Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 26 April 2022

Is the UK heading for a recession?


My guess is probably, but what do I know? What I do know is that unconditional [1] macroeconomic forecasting is a mug’s game, and the only reason some people do these forecasts is that they are generally better than an informed guess, but only a little better. What I can do in this post is make some I hope helpful points about annual versus quarterly growth, look at some of the evidence and some key behaviour that will decide whether a UK recession is on the cards.

As Duncan Weldon reminds us, most established economic forecasters are terrible at forecasting recessions. One reason has little to do with economics, and a lot to do with human nature. I learnt this very early. My first job was helping to forecast the world economy in the Treasury, and it was after the first oil shock of 1973/4. Our initial forecast showed a collapse in world trade. Our boss was not happy - nothing like that had happened since WWII. As a result of his unhappiness we revised our forecast up, but our initial forecast was nearer what actually happened than our revised forecast. Established forecasters are always looking over their shoulder at other previous forecasts (by themselves and others) and hate being too extreme. As a result, they tend to miss booms and recessions.

A second reason that domestic forecasters miss recessions is that they fail to recognise that what they are seeing domestically is often also happening in the rest of the world. That is true today with a global cost of living crunch. Indeed that psychology of forecasting can allow non-forecasters or ex-forecasters like myself a slight advantage. In this post I tell the story of the 2009 recession, where in No.11 Downing Street I at least held my own among more professional forecasters simply because I applied these two observations about forecasting the extent of that recession.

It should not come as a surprise, therefore, that no major forecaster has predicted negative annual growth this year or next, despite what is expected to be the biggest fall in living standards in any single financial year since ONS records began in 1956-57. Instead consumers are expected to dramatically reduce their savings, as this chart from the latest OBR forecast shows (look at blue line).

So, sticking with this OBR forecast, we have real household disposable income falling by 1.5% this year and 0.2% next year, but aggregate consumption is forecast to increase by 5.4% and 1.0% respectively. At first sight this looks very implausible.

It looks even more implausible if we look at surveys of consumer confidence. To quote from Duncan’s piece: “The GfK Consumer Confidence Index fell for the fourth month in a row to -31 from -26 in February, its lowest since November 2020, deep in the coronavirus pandemic. Readings of -30 and below have presaged recession on four out of five occasions since the survey started in 1974.” Since then the March data is available, and it’s at -38!

David Blanchflower talks about this data and similar for the US here, and is in little doubt that a recession is on the cards. So how would economic forecasters, and the OBR in particular, defend their forecast of strong growth in consumption this year, and positive growth next year, despite falling incomes? The answer also comes from the chart above. The pandemic led to unprecedented increases in household savings, because most maintained their incomes but the pandemic led to sharp falls in ‘social consumption’. So most consumers will have plenty of scope to run down their savings as their incomes fall.

Furthermore, standard theory suggests that consumers who have the ability to do so will try to smooth out fluctuations in real income, if they think the fall in their income is temporary. Indeed, after social consumption has been suppressed during the pandemic, there may be some bounce back as consumers try to partially recoup the spending they had missed out on. (For a similar reason, consumers switched spending from services to goods during the pandemic, which partly explains some of the supply side inflation we have seen). To set against that the pandemic is not over, despite what some politicians might say, so that will inhibit consumption.

Rapid consumption growth is what we saw at the end of last year during the vaccine led recovery from the pandemic. The level of consumption in the fourth quarter of 2021 was over 8% higher than a year earlier. Crucially, that means that even if quarterly consumption in 2022 was flat at the 2021Q4 level, annual growth this year would be very high. The lesson here is that for this year, look at quarterly growth through the year rather than year on year numbers.

Does the recent fall in retail sales also suggest a recession? Again we have to be careful. As many people are starting to behave as if the pandemic is over, we would expect to see a switch from goods you buy in shops or online to social consumption which are services like travel or eating out. As James Smith notes, online sales are also falling back to more normal levels. This doesn’t necessarily imply a fall in total consumption.

So where does that leave us? While many consumers are in a position to use savings to finance consumption growth, they will only do so if they are sure the cost of living crunch is temporary rather than permanent. Many will not be so sure, and together with those who can only maintain consumption through borrowing, it seems likely that the aggregate level of consumption will fall through this year. That in turn means it’s likely that we will see falls in the monthly path of GDP through this year, and indeed that is something the OBR are expecting to happen (p.42). [2] In that sense the OBR is forecasting a recession during this year, but not in the annual figures that everyone focuses on.

For reasons already explained, that quarterly path could still leave a relatively healthy year on year growth rate for this year because of strong growth due to the vaccine based recovery through 2021. The big unknown is what happens in 2023. Looking at the OBR’s forecast savings ratio chart above, what looks implausible is the very slow recovery in savings from 2023 onwards. If annual growth is going to be negative at any point, it is likely to happen next year rather than this, because the inflation we are currently seeing keeps incomes low and consumers try and get back to more normal levels of saving.

[1] By unconditional, I mean forecasts of what will happen to a macroeconomic variable in a year or two’s time. In contrast a conditional forecast asks how that variable will change if policy changes, for example. Conditional forecasts are much more focused, and therefore more reliable. Politicians and some journalists often do not, or pretend to not, know the difference between these two types of forecast. For example Brexiters during the 2016 referendum used the unreliability of unconditional forecasts to cast doubt on conditional forecasts like Brexit will lower GDP, which was a simple error.

[2] That in turn makes a technical recession in the UK (two consecutive falls in quarter on quarter GDP) possible, but it’s wrong to get hung up on this technical definition. A quarterly path of GDP growth that goes +2.0, -0.1, -0.1, +2.4, +2.4 is a technical recession, while a path that goes +0.2, -1.0, +0.1, -2.0, +0.1 is not, but that latter is much worse than the former. I tend to use the term recession in a much less precise way, to mean an economic downturn that is particularly severe.

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