Getting the answer right is the key to successful economic forecastingby Duncan Weldon / January 26, 2017 / Leave a comment
The figures are in. According to the initial estimate by the Office for National Statistics, UK GDP growth in the fourth quarter of 2016 came in at 0.6 per cent—and at 2 per cent for the year as a whole. That’s a touch above the consensus forecast but well ahead of what almost every observer—including your writer—was looking for just six months ago.
A good rule of thumb when looking at GDP figures is “never overanalyse one set of quarterly numbers, especially if they are only the first estimate,” but in the context of the wider failure of forecasting over the past few months, it seems prudent to set that rule aside and look at the bigger picture.
Since the UK voted to leave the European Union back in June, the economy has been resilient, even solid. True, growth has been reliant on the consumer and that consumer spending has been underpinned by a fall in the household savings ratio (the amount of disposable income that households, on aggregate, set aside), but, if we are honest, the same could be said for most periods of UK growth over the past few decades. That’s what our national growth model looks like.
Six months on it is worth stepping back and asking, what went wrong with the post-Brexit forecasts? Only after doing that can we have reasonable stab at estimating what the outlook for 2017 is.
It’s important here to be clear: we are talking about two distinct sets of propositions about what the impact of Brexit would be on the UK macroeconomy, one concerned the long-term, one concerned the short-term.
The (consensus) long-run view, which I still don’t see any reason to challenge too deeply, was that cutting ties with our largest trade partner would lead, over the years, to a more closed UK economy. It seems highly likely that whatever post-Brexit UK-EU deal we end up with, it will not be as deep as the current arrangements. And it strikes me as highly unlikely that our new won freedom to strike our own trade deals will be enough to make up for the loss of market integration with our most important economic partner.
A less open and less trade intensive UK economy should experience slower productivity growth in the coming decade—trade has always been a great spur to productivity. That slower growth in productivity will mean slower growth in GDP per head. Add in the impact of a fall in immigration—which also seems likely—and you have an economy that is in, say, 2030 smaller than it would have been otherwise. The long-run impact then is likely to be negative, although negative in this case is defined as “slower growth” rather than as “an actual fall in GDP.” Of course given we will never know what the counterfactual of the UK remaining in the EU would have looked like, I rather suspect this is an argument that will never be resolved. We’ll still be arguing about this one in 2030. Sorry.
But what of the short run impact? The one that hasn’t really materialised. The Treasury’s analysis of the short term impact was stark.
“A vote to leave would cause an immediate and profound economic shock creating instability and uncertainty which would be compounded by the complex and interdependent negotiations that would follow. The central conclusion of the analysis is that the effect of this profound shock would be to push the UK into recession and lead to a sharp rise in unemployment.”
The weakest defence of that analysis is to argue—as some do—that it assumed that Article 50 would triggered immediately. I hear this defence a lot but I have yet to see the argument by which an immediate triggering (which very few people seriously expected anyway) would have led to a radically different economic outlook.
The better defence, although one that “Remain” voters are always less likely to leap to, is that the document’s central case was always fundamentally flawed in that it assumed there would be no macroeconomic policy response to Brexit. In reality of course the Bank of England reacted quickly with a rate cut and a restarting of quantitative easing, while the Treasury has slightly eased fiscal policy.
That said, monetary policy operates with a lag—one often described as “long and variable”—and to argue that the only reason we dodged a bullet over the last six months is because of a rapid response by the Bank of England requires some heroic assumption.
In reality, the big call underlying the consensus view of the short-term impact of Brexit was that, knowing they would poorer than expected in the long-run, firms and households would react in the short-term by trimming their spending now. That hasn’t played out as expected.
While December’s retail sales figures came as disappointment to analysts, the bigger picture has been of a happy consumer willing to keep on spending. Add in the fact that financial markets were relatively well behaved and that any future cuts to business investment spending appear to come on a large lag (corporate spending plans can be difficult to switch off instantly), and the picture has been of relatively healthy demand growth. The labour market too seems relatively perky, employment has stayed at record highs, unemployment is low and while wage growth remains well below pre-2008 levels it has slightly picked up in recent months.
So, as ever, when asking how the British economy will perform in 2017, the question is really: what will the consumer do?
The one bit of almost everyone’s forecast that has played out as expected has been a collapse in the value of Sterling. As that feeds through into consumer prices—and the effect is already very visible in the prices paid by producers—then inflation will pick up sharply.
It seems highly likely that real incomes (accounting for prices) will once again fall. The working assumption of many is that faced with a real income squeeze, British households will trim their spending plans and the consumer motor will falter somewhat leading to a slowdown in growth. Perhaps.
But it is worth not entirely discounting the idea that households will be happy to borrow and run down savings to maintain spending. As long as unemployment remains low then credit availability is unlikely to be too constrained (banks in general being happier to lend to those in work) and if consumers believe that the income squeeze is temporary they may be prepared to look through it.
Calling the UK consumer the right way is the key to getting 2017 growth right, just as it was in 2016 and just as it almost always is. Now strikes me as a good time for economists to emphasise the uncertainty around their forecasts—rather than doubling down on strident calls.