The British economy unexpectedly shrank by 0.5% in the last three months of 2010 – a shock to many, given the improved economic conditions of the rest of the year.
Economists had forecasted growth of between 0.2% and 0.6%, but the icy weather the UK experienced throughout the last quarter has hit the economy harder than expected. The combination of a contraction in the economy, severe spending cuts and rising inflation is now leading to speculation that Britain is heading for a double dip recession.
How had the economy fared in 2010?
Growth prospects for the final quarter of last year were cautiously optimistic. The economy grew by 0.7% in the third quarter of 2010 and by 1.1% in the second quarter of last year, and although many predicted that growth would be stunted by the poor weather, few believed that the economy would contract at all – let alone so abruptly.
A reduction in the construction industry by 3.3% in the final three months of the year has been largely attributed to the drop in gross domestic product (GDP), but others are blaming the swift attempts by the coalition government to reduce the UK’s deficit as a catalyst for the contraction. Measures such as the increase in Value Added Tax (VAT) to 20% and public sector spending cuts have been criticised by some economists, who argue that a concentration on economic growth, rather than deficit reduction, would be better for Britain’s financial health.
Interest rates have been kept at a historic low of 0.5% to stimulate the economy. However, with CPI inflation now standing at 3.7%, the Bank of England’s Monetary Policy Committee (MPC), the body that sets interest rates, may consider lifting them to combat rising prices.
What would a rise in interest rates mean?
There are pros and cons to rising interest rates, but there are major concerns that any rise would have a detrimental effect on the UK’s prospects for economic growth. While savers would benefit from an increase in rates, the housing market would be adversely affected.
Should mortgage rates increase, households will have less money to spend and this could increase the risk of people falling into arrears or defaulting on their home loans. In turn, this could affect all types of borrowers, including credit card holders.
When people have less money to spend, less cash flows into the economy and therefore it’s less likely that there will be economic growth.
Any increase in the cost of credit is also likely to have an impact on investments, traditionally depressing share and bond prices. Company profits may be inhibited, again reducing the potential for growth.
How real is the double dip recession threat?
Technically, if the economy contracts in the next quarter (January 2011 to March 2011), the UK will fall back into recession. This could be timed with Chancellor George Osborne’s first traditional Budget, due on 5th April 2011.
The news has rattled the UK’s markets. Sterling has fallen against the dollar to trade at £1.58, while the FTSE 100 is down by 0.62%.
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