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Economic Review

August 2011 Key points GDP growth in the second quarter remained at 0.2 per cent in the second estimate. A downward revision in the growth of, and contribution from the production sector was offset by upward revisions to growth in the sub-sectors of the service sector. The slowing of growth in the manufacturing sector in June, and the persistence of weak growth in the mining and quarrying sector, resulted in flat growth in the production sector in June, on a month on month basis. Compared to the same month a year ago, output in the production sector has been declining in April, May and June. The construction sectors performance improved in June and Q2. But growth was driven by new work, in particular new housing and infrastructure. Repair and maintenance work weakened further in Q2, having already contracted in Q1. The service sector continued to experience solid growth in the second quarter, as it has done for much of 2010 and 2011 to date. In the latest quarter, service sector growth has been driven by business services, the hotels and restaurants sector and transport and storage. In June, growth in the service sector contracted by 0.1 per cent, due to weakness in business services and distribution. But there was relatively robust growth in the government and other services sector and hotels and restaurants. There was also strength in other business services, a sub-sector of business services. The UK trade deficit worsened in June, from -4 billion in May to -4.5 billion. This was driven by a widening in the goods trade deficit with non-EU trading partners, in contrast to a narrowing of the trade deficit with EU partners. The balance of trade in oil was a significant contributing factor. Growth in the retail sector has continued to be broadly flat in July, in volume terms and compared to the same month a year ago, relative to the growth rates seen during 2010. The growth picture in July continues the weak growth pattern seen for most of 2011, and is indicative of the tight financial position that households find themselves in as well as consumers weak confidence. The labour market weakened in the April to June period, compared to the January to March period. Although the employment level rose slightly, the level of unemployment rose by more, and the employment rate remained at 70.7 per cent whilst the unemployment rate notched up to 7.9 per cent. In addition, the claimant count increased and the number of unemployed people per vacancy rose to 5.4. Wage growth remained weak in the three months to June, at 2.2 per cent excluding bonuses and 2.6 per cent including bonuses. This is particularly weak considering CPI inflation averaged 4.4 per cent over the same period. Real wage growth therefore continues its negative path. CPI inflation moved up to 4.4 per cent in July, from 4.2 per cent in June. The recent significant price increases announced by energy suppliers led the Bank of England to indicate that it expects inflation may rise to around 5 per cent in the near term. Producer input price growth far outstripped producer output price growth, as it has done for many months now. This reflects the continued escalation in prices of energy, industrial raw materials and commodity prices in general. In particular, crude oil prices have risen sharply due to supply disruptions. Public sector finances were better than market expectations in July, due to stronger VAT receipts relating to the 2.5 per cent VAT rate rise, but self assessment and corporation tax receipts were weaker than expected.

GDP growth in Q2 2011 remains at 0.2 per cent The second estimate of GDP growth in the second quarter, based on the output measure, remains at 0.2%. Within that estimate, the contribution to growth from the production sector was revised down slightly but this was offset by a small upward revision to service sector growth, and so its contribution to GDP growth. This estimate of growth is broadly consistent with the mainstream external expectations for Q2 GDP growth, and is consistent with the wider pressures on the economy of: - weak growth of household disposable income and real wage growth, - declining consumer confidence, - a sense of uncertainty about expectations and security of employment, - relatively weak consumption and demand in the UKs key export markets, and - mixed indicators about the resilience of investment in an environment of relatively weak growth, uncertain expectations of the outlook for growth and constraints on borrowing, particularly for small and medium sized businesses. Counter to these downward pressures on the economy and growth are some elements of relatively resilient growth, mainly in the business related service sectors. For example, other business activities, which makes up nearly ten per cent of the economy and includes services such as legal services, accounting and auditing, business and management consultancy, architectural and engineering services, has shown solid growth over the last six months. Other business services growth, on a month on month basis, has averaged 1 percent between January and June, compared to an average of 0.5 per cent for the service sector as a whole and 0.1 per cent for the manufacturing sector. In addition, business sentiment remains relatively buoyant. And borrowing by larger companies is relatively accessible. Contribution to Q2 GDP growth by sector (per cent)
0.3 0.2 0.1 0.0 -0.1 Financial intermediation Wholesale, retail & motor trades Public admin, education & health Construction Transport & storage Post & telecomms Business services & real estate Manufacturing Hotels & restaurants Ownership of dwellings Other services*

