UK Economy ... Hurry Up and Wait?

As the global economic downturn morphed into a full-blown collapse last year, global central banks rolled up their sleeves and got to work. As with the Fed in the U.S., the Bank of England (BOE) looked across its hemorrhaging economic landscape and reacted swiftly to stop the bleeding.

The first line of attack was monetary policy, as the BOE slashed rates from 5 percent in early October to its current all-time low of 0.5 percent since last March. With rates as low as they could go, the next step was to inject money into the economy through "quantitative easing" (QE) via purchases of assets through freshly created central bank funding.

As with the swiftness of the BOE's monetary easing policy actions, the huge amount of QE has also been unprecedented. The initial goal established in March was set at approximately GBP 75 billion, predominately through gilts held by investors such as insurance companies. However, it quickly grew to GBP 125 billion by May, with the expectation that the program would be completed in three months time, again more than previously predicted. The big unknown at this point is whether these aggressive stimulus actions are working.

There have been some encouraging signs over the last couple of months. The equity markets have rallied nicely as investors have begun to embrace risk again now that their fears of bank failures have receded. Recent surveys of businesses and consumers have also picked up as sentiment has become much less negative. In another economic barometer relating to the general health of the economy, real estate agents have reported a general rise in property inquiries from new buyers, adding another positive data point that the economy is lifting out of the "bottoming-out" phase of the recession.

The positive signs in the economy haven't translated well in the labor markets as of yet though. The unemployment rate in the UK has jumped from 5.8 percent in 2008 to a projected 8.3 percent in 2009 (biggest rise since 1981), with 2010 expected to peak at 9.7 percent. In another sign of the overall weakness, average earnings have fallen by nearly 1 percent as compared to a year ago, which is the first ever decline in that category since 1964!

Last May the BOE doused much of the rekindled optimism surrounding the UK's economic prospects when presenting its quarterly Inflation Report. The gloomy report more than offset its previous forecasts, as its central projections implied that GDP will be negative this year by nearly 4 percent (recently pointing to nearly 6 percent), but encouraged by the prospects of growing by 1 percent in 2010.

Despite this negative outlook, the BOE envisions a recovery to start by year-end. If and when the economy does spring back to life depends on a few key sources. First, the economy should get a boost by what Mervyn King, the bank's governor, describes as an "unprecedented policy stimulus, by both monetary and fiscal." Second, the big depreciation in sterling since last summer will help support exports and constrain imports. And third, the inventory cycle will turn around as producers start to satisfy rising output, rather than running down inventories.

All of these counterforces to the downturn appear to be strong enough to end the recession before too long. The real worry is whether the recovery will be sustained, and if it is, whether it will be weak rather than strong. Any bounce in activity from a turnaround in the inventory cycle should be short-lived if underlying demand fails to revive. Since consumer debt is still high, people will want to increase savings, which will have a negative effect on spending. With business investment also expected to be weak as firms curtail their borrowing, recovery will hinge on foreign trade. The big fall in sterling should help exporters, but what is really needed is a quick and strong upturn in the UK's main foreign market - the euro zone - which at this point doesn't seem likely.

Even if a sustained recovery finally does get underway, it will most likely be tempered for several years by fiscal constraints and the reversion to a more normal monetary environment. The OCED recently indicated in a report that past growth in Britain had been unsustainable and driven by the last credit boom. Any recovery will be sluggish, with growth expected to remain well below trend as households and firms rebuild their balance sheets. That gloomy forecast seems all too realistic considering where we came from last fall.