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The good, the bad and the ugly of UK economics

The good, the bad and the ugly of UK economics

10 July 2012 / by Oliver Roylance-Smith

The continuous stream of both positive and negative economic news has shown the good, the bad and the ugly of UK economics recently and it can be a real challenge to understand what to make of it all. We take a look at the latest events that could have a real impact on your savings and investment decisions.

A real life spaghetti western

Sometimes it is hard not to be cynical about a great many things to do with the economy. With the recent news of the scandal around Barclays and their record fee by the FSA for rigging the LIBOR rate, you could be forgiven for thinking that greed has been the most influential factor for the current crop of financial elite.

Ultimately the government and the Bank of England’s goal is to reduce debt and get the economy going again but whether we like it or not, the banking industry plays a fundamental, if not critical role in the reality which will unfold. It is therefore important for both savers and investors to understand the context within which economic events take place and as you might feel that all we hear is bad or negative news, we’ll start off with the good.

The good

Inflation figures from the Office for National Statistics gave us some cause for hope when their latest report revealed that the annual headline rate of inflation fell to 2.8%*, its lowest level since November 2009.

Every saver will know that the main side effect of the record low 0.5% Bank of England interest rate is that we have had to endure some of the lowest returns available on our savings for some time. The reality is that the difference between leading instant access and longer term fixed rates being less than 1% per year – what this tells us is that there is great uncertainty about what lies ahead. However, this situation is made even more serious by high inflation so the second consecutive reduction to inflation is indeed a welcome one.

We should though always remember the impact of inflation on our savings. If we receive a 5% return each year for 5 years, this equates to growth on a £10,000 deposit of £2,763. However, if inflation has been running at its current rate of 2.8%, in real terms this growth is only £1,149, well under half the original figure and this is before any taxation is taken into account – points well worth considering before taking action.

The bad

Although the reduction in inflation is on the face of it good news, as we recently commented it is highly unlikely that things are as they seem and there are a growing number of factors which collectively suggest that inflation is far from under control. We also reported last month that with inflation getting closer to the Bank of England’s target rate, the Bank had room to restart quantitative easing (QE) as early as next month - and indeed they have done just that.

This decision was made all the more easy by the confirmation that UK GDP fell by 0.3% in the first three months of the year, sending the UK into recession following a 0.3% drop in the previous quarter. Embarrassingly in March the Office for Budget Responsibility predicted that the economy would grow by 0.8% this year and 2% in 2013, a stark contrast to the reality which has unfolded. Leading credit ratings agency Standard & Poor’s labelled their forecasts as ‘overly optimistic given the challenges facing the economy’ and they were certainly proved right.

The Office for National Statistics is to release its initial estimate for the second quarter GDP on 25th July but there is growing consensus that amid recession in the Eurozone and slowing global growth, combined with the UK’s weak private sector and softening trade (the areas the assumed growth was reliant on), the figure will remain negative – could the bad news get any worse?

From bad to worse

The extension of its QE programme to £375 billion was therefore expected. However, more worrying for savers is that the Bank of England discussed the case for lowering the interest rate from the current level of 0.5% for the first since last September. For the time being at least the Monetary Policy Committee is sticking to the view that there is not a compelling case that lower interest rates would add to the overall impact.

However, as sceptics have pointed out the previous rounds of QE had largely remained in the hands of commercial banks with 85% of the previous £125 billion of newly printed money ending up back at the Bank of England rather than finding its way to the real economy.

However, if the further round of QE does not have the desired impact, there will no doubt be further pressure on this as one of the few remaining alternatives. This causes little in the way of hope for increases to savings rates any time soon and with records low returns available on fixed rates becoming the norm, this spells things going from bad to worse, especially for savers.

The ugly

So this is not a good time to have to consider your savings options. If ultimately the landscape shapes into lower interest rates, continued low growth and increasing inflation, this is about the worst case scenario for savers. Unfortunately this does seem a possibility - the picture is certainly darkening with the economy having barely grown in the past 18 months and consumer buying power has been eroded by persistently high inflation, muted wage growth and rising unemployment.

Certainly previous rounds of QE have been far from successful in terms of what they have been designed to achieve so although this latest round might be appropriate, is it going to be enough?

At the end of June, the governor of the Bank of England, Sir Mervyn King, told the Treasury select committee that the crisis is far from over and the above tells us he was spot on: ‘All the way through, I’ve said to this committee that I don’t think we are yet half-way through – I’ve always said that and I’m still saying it now’ he told MPs.

From a saver’s point of view, the important point is to bear in mind the length of time these decisions and their impact take to assess, review and then act again. If we are to believe Mr King, and everything points to this being true, then this implies that interest rates will stay at these levels for at least another three years to 2015 and a further round of £375 billion of QE is potentially on the agenda.

Combined with the potential for increased inflation due to upward pressure on commodity prices and the effects that increased money supply will have once it starts to flow into the wide community, and the continuation of suffering from low interest rates makes for a truly ugly scenario.

Short-termists beware

It is very easy to bury your head in the sand and hope it will all go away. The reality is that there is a swell of worsening economic data and increased uncertainty about how to fight our way out of the current situation. Worse still, some of the contributing factors are clearly beyond our control.

What the last three years have shown is that taking the ‘wait and see’ attitude rarely pays off and that we really need to understand the impact of inflation, continued low interest rates and sluggish economic growth on all of our savings and investment decisions.

The bigger picture should be taken more seriously now than ever before since the cost of losing sight of these important factors could be costly….

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* Source: Office for National Statistics, 28th June 2012

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