Guest blog: The UK is looking to a year of modest growth

This time last year the UK was just coming out of the longest and deepest recession it had experienced since the 1930s. We weren't alone: most advanced economies also suffered, and unprecedented and coordinated action on monetary policy across the globe showed the extent of commitment to turn things around.

In the UK interest rates are still at historically low levels and the labour market has been remarkably resilient. But there are uncertain times ahead. The economy is growing and we expect it will continue to do so. However, several drags on demand mean that the rate of growth is likely to be modest during 2011 and that it will take about two more years before we recover the ground lost in the recession.

Consumers account for the largest proportion of demand in the economy. But high levels of borrowing mean that their household balance sheets still need to be fixed and this will continue to affect their capacity to spend in 2011. Tax and VAT rises will also be biting, and the availability of credit is also an issue - particularly in the recovery of the housing market.

Of course, low interest rates will help the deleveraging process and prevent large numbers of distressed sales, but restoring balance to the economy will still take some time, especially as spare capacity in the labour market means that earnings growth will be modest.

Firms also have to repair their balance sheets. In riskier times this affects their ability to invest, while business confidence affects their desire to do so. If confidence is resilient businesses will be happier to take the plunge, but low capacity utilisation rates and uncertainty about the pace and sustainability of recovery will act as a drag on demand from this quarter, too.

The need to get the public finances in order is another drag on demand. Public sector cuts have been swingeing and will continue to hurt for some time. Half a million public sector job losses have been announced, but there are also private sector jobs that rely on government spending which will be lost.

The parts of the private sector that are recovering will be able to absorb some of these losses but how many is uncertain. This is one of the key risks to a continued recovery. But weak demand means that inflation should remain low and so interest rates can remain lower for longer. This will be a support against all of the drags on demand, particularly as it helps the deleveraging process. And to the extent it helps the currency remain competitive it will help to improve demand from external trade.

There are risks around our central view that the recovery will continue - albeit at a slow pace. The first is that the Monetary Policy Committee has miscalculated the level of spare capacity in the economy and its ability to contain inflation. If inflation were to become embedded, interest rates would have to increase more rapidly which could seriously undermine the recovery.

Another risk is that the labour market could falter. If the private sector cannot pick up job losses from the public sector in time, or business confidence slips which leads to a shake out of existing labour, the resulting increase in unemployment would have severe implications for a continued recovery.

Join Stephen and other economic experts for NatWest's free webinar this Wednesday 8 December at 2:30pm on 'Economic outlook 2011 and beyond - the impact on UK businesses'.

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