Demand and output

Quarterly GDP growth slowed in 2018 Q1 to 0.1%, from 0.4% in 2017 Q4 (Chart 2.1). That was 0.3 percentage points weaker than expected at the time of the February Report. As discussed in Box 3, part of that slowing is likely to have reflected temporary factors, with the boost from the reopening of the Forties oil pipeline more than offset by recent disruption from adverse weather.

Part of the recent weakness is also likely to be revised away over time, with output growth expected to be revised up to 0.3% in the mature estimate. Preliminary estimates of quarterly GDP growth are typically revised up, with a greater upward revision in the first quarter of the year than in other quarters. In addition, estimates of output growth in quarters with substantial snowfall have tended to be revised up significantly. That expected upward revision is also supported by survey indicators of activity, which overall point to only a modest slowing in output growth in Q1.

At a sectoral level, a contraction in construction activity weighed particularly sharply on output growth in Q1 (Chart 2.2). That is consistent with both the role of weather‑related disruption — the Bank's Agents report that construction activity was affected by the snow and by inclement weather more generally — and the potential for a substantial upward revision to growth. Early estimates of construction output have been particularly prone to upward revisions in recent years. In addition, the purchasing managers' index for construction suggested that output recovered in April, probably as the effects of snow abated. Adverse weather may also account for part of the weakness in consumer services growth. By contrast, business services activity was strong and growth in manufacturing output remained positive.

Headline GDP growth is projected to pick back up to 0.4% in Q2, consistent with survey indicators of growth. There is considerable uncertainty about momentum in the first half of the year, however. On the one hand, if adverse weather accounted for a larger part of the weakness in Q1, then growth could pick up by more in Q2 (see Box 3). On the other hand, if more of the weakness reflected underlying growth, then it could recover by less.

GDP growth is projected to remain around 0.4% over the rest of the year, as the underlying drivers of growth remain supportive. Within that, the rotation in demand growth toward net trade and business investment (Section 2.1), and away from household spending (Section 2.2), since mid-2016 is projected to persist (Chart 2.3).

2.1 Net trade and business investment

The strength of global growth over the past 18 months, together with the past depreciation in sterling, appears to have boosted net trade. That, in turn, should help to support business investment. Greater external demand for UK goods and services, combined with a rise in profit margins on those exports in sterling terms, should encourage exporters and other firms in the supply chain to expand production and invest in capacity. In addition, higher import prices will have encouraged UK households and companies to substitute towards domestically produced goods and services.

Net trade subtracted 0.4 percentage points from aggregate demand growth in 2017 Q4. This partly reflected a drop in net exports of non-monetary gold. But this component is very volatile and is offset by changes in the contribution to GDP growth from valuables.¹ The closure of the Forties oil and gas pipeline in December (see Box 3) also weighed on net trade in 2017 Q4. The resulting fall in domestic production of oil and gas temporarily reduced fuel exports, and fuel imports increased to make up the shortfall. That effect should have unwound in 2018 Q1, as the pipeline was reopened by January, boosting net trade.

Consistent with the fall in net trade, the nominal trade balance widened in 2017 Q4. This, however, was more than offset by a narrowing in the income deficit, reflecting a rise in the net rate of return on UK foreign direct investment. As a result, the current account deficit — which reflects the balance of nominal trade flows and other payments between the United Kingdom and the rest of the world — narrowed slightly to 3.6% of GDP.

Over 2017 as a whole, net trade contributed positively to GDP growth, having subtracted from growth on average over the past (Chart 2.3). That positive contribution reversed some of the large fall in 2016 and was greater than expected a year ago, supported by stronger-than-expected global growth (see Box 5).

Continued strong global growth (Section 1) is projected to support net trade further over 2018 (Table 2.A). The outlook for net trade will depend, however, on how the supply chains and capacity of companies, both in the UK and abroad, evolve in response to Brexit and the associated depreciation in sterling.

That fall in sterling should incentivise domestic producers of substitutes for imports to expand production and capacity in response to higher import prices, if these encourage domestic companies to source more goods and services from the UK. Contacts of the Bank's Agents have reported an increased incidence of companies switching to domestic suppliers. Perhaps partly reflecting that, import growth slowed in Q4, despite the temporary increase in fuel imports that quarter (Table 2.B). As a result, import penetration — the proportion of demand satisfied using imported goods and services — has remained broadly flat.

By boosting exporters' margins in sterling terms, the fall in sterling should also support an expansion in export volumes. Alongside continued robust export growth, sterling export prices rose by 14% between 2015 Q4 and 2017 Q4, and survey indicators continue to point to strong export growth in coming quarters (Chart 2.4).

With limited spare capacity for many firms, that expansion in domestic production, both to support import substitution and for export, will require investment in additional capacity. The recovery in business investment has been relatively modest, however (Table 2.B). As a result, growth in the capital stock has been particularly weak since the crisis in comparison with periods following previous recessions (Chart 2.5).

Evidence of increased investment among exporters, in particular, remains mixed. Although some business survey indicators suggest that investment intentions among manufacturers have picked up over the past year, the Bank's Agents' company visit scores suggest that exporters' and non-exporters' investment intentions have been broadly similar in recent months. And the Bank's Decision Maker Panel (DMP) Survey suggests that, despite the rise in their operating margins, exporters' investment spending grew no faster than that of non-exporters in 2017.

The muted response of business investment is, at least in part, likely to have reflected the expected impact of Brexit and associated uncertainty. In the Bank's DMP Survey, however, the drag on investment growth from Brexit uncertainty appeared to diminish in 2017 H2.² And respondents to the 2018 Q1 Deloitte CFO Survey no longer viewed the effects of Brexit as the biggest risk facing their business at the moment. But the Bank's Agents reported that that had not yet been enough to prompt a material change in contacts' investment plans and there were few signs that companies were making up the past weakness in investment, with most survey indicators of investment intentions little changed (Chart 2.6).