* Other services includes sewage and refuse collection, recreation and private personal services. The second and third estimates of quarterly GDP growth usually encompass expenditure and income based estimates, as well as the output estimate. However, this month the estimate is based on the output measure alone because of changes that will be brought in with Blue Book 2011, and the desire to ensure that the third estimate and expenditure, income and output estimates are all consistent with the new Blue Book 2011 methodology and classification. Production industries In the production sector, the main component, manufacturing, experienced some weakening of growth in Q1 and into Q2, with the sector contracting in Q2 by 0.5%. This is a downward revision to manufacturing growth between the first estimate and this estimate, of 0.2 percentage points. In conjunction with a downward revision to growth in the mining and quarrying sector, offset by an upward revision to growth in the utilities

sector, growth in the production sector has been revised down from -1.4 per cent to -1.6 per cent. Growth, on a month on month basis, in the manufacturing sector over the last six months has been somewhat erratic due to the adverse effects of the snow in December, additional bank holiday in late Aril and supply chain effects relating to the Japanese earthquake and tsunami. But the weakness in some months brought about by these effects has fed into some stronger growth rates in subsequent months due to a return to previous levels of output and, in some instances, some recovery of lost output. However, compared to a year ago, manufacturing output growth has been relatively stable and solid, though this growth has been moderating as the month on month growth rates have turned negative in some months over the last 6 months. Output in the mining and quarrying sector has been weakening for some time. Over the last six months or so this has been partly due to prolonged repair and maintenance work on increasingly aging North Sea infrastructure. In the utilities sector, output growth has been relatively weak in the last six months, compared to 2010. Growth in this sector has been pulled down, to some extent, by weaker demand in April due to the unseasonably warm weather, and in January due to the surge in demand in December. Output recovered in May and June, but remained weak compared to the same months a year ago. Construction The performance in the construction industry was one of two halves in 2011 Q2, with new work growing by 2.4% compared to repair and maintenance work contracting by 3.2%. The growth in new work was due to new public and private sector housing, infrastructure work and commercial construction work. The weakness in repair and maintenance was reflected in all the sub-components of housing and non-housing repair and maintenance. Despite the governments fiscal consolidation programme, public sector new housing made a positive contribution to growth of 0.1 percentage points, though growth in this component has been softening over the last four quarters. The construction sectors performance improved in Q2, compared to Q1, due to a turnaround in the growth of new work, from -4.2% to 2.4%. This was due to an improvement in new housing work, which moved from contraction in Q1 to positive growth in Q2. However, repair and maintenance work worsened in Q2, with growth declining further from -0.8% to -3.2% between Q1 and Q2. Service sector Growth in the service sector remained at 0.5 per cent in Q2, as it was in the first estimate of Q2 GDP growth. However, within the sector, there was a downward revision to transport and communications services offset by upward revisions to distribution, hotels and catering and government and other services. More specifically, looking at the sub-sectors in more detail, weakness in the service sector came from post and telecommunications, financial intermediation and other services. But there was solid growth in the hotels and restaurants sector, transport and storage, business services and public services. Much of the relative strength in these particular components of the service sector relate to inter-business activity, as mentioned above. The solid growth of hotels and restaurants is thought to reflect a combination of the warm weather in April and May, the additional bank holiday, the relative weakness of sterling encouraging foreign tourists to visit the UK and the apparent inclination of UK holidaymakers to stay in the UK rather than travel abroad.

Labour market The labour market weakened in the three months to June, with increases in employment levels slowing and unemployment levels starting to rise, compared to the previous three month period (January to March). In addition to the unemployment level and rate rising, the claimant count rose to 4.9 per cent in July from 4.5 per cent in March, and the number of unemployed people for each vacancy increased from 5.1 to 5.4 between January to March and April to June. However, the economically inactive level and rate both decreased. Change in the employment and unemployment levels, on previous quarter (thousands)
300 200 100 0 -100 -200 -300 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 2008 2009 2010 2011 Q2 Employment Unemployment Change in level (thousands)

Total actual weekly hours worked decreased sharply (-1.2 per cent) in the April to June period, in large part due to the number of bank holidays as well as the additional bank holiday towards the end of April. Wage growth continued to be well below inflation at 2.2 per cent for regular wage growth (excluding bonuses) and 2.6 per cent for wage growth including bonuses (three months to June). Even at this rather modest rate of regular wage growth, the relatively strong wage growth in the financial sector of 5.2 per cent (excluding bonuses) skewed the average for the whole economy upwards. The downward pressure on household real disposable income continues, and there seems little prospect of an improvement in the near term with the Bank of England reporting in its latest MPC minutes that inflation expectations remained reasonably well anchored and there being little indication of wage bargaining gathering pace. The labour market had been showing a degree of resilience in recent months, given the weakening in GDP growth over the last three quarters, but this latest picture of the labour market suggests quite a bit more uncertainty about job security and employment prospects. Some commentators consider the claimant count to be a reasonable leading indicator of unemployment, and with the claimant count rising in the latest period, external expectations are of some possible further weakening to come.

