Prospects for the UK economy by Simon Kirby, Senior Research Fellow, NIESR on 08-May-2012

The UK economy contracted in the first quarter of this year by 0.2%, returning the economy to recession. Of course, revisions may change this. However, small quarter to quarter movements of this sort are largely irrelevant to the broader picture of an economy that remains very weak. Our monthly estimate of GDP suggests the level of economic activity in the economy in March 2012 was the same as in September 2010. This clearly does not constitute a sustained recovery, so the question of whether or not the economy is technically in a double-dip recession is moot.

Such weakness is likely to persist over the next couple of quarters, and means that growth this year will be close to zero. But from the start of next year we expect more robust growth, with a sustained period of above-potential growth from 2014, which is necessary to reduce the output and unemployment gaps.

The unemployment rate will rise to about 9% this year and remain high throughout the forecast period. Elevated unemployment for such a long period is likely to do permanent damage to the supply side of the economy, with large long-run economic costs. Our central forecast is that inflation will fall below the 2% target at the end of this year.

It remains our view that fiscal policy could be used to raise aggregate demand in the economy with little to no loss of fiscal credibility. We have never and do not now advocate scaling back the government’s medium- to longer-term policy of fiscal consolidation. However, the UK also suffers from a lack of demand in the short term. As we noted in our January Review, a 1% of GDP increase in government investment this year would boost GDP by around 0.7%, assuming no reaction by the MPC. A temporary boost to net investment, which has been cut extremely sharply, would have no direct effect on the government’s primary fiscal target of balancing the cyclically-adjusted current budget in 2016–17.

In summary:

• More than four years after the start of the recession, the economy is well over 4% below its pre-crisis peak. This persistent weakness is unprecedented.
• Growth this year will be close to zero, but about 2% in 2013.
• Although our inflation forecast has increased, largely as a result of the increase in oil prices, we still expect it to fall below target by the end of the year
• We expect the cyclically adjusted current budget to be in slight surplus in 2016–17.
• We expect the unemployment rate to rise to almost 9% at the end of this year and to remain elevated throughout the forecast period. This will do permanent damage to the UK’s productive capacity.

For more information on the National Institute of Economic and Social Research, please visit: www.niesr.ac.uk

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