In the latest issue of the Deloitte Economic Review, our Economic Adviser, Roger Bootle, looks at whether the sharp slowdown in the growth of the UK economy during 2005 is merely a temporary pause for breath or the start of a sustained period of weakness. His main points are as follows:

• The outlook for the UK economy is probably more uncertain than it has been for a number of years. But on balance we think that the economy has entered a period of fundamental readjustment, where the household and public sectors are unlikely to be very supportive of GDP growth. As it is unlikely that the external and corporate sectors will be able to offset this weakness, we think that growth will come in below trend again this year, at around 2%.
• One possible reason for greater optimism is that the lion’s share of last year’s slowdown may have been due to the external shock of the surge in oil prices. Indeed, some very rough rules of thumb suggest that this may have accounted for over three quarters of the slowdown in growth. But even if oil prices remain at their current high levels, the negative effects on growth will fade away over the coming quarters. And if oil prices were to fall, then this would provide a boost to growth.
• What’s more, the relatively limited impact on inflation from the jump in oil prices compared to previous periods and the apparent soft(ish) landing in the housing market both bode well for the economy’s medium- to long-term growth prospects.
• However, it is possible that other factors will diminish any such boosts. For a start, the rise in oil prices may have done lasting damage to the economy’s growth potential if oil-intensive elements of the capital stock have been rendered unprofitable.
• If this is the case, then economic growth could be depressed until oil prices return to previous levels or until cheaper, alternative sources of energy are utilised.
• And second, the accompanying rise in inflation to above the 2% target rate means that policymakers have not loosened policy in response to the slowdown in activity as aggressively as they did following previous negative shocks to demand, like the Russian debt crisis or the 9/11 terrorist attacks. This may mean that growth will not recover as quickly and strongly over the next year or two as it did after previous downturns when the absence of price pressures allowed the policymakers to act rather more decisively.
• With growth set to come in at just 2%, the Monetary Policy Committee is likely to support economic activity by reducing interest rates further. Although one obstacle to lower rates is the relatively high rate of inflation, we think that this will soon cease to be a barrier as the impact from higher energy prices fades and core price pressures remain subdued in response to weak activity. We expect that interest rates will fall to 4% in 2006, although they could go lower.
• Looking a bit further ahead, the combination of lower interest rates and a lower pound should see economic growth accelerate in 2007. However, a weaker international environment will mean that any recovery in future years is unlikely to be spectacular. 
• The US economy will carry considerable momentum into 2006. But we have become increasingly concerned that an end to the current housing market boom will cause a major economic slowdown, and possibly even a recession, sometime in 2007. Some of this slowdown in US growth will be offset by an improvement in activity in the euro-zone, despite higher continental interest rates.
• However, a US led-global economic slowdown is still likely to dampen demand for the UK’s exports. But this should not get in the way of stronger and better-balanced UK economic growth in 2007 – although there is another difficult year to get through first.
  

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Read out  latest issue of the Deloitte Economic Review, by  Roger Bootle.

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