the regular pay figure (excluding bonuses) was 1.8%. When faced with similar figures for May to July 2011, the ONS pointed out that most people's wage growth was below the average figure, as the average included a 4.8% increase in regular pay for those in the financial sector.

Most employees are seeing their real wages decline. While those in the private sector receive low awards, many of those working in the public sector are in the first year of a two-year pay freeze (for those earning more than £21,000 per year).

There is some hope ahead, with the Bank of England's August inflation report (PDF format, 608K) (external website) predicting that earnings growth is likely to pick up. XpertHR's pay prospects survey shows that private sector wage-setters are expecting to boost wages by 2.5% in 2012, while XpertHR's panel of leading forecasters predicts an average rate of change in annual earnings of 2.4% in 2011 and 3% in 2012 (see chart 1).

Union power remains

Although pay rises have been significantly lower than inflation, the unions have continued to be a powerful influence in certain sectors, securing pay rises far closer to the level of inflation than to the median pay award of 2.2%.

One of the best pay deals offered this year is a potential 5% pay rise for tube driversfor 2011 (backdated to April), followed by three years of RPI inflation plus 0.5%. This however, is an anomaly. XpertHR's coverage of the wage bargaining agenda says the Federation of Master Builders thinks the economic outlook is "very grim" and the Communication Workers Union believes that the economy will place significant downward pressure on pay awards.

Concern about job losses means we are less likely to see industrial action in some sectors. However, following June's union action (taken by unions including the National Union of Teachers and the Public and Commercial Services Union (PCS), we will see several public sector unions and the TUC react to the public sector pension cuts on 30 November. They will take part in a nationwide day of action (external website), which could see three million workers joining events such as strikes and rallies.

Challenges for the future

While there is little optimism about the economy overall, forecasters are in general agreement that 2012 will be better for the economy than 2011, particularly in terms of growth and lower inflation.

Inflation is likely to drop closer to the Government's target of 2% CPI as 2011's VAT increase to 20% falls out of the year-on-year comparison. QE is also expected to help push inflation down. Before QE2 was announced, NIESR said: "A modest loosening [of fiscal policy] would improve prospects for output and employment, with little or no negative effect on fiscal contribution."

Some commentators hold the view that decisive action from the European policymakers in November's G20 meeting could help avoid Europe going into recession. However, many have noted the need for quick action on tackling the eurozone debt crisis. MPC member Ben Broadbent said that, for eurozone policymakers, "the time had come for action rather than words" (on the Reuters website). Fellow MPC member and Bank of England chief economist Spencer Dale (on the Daily Mail website) said: "The only thing I would wish for is whatever the euro-area authorities decide to do, they do it quickly and decisively ... decisive, clear, timely action is what is needed."

A sign that the UK economy is a step removed from the European and US crises is the fact that in October 2011, the ratings agency Standard & Poor's kept the UK at an AAA rating (on the BBC website) despite downgrading the US economy from an AAA rating to AA+ on 6 August.

This has little bearing on consumer confidence, however, which has remained shaky throughout the year to September 2011, according to GfK. The lowest scores were seen in April (-31), and from July to September (-30 to -31), and it is unlikely that we will see much change in the October score given the current economic situation.

NIESR believes that it may be some time before spending improves: "We expect relatively weak growth in rates in consumer spending, at 0.7% and 1.6% in 2012 and 2013 respectively. It is only at the end of 2014 that we expect the level of consumer spending to return to the pre-recession peak in the first quarter of 2008."

The CBI commented in its "Economic and business outlook" in August 2011: "Weakness in domestic spending - in the consumer and the public sectors - means that the recovery going forward is still expected to be sluggish."

The UK's economic recovery will remain on a rollercoaster for several months to come, but there are glimmers of hope. In the past couple of months, both the British Chambers of Commerce and the Institute of Directors (PDF format, 750K) (external websites) have produced proposals to boost business growth and we will hear more plans to get the economy in gear in the Chancellor's Autumn statement on 30 November.

The Bank of England said in its October MPC minutes: "It seemed likely that much of the continuing slowing in underlying growth in the United Kingdom was being driven by the deterioration in the external environment." This recovery may be more dependent on the health of the US and the eurozone's finances than it has been in previous months, but QE2 may well be the stimulus needed to set the UK economy back on a path of growth.

Author: Jo Doonar, deputy editor, pay and benefits.