The forecast

A good year ahead for the UK economy? Predictions from BNP Paribas economist, Alan Clark.

Growth* the overall picture*

The UK economy has finally begun to expand again, following the longest and deepest recession since the war. On the way down, most forecasters consistently underestimated the severity of the slowdown. I believe that many are now underestimating near-term growth. I expect the economy to expand by 2 per cent during 2010 - much higher than the consensus, which has gradually been creeping up from around 1 per cent and is now approaching 1.5 per cent.

However, much of the impetus for the recovery is temporary. The prevailing view is that growth will gradually accelerate during 2011. But I believe it would be a mistake to extrapolate the near-term trajectory for growth. I expect that, after a good start to 2010, the economy will enter a weaker period (or "soft patch") in late 2010. This could mean sluggish growth of 1.5 per cent during 2011 - below consensus expectations for around 2.5 per cent.

The influences that are likely to support growth in the near term are: the end of destocking, the bounce-back from artificially low levels of manufacturing output and real disposable income growth.

Destockingeverything must go

Destocking was a major drag on the UK's economic output in early 2009. When firms stop running down stocks this will boost growth. The inventory to sale ratio remains low by historical standards so there is room for some rebuilding of inventories. But this is a one-off correction and can't be relied upon to generate growth much beyond this year.

Real disposable income*the money in our pockets *

Real disposable income growth has been rapid of late. Only two other quarters in the last decade saw faster growth than the 5.2 per cent recorded during third quarter (Q3) of 2009. Take-home pay growth has been boosted by a plunge in the mortgage interest burden (following the Bank of England's decision to cut the base rate to 0.5 per cent) and by government spending (or "loose" fiscal policy). The drop in inflation during 2009 helped to increase real purchasing power.

Sadly, this rapid growth is a temporary phenomenon. All three of the boosting factors will disappear and may even reverse: interest rates are not falling any more, fiscal policy is unlikely to be loosened further (the government cannot keep spending) and inflation is rebounding, at least for now. With slow employment growth and low wage inflation (few new jobs or pay rises), real disposable income growth is likely to be much slower in the quarters ahead.

Fiscal policytrouble ahead...

The conditions that are currently favouring short-term growth are likely to become highly unfavourable. Fiscal policy, for example, will be tightened. We expect the Conservative party to win the general election and get to work early in fixing the public finances. Much emphasis has been placed on reducing spending and the sale of government assets. However, it is hard to envisage how the deficit can be cut without tax hikes, which will inevitably weigh on growth.

Exportson the bright side...

The one bright spot in the outlook is exports. Once the effect of the near 20 per cent depreciation in sterling exchange rate kicks in, it should result in export growth approaching double digits. This should partly compensate for the drag from government spending cuts and sluggish consumer spending growth.

Inflationthe price of eggs

Over the last two years, inflation has been consistently higher than expected. In the last 21 months, Consumer Price Index (CPI) inflation has been lower than expected only twice and above expectations 16 times. Much of this is due to the pound's depreciation. However, government policies, such as the car scrappage scheme (which offers £2,000 to car owners wishing to trade in their car for a new model) have also contributed.

CPI inflation rose to 2.9 per cent this month (up from 1.9 per cent in November) this was largely due to the increase in VAT (back to 17.5 per cent). I expect CPI inflation to continue rising, reaching 3.5 per cent by the end of the month. For the rest of 2010, I expect CPI inflation to be in the range of 2 to 2.5 per cent, partly helped by a second VAT hike (up to 20 per cent) after the election.

However, once the impact of the pound's weakness fades and the effects of the output gap begin to be felt, we expect CPI inflation to fall below the 2 per cent target.

Interest ratesthe price of lending

I disagree with the prevailing view, which expects the Bank of England to begin to raise interest rates during the second half of this year. There will be considerable tightening in monetary policy even without Bank being forced to raise rates. The incoming government is likely to deliver significant tightening in fiscal policy. Yields on government bonds (gilts) are expected to rise on the back of surging issuance and no further buying by the Band of England, once quantitative easing (QE) comes to an end. If we enter 2011 with weak economic growth, rising unemployment and below target inflation, I find it hard to envisage the Bank of England raising interest rates.

The QE question printing money

The Bank looks set to pause its purchases of gilts under the Asset Purchase Facility at the February meeting. There is still a strong case for expanding QE further. There is uncertainty over who is going to absorb more than £200 billion of gilts once the Bank has stopped buying them. However, with the macro economic data going largely to plan, it seems the Monetary Policy Committee is losing its appetite for more purchases at this stage.

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