Economists confounded by extraordinary year
As we enter a new year, it is tempting to take stock of what happened in 2016 and cast an eye on the year ahead. However, the events of last year were somewhat extraordinary and the ability of economists to accurately forecast future performance was again shown to be deeply flawed.
The consensus of economists earlier in 2016 was that, following a vote to leave the European Union, the UK economy would freefall into recession by the turn of the year. In reality, the economy finished the year in rude health.
Data from the widely regarded PMI (Purchasers Managers Index) presented a growing economy. The all-sector PMI hit a 17-month high in December, with the majority of businesses seeing an increase in sales and activities. The manufacturing sector was particularly strong, reaching a 30-month high figure of 56.1 - up significantly from 53.6 in November (the figure of 50 is balanced - anything above 50 signifies more businesses reporting growth than not; under 50 the opposite).
The service sector PMI grew at its fastest rate for 17 months and increased for the third month running (up to 56.2 in December) while the construction PMI also saw its fastest growth for a year, driven mostly by an increase in housebuilding activity. Retail activity in the period running up to Christmas was also strong, with many retailers recording growth in sales, suggesting that consumer confidence remained high.
The local (Coventry & Warwickshire) and national Chamber of Commerce Business Survey also painted a picture of guarded optimism. While not at the same high levels seen at the start of 2016, the majority of businesses surveyed had seen an increase in export sales over the past quarter, and an increase in orders for the next year. A clear majority were also confident about future sales, turnover, employment and investment for the coming year.
All this might lead us to conclude two things: that 2017 will be a year of strong economic growth - and that economists should stop trying to undertake forecasts! However, while there were clearly many errors in economic modelling last year (particularly with respect to underestimating the impact of the devaluation of sterling, and misunderstanding how individuals would respond to the result and not necessarily make rational economic decisions), economists still look at the underpinning fundamental issues within the UK economy and maintain a view that a downturn in growth prospects is likely.
Inflation will inevitably rise in 2017 as a consequence of currency devaluation, weakening consumer spending powers as real wages are likely to fall. Furthermore, given the Bank of England’s targets around keeping inflation to below 2%, an interest rate rise is likely. The impact that this may have on individuals' spending and business investment activity is unknown. However, we do know that levels of personal debt are high – the levels of unsecured consumer credit rose by 10.8% in the year to November (the fastest rate for more than 11 years) and levels of personal debt now approaching the peak that occurred in 2008…just before the Great Recession and credit crunch.
An increase in borrowing costs and a tightening of real wages could either lead to a reduction of consumer spending, or a further increase in reliance on credit to fund spending – which is clearly unsustainable in the long-run.
Of course, the huge difficulty within economics is that it seeks to put some form of structure around millions of unrelated individual decisions and actions, which can be “irrational” from an economist's perspective but perfectly sensible to those individuals. As 2016 has shown us, just because our theories would suggest that something should happen, it doesn’t mean it will. The future is unwritten – all we can do is try to make sense of it as it unfolds.