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Why the UK recovery threatens to deceive

Optimism around the UK economy has been picking up lately: improved industrial production, a rebound for sterling, even the outgoing Bank of England governor is sounding a little more upbeat. But these tender green shoots of recovery are deceptive. They will probably turn out to be weeds.

Ross Walker, Senior UK Economist at RBS

The general pace of growth will remain distinctly sub-trend, even though we should see modest growth of 0.8 per cent this year and 1.5 per cent in 2014. We should not let a short-term improvement in volatile data obscure the stubbornly entrenched imbalances hurting the British economy. The Treasury’s solution – ‘monetary activism’ – remains a somewhat hazy concept. Mark Carney is the man charged with leading its practical implementation when he becomes governor in July, but the UK’s inflationary tendencies – which increasingly suggest there are serious supply-side log jams – highlight just how constrained he may be.

Monetary activism can only work if it is accompanied by radical supply-side reform and a genuine fiscal correction. There is little evidence of either.

While the rhetoric remains tough, the reality is that the UK has made comparatively little progress on fiscal consolidation and inroads on an underlying deficit equivalent to 8 per cent of GDP. Difficult decisions are increasingly being kicked into the long grass beyond the 2015 election. That is a risky approach if a more acute fiscal adjustment is forced upon the UK should investors revolt over low-yielding gilts and an economy that refuses to recover.

The protracted process of deleveraging Britain’s excessive public and private sectors will nevertheless remain the defining feature of the UK economy. It will probably take the remainder of this decade to complete the fundamental task of re-balancing.

Though the financial sector has made welcome progress in reducing its risk profile, the household sector is - at best - only halfway through its necessary deleveraging and the public sector lags some way further back.

Static household incomes make it unlikely that British consumers will come to the rescue. Wage settlements remain low and unemployment is rising so household incomes that are already overly dependent on the welfare state will remain muted. Add to this inflation that persistently exceeds the Bank of England target and their purchasing power continues to be crushed.

The lack of an export-led recovery completes the gloomy picture. The current account deficit reached 3.7 per cent in 2012 – the largest external imbalance for more than two decades, and this against the backdrop of four years of economic stagnation. Though trade should make a contribution this year and next, it will be insufficient to plug the gap in domestic demand, particularly as the UK’s most important trading partner, the euro area, slides into recession.

Against this worrying backdrop it is hardly surprising that UK companies continue to hoard sizeable cash piles rather than invest. There are even early signs that firms’ appetite for hiring may be on the wane.

It is difficult to banish pessimism in this situation. Squeezed households, government cuts, hesitant investment and weaker external demand hardly suggest fertile soil for those green shoots.

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