Trade The UKs trade deficit deteriorated further in June, to -4.5 billion. This was driven by a fairly marked worsening in the goods trade deficit with non-EU partners, which widened from 5.1 billion in May to 5.7 billion in June. In contrast, the deficit on goods trade with the EU narrowed slightly, by 0.2 billion. And the services surplus narrowed by less than 0.1 billion, leaving the balance of trade in services at 4.4 billion for June.

On a quarterly basis, the goods trade deficit worsened in Q2, compared to Q1, by 2.4 billion and the services surplus narrowed by 0.5 billion, in nominal terms. The balance of trade on goods and services (in value terms) has been deteriorating since February, and is now back to a level similar to that experienced between March and October 2010, when it averaged 4.2 billion. This deterioration follows a short period of improvement a narrowing in the deficit - between January and May, when the balance of trade in goods and services averaged 2.8 billion. The balance of trade in services had been gradually rising between April 2010 and March 2011, but since March, the surplus has been narrowing each month, and is now back to the level it was in January this year. Trade balance ( billion)
6 4 2 0 billion -2 -4 -6 -8 -10 2010 Jan 2010 Jul 2010 Apr 2011 Jan 2010 Oct 2011 Apr Goods & services Goods less oil & erratics Goods Services

The slight improvement in the deficit with EU trading partners was due to a larger drop in imports from EU partners than the drop in exports to EU partners. The worsening in the balance of trade in goods with non-EU partners was driven by a fairly marked fall in exports coupled with a rise in imports from non-EU partners. Weakness in exports to both EU and non-EU partners was due to falls in chemical and capital goods exports, but in addition for EU trade there was a marked drop in exports of intermediate goods and semi-manufactured goods excluding chemicals, and for non-EU partners there was a sharp drop in exports of oil and silver. This drop in exports of oil to both EU and non-EU partners, alongside an increase in imports of oil from non-EU partners resulted in a sharp deterioration in the balance of trade for oil. This deterioration was particularly driven by a marked reduction in exports of oil to non-EU trade partners, and this fed through to an increase in the deficit on oil with non-EU partners. In contrast, the UK runs an oil trade surplus with EU trading partners, but this surplus was reduced in June, exacerbating the increase in the deficit with non-EU partners. The balance of trade for oil has been fairly stable between July 2010 and May 2011, averaging -0.8 billion. But in June, the trade deficit for oil increased to -1.6 billion. The drop in oil exports and increase in imports perhaps reflects, in part, the prolonged period of maintenance of North Sea oil infrastructure.

Export and import growth (per cent, month on month a year ago)
25 20 Percentage growth 15 10 5 0 2010 Jan 2010 Jul 2010 Apr 2011 Jan 2010 Oct -5 2011 Apr Exports goods Imports goods Exports less oil & erratics Imports less oil & erratics

Export growth of goods (month on same month a year ago) has been stronger than import growth for much of 2011, until June. This marked an important turnaround in the growth profiles of exports and imports of goods, having shown little response to the depreciation of sterling during 2008 and 2009, and contributed less than expected to GDP growth during a time when net trade might otherwise have been expected to contribute more positively to GDP growth. But the growth profiles of exports and imports of goods have both fallen between May and June. The drop in export volumes of goods was due to a decline in exports of fuel and semi-manufactures, the latter of which contributed to flat growth of manufactures in June. This corresponds to the national, regional and global slowdown in manufacturing in recent months. Import growth weakened in good part due to a 24 per cent drop in imports of cars from the EU. Retail sales Retail sales growth, in volume terms and compared to the same month a year ago, has been more or less flat in May, June and July, relative to the growth path of volumes of retail sales excluding fuel over the last three and a half years (start of 2008). Growth of both all retail sales and excluding fuel have averaged 0.1 per cent and -0.1 per cent respectively over the last three months. And if the pick up in retail sales in April is excluded from the latest six months, then these two series have averaged growth of 0.4 per cent and 0.1 per cent respectively. That compares with average growth rates during 2010 (excluding the snow affected January and December) of 0.8 per cent for all retail sales and 2 per cent for all retail sales excluding fuel. So there are indications of the pressures that consumers are under in retail sales activity. Retail sales growth, including and excluding fuel (per cent, month on month a year ago)
7 6 5 4 3 2 1 0 -1 -2 -3 -4 2008 Jul 2008 Jan 2009 Jan 2008 Oct 2008 Apr All excl fuel All incl fuel

