The UK will suffer from US recession

With the US in the middle of another recession, an economic slowdown looms large for the UK, writes Dennis Turner

A booming housing market, high levels of consumer borrowing, a pick-up in consumer price inflation, a balance of payments that is heavily in the red and a large fiscal deficit all point to an economy that is heading for a bit of a bump.

Familiar as it may sound, this catalogue of woes refers to the US rather than the UK. And while the prospect of a recession in the world’s largest economy is at the extreme end of the forecasting range, the dreaded ‘r’ word has re-entered analysts’ vocabulary. At the very least, a short-term slowdown is very much on the cards.

Over the past two or three years, the world economy has been growing at rates of between four and five per cent. As ever, the US has been at the heart of the growth. After the brief recession in 2001, US growth picked up and has been above three per cent per year since 2004.

The primary driver behind the slide into recession five years ago was the squeeze on company profits and the business need to run down borrowings. As companies reduced their debt, households were persuaded to take on more.

Predictably, US households responded by spending and borrowing. As in the UK, the housing market was at the centre of the action. As the number of transactions rose, so did prices, and increased borrowing was the obvious consequence. Outstanding mortgage debt of $5.1 trillion at the end of 2001 had virtually doubled by June 2006.

Given its remit, the Federal Reserve (FR) could not be complacent about the rise in inflation, which at one point topped four per cent. Inflation was already edging up when oil prices rapidly increased. Since fuel taxes are proportionately lower in the US, higher oil prices had a much bigger impact on living costs than in Europe. So, at each of its 17 meetings between June 2004 and June 2006, the FR added 0.25 percentage points to its benchmark rate, taking it from one to 5.25 per cent.

This was clearly going to hurt and the pain is now being felt. Growth slowed to a more modest 0.7 per cent in the second quarter – following an unsustainable 1.4 per cent in the first three months of 2006 – and the pace of job creation slackened. The non-farm payrolls measure of employment slipped from an average of 175,000 per month in the first quarter to just 51,000 in September.

This downturn in the housing market coincided with other strains and stresses on household incomes. After adjusting for higher debt repayments, higher taxes and general consumer price inflation, an apparently healthy seven per cent growth in nominal incomes translates into a mere one per cent increase in discretionary spending power. Faced with the prospect of an imminent slowdown, the FR stopped hiking rates at its past two meetings. There is also a growing opinion that the next move in rates will be down. This will further undermine the dollar and make life harder for UK exporters to the US. On the plus side, weaker growth in the US will take the froth off commodity markets and ease the inflationary pressures for UK companies.

It may no longer be true to say that when the US sneezes, the UK catches a cold, but we will feel the impact of a US slowdown. This will come via a weaker dollar, tighter export markets and weaker returns to UK firms on their US investments.