Following the release of the June industrial production figures, it was always likely that the preliminary second quarter GDP figures would be revised down a shade. What financial markets were not braced for, however the second estimate would show the UK economy had ground to a complete halt. The expenditure split of the data also contained one or two surprises with consumer demand estimated to have contracted by 0.1%; spending on the high street slowed markedly during the quarter, but growth had remained positive. This means that non-retail spending, which is normally more resilient, must have fallen considerably. Similarly, although a sharp fall in business investment had been reported the day before, the 5.3% decline in overall fixed investment spending was much larger than the consensus had been expecting at the start of the week. But as far as we are concerned, the most alarming feature of the figures was the huge rise in inventories during the quarter, which added some 0.6 percentage points to the headline quarterly GDP growth figure. In other words, had it not been for this, instead of being flat, headline GDP would have contracted by 0.6%. As a result, final domestic sales, which are our preferred measure of the economy’s underlying strength, declined by 0.9%, the weakest showing since the dark days of 1991.
This explains why Mervyn King presented such a downbeat assessment of the economy at the press conference for the August Bank of England Inflation Report. Just to have a neutral effect on GDP in Q3, inventories need to increase by no less than the change in stock-building between the first and second quarters (£1.8bn in chained 2003 volume terms). But given the weakness of final demand, much of the build up in stocks in Q2 is likely to have been involuntary. As a result, companies will do everything in their power to reduce their inventories not add to them further. Inventories are therefore likely to make a large negative contribution to headline growth in Q3. True, net exports are currently supporting overall activity, but only by virtue of imports falling more quickly than exports, itself a feature of weak final demand.
From here, with the squeeze on disposable incomes intensifying and the labour market deteriorating, it is difficult to see why consumer demand should rebound any time soon. Similarly, with house prices falling and mortgage approvals plummeting, construction investment surely has further to fall. Consequently, and with the new lower starting point for the second half of the year, economic growth in 2008 as a whole now looks like coming in at 1.0% with only 0.8% in prospect for 2009. That’s the bad news. The good news is that the MPC should now be free to start cutting interest rates. We have long held the view that interest rates would start to decline in November. By following this data, and with the inventory overhang it is likely to intensify the price discounting on the high street, the first cut could now be even earlier.