The recent debate about whether or not the economy will enter a recession reminds me of the old joke about two economists in a room coming up with three opinions.
Earlier this week the International Monetary Fund said there will be a recession. On Thursday, the Chancellor said that “we are set to avoid recession”. That’s two opinions. The third comes from the Bank of England. It isn’t sure. Back in February it was forecasting a recession. But it recently revised up its forecast. We won’t know for sure where it stands until its new forecasts are published in full in May. None of this paints economists in a good light.
What’s worse is that there is no official definition of a recession. And the most common one of a decline in economic output lasting at least two consecutive quarters can be very misleading. By that measure, a 10% decline in output in one quarter is not a recession, but two 0.1% q/q declines in a row is. I know which one I would prefer.
So what does a recession really mean? Perhaps the best way to think about it is that it involves a period where national income declines. If spread evenly, all households and businesses would experience a fall in their income and their living standards would decline. In practice, some businesses fail and others reduce headcounts, so those people unlucky enough to lose their jobs experience a large fall in their income.
So why is there so much disagreement now about whether or not there will be a recession? We know that the UK’s national income has declined because energy prices surged after the end of the pandemic and Russia’s invasion of Ukraine.
The UK has had to pay more for its imports than it received for its exports, which meant it had less money to spend on other things. More often than not, such conditions would lead to a recession.
But this time it seems that the Government and businesses have helped to cushion the blow. By borrowing money (some from overseas) and handing it out, the Government has supported the incomes of both households and businesses.
Households have received extra help from businesses. Companies have found it hard to source suitable workers since the pandemic. Not only has that made them reluctant to reduce headcounts, but it has also meant they have been paying higher wages to retain and attract workers.
Households haven’t escaped scot-free. In the year to the third quarter of 2022, their incomes fell by 2.5% after taxes and adjusting for inflation. But in the fourth quarter, thanks in part to the government handouts, their income rebounded by a decent 1.3%.
The upshot is that the economy hasn’t been weak enough to meet the usual definition of a recession. But it’s not really grown either. Indeed, GDP didn’t rise at all in February, a result that was partly due to the strikes by civil servants, train workers and teachers.
On balance, I think there will be a mild recession this year, which may involve activity falling by around 1%. Admittedly, the big fall in energy prices in wholesale markets so far this year will relieve one source of downward pressure as it will eventually lead to lower utility bills.
But the full drag on the economy from the rise in interest rates from 0.10% to 4.25% that we have already seen, which is designed to reduce inflation, has yet to be felt.
Higher interest rates don’t really reduce the national income of the UK. Rather they redistribute it from borrowers to savers. And because savers tend to spend a smaller share of their income than borrowers, this tends to lead to lower economic activity.
The bigger picture is that it doesn’t really matter if the economic data meet the usual definition of a recession or not. But a period of weaker economic activity is probably necessary to reduce inflation from 10% to the Bank of England’s target rate of 2%.
Without it, there is no incentive for businesses to stop raising their selling prices so fast. That economic weakness will either happen as a result of the rises in interest rates already seen or the Bank of England may have to generate it by raising interest rates even further. That’s a fourth opinion to throw into the mix.
Paul Dales is chief UK economist of independent global research consultancy Capital Economics