2009 Jul

2010 Jul

2010 Jan

2009 Oct

2009 Apr

2010 Apr

2011 Jan

2010 Oct

2011 Apr

2011 Jul

Growth in sales of both food and non-food stores was negative in July, in volume terms and compared to the same month a year ago. Food store sales growth has been negative for most of the last eighteen months, demonstrating both the impact of relatively strong inflation of food and drink as well as the pinch that these high price increases alongside modest wage growth is having on households confidence and inclination to spend. Further evidence of this position is the persistent negative sales growth over the last year of household goods stores, which retail the bigger ticket, more durable goods. However, there was quite considerable strength in growth in the non-store retail sector, though this only accounts for 4.5 per cent of the retail sector. This assessment of the retail sector is based on the growth profiles on a month on month a year ago basis because the month on month growth rates tend to be more erratic, and so more difficult to assess trends in growth rates and activity. The implied deflators, particularly for predominantly food stores, continued to rise during 2011, reflecting some of the price pressures in the CPI basket.

Producer and consumer price inflation As has been the case for several months now, input prices in the manufacturing sector rose at a much faster pace than output prices 18.5 per cent and 5.9 per cent respectively, in July compared to July 2010. Although input prices make up a varying proportion of the total cost structure depending on the manufacturing sub-sector, this considerable difference in the pace of price increases, and having persisted since the end of 2009, is likely to be having some impact on manufacturers profit margins. It could well also be having some impact on their confidence about near term profitability and the sustainability of business. However, as the chart below illustrates, input price growth being considerably higher than output growth has arisen for much of the last twelve years. Producer price growth input and output prices (percentage change month on month a year ago)
Output prices 30 20 10 0 -10 -20 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Input prices

Consumer price inflation, the headline inflation measure, crept up to 4.4 per cent in July, having dropped in June to 4.2 per cent. CPI has been around 4 per cent for some months now, and the Bank of England expect inflation to rise temporarily to around 5 per cent in the near term as the recent sharp price increases of gas and electricity suppliers feed in to CPI inflation. With wage growth at 2.6 per cent including bonuses and 2.2 per cent excluding bonuses for the April to June period, and inflation averaging 4.4 per cent for the same three months, it is very apparent why households are continuing to feel

constrained by declining real wage growth and disposable income, and are seeking to limit the extent of their spending. The RSI and June Bank of England Agents Report both indicate that spending on big ticket goods is being held back, and other areas of spending are showing weakness, as discussed in the sections above on the service sector and the RSI.

Public sector finances The public sector finances for July 2011 were better than market expectations. The public sector current budget was in surplus by 2.1 billion and public sector net borrowing for the month was just 20 million, down from 3.5 billion in July 2010. This improvement in part reflected stronger growth in central government receipts than expenditure, up by 2.8 billion (5.6 per cent) and 0.9 billion (1.9 per cent) respectively compared to July 2010. A key driver of the growth in receipts was VAT, which rose by 1.7 billion, though part of this is based on projected receipts. The standard rate of VAT was raised to 20 per cent in January, and this has been an important contributory factor to the rise in VAT receipts. 'Other taxes' were up by 0.7 billion, entirely driven by the new Bank levy. Income tax and NIC receipts were up by just 0.4 per cent (0.1 billion). July receipts are usually boosted by relatively high self-assessment and corporation tax receipts, but this July self assessment receipts were down by 19 per cent (5.2 billion) and corporation tax receipts rose by just 1 per cent (0.1 billion) due to weak financial sector and offshore receipts. Financial sector receipts were weakened by the provision for the mis-selling of PPI policies and write-down of some euro area assets, and offshore receipts were weak due to low North Sea oil and gas production. The 1 per cent rise in corporation tax receipts compares unfavourably with the Budget forecast for corporation tax receipts of 14 per cent for the year. In expenditure, central government spending on debt interest and net social benefit payments were up by 11.1 per cent and 4.3 per cent respectively. Other current expenditure, which encompasses spending by government departments, was marginally lower. However, this is mainly associated with changes to the timing of grant payments, and the situation is likely to unwind with higher expenditure in August. On a financial year to date basis (April to July 2011) central government current expenditure is 3.2 per cent higher than in the corresponding period in 210-11, and compares with the OBR's full-year central government expenditure growth forecast of 3.6 per cent. However, central government expenditure estimates in the early part of the financial year are quite provisional and subject to revision.