While the recent rise in Bank Rate has raised interest rates on borrowing for businesses (Section 1), financial conditions remain accommodative and are likely to have been supporting investment. Reflecting the factors weighing on investment growth, however, there are few signs that demand for credit among businesses has picked up over the past year. Net new external finance raised by UK corporates has fallen since mid-2017, driven by lower net equity issuance and bank lending growth. And respondents to the latest Credit Conditions Survey suggested demand for credit across corporates of all sizes was unchanged in 2018 Q1, having fallen significantly in the second half of 2017.

Overall, business investment is projected to grow at around its current rate in the near term (Table 2.A). Although global activity and financial conditions are expected to remain supportive, investment is likely to remain sensitive to developments in negotiations around the UK's future trading arrangements with the EU.

• Notes
  1. Non-monetary gold is a volatile component of UK trade, reflecting activity in the London gold bullion market, and has no impact on aggregate demand; movements in non-monetary gold are offset by movements in private sector investment in valuables.
  2. As of April 2018, the survey panel consisted of around 3,700 companies, with around half responding to the survey each quarter.

2.2 Household spending

Consumption

The main driver of consumption growth is real income growth. Real income has barely risen since 2016 (Chart 2.7), reflecting subdued nominal wage growth (Section 4) and the reduction in households' purchasing power as a result of the fall in sterling around the EU referendum. In addition, net taxes and benefits, as well as a fall in dividends receipts, have weighed on real income growth over that period.³

As expected, households have adjusted only gradually to the slowing in real income growth and the saving ratio has fallen (Chart 2.8). Consumption growth has averaged 0.3% a quarter in 2017, compared with 0.6% on average during 2013–16 (Table 2.B).

In recent months, wage growth has started to rise and the effect of sterling's depreciation on inflation has diminished (Section 4). That has eased the squeeze in real income growth, and should support household spending growth. The extent to which households continue to spend a greater proportion of their current income, relative to the recent past, or choose to rebuild their savings, will depend partly on their confidence around future incomes and economic prospects. The GfK measure of consumer confidence has fallen since the start of 2016, and fell slightly further in April, although it remains only a little below its historical average.

Interest rates and the availability of credit will also affect households' spending decisions. Growth in consumer credit — the type of borrowing most directly associated with household spending — slowed sharply in March. That may have been affected by the impact of adverse weather on consumer spending and, to that extent, should recover in April. There is also some evidence of a tightening in consumer credit conditions over the past year, with respondents to the Credit Conditions Survey, for example, reporting a reduction in consumer credit availability in 2018 Q1. That said, consumer credit conditions remain supportive overall, with competition between lenders reported to be intense.

Interest rates affect consumption via the interest paid and received on mortgages and deposits, the largest components of borrowing and saving respectively. As discussed in Section 1, although mortgage interest rates have risen in response to the rise in Bank Rate, they remain lower than in mid-2016. Lower mortgage interest rates over that period have encouraged households to remortgage (Chart 2.9) to lower their interest payments, which will have supported consumption growth. Deposit rates have been broadly stable over that period.

Despite that support from credit conditions, and an easing in the squeeze on real incomes, consumption is expected to have grown by only 0.1% in 2018 Q1. As discussed in Box 3, a large part of that weakness, relative to recent quarters, is likely to reflect the temporary impact of adverse weather on certain types of household spending. For example, retail sales — which account for around one third of household consumption and will have been affected by snow — fell sharply in Q1. In addition, there have been more persistent sector-specific pockets of weakness. Car purchases, for instance, have been particularly weak over the past year. As explained in Box 4, however, this has not been matched by more widespread weakness in durables spending and is likely to mainly reflect factors specific to the car market.

Abstracting from the temporary effect of weather-related disruption, and accounting for future revisions, underlying consumption growth was estimated to have remained around 0.3% and is projected to be stable in coming quarters (Table 2.B). That path for household spending growth remains modest by historical standards, consistent with subdued real income growth.

Housing

Developments in the housing market can provide a signal about developments in household spending more generally. That is largely because decisions about whether to buy a house and whether to spend share common drivers, such as income expectations and confidence. In addition, house prices can affect household spending directly. One such channel is by raising the value of homeowners' equity, which they can use as collateral against which to borrow, though this effect is estimated to be small.

Activity in the housing market has remained broadly stable, but subdued. Mortgage approvals for house purchase have been broadly unchanged since 2016 despite support from low mortgage interest rates (Chart 2.9). Within that, homemover and buy-to-let activity has fallen somewhat, offset by a pickup in activity from first-time buyers.

Relatively subdued housing market activity, given the low cost of credit, is likely to have partly reflected the squeeze in real incomes over that period and slightly lower confidence in the general economic situation, with households perhaps choosing to delay moving as a result. Past regulatory action, such as the Recommendations by the Financial Policy Committee to lenders to limit the proportion of new mortgages at loan to income multiples of 4.5 or above, and around lenders' affordability tests, are estimated to have had only a small impact on aggregate mortgage approvals. In coming quarters, activity in the housing market is likely to pick up modestly as real income growth recovers somewhat and credit conditions remain supportive.

National house price inflation slowed to 2.6% in 2018 Q1, from around 8% in 2016 Q1, according to the average of lenders' indices (Chart 2.10). But within that, house price inflation in London and the South East slowed more sharply, with prices broadly flat in the four quarters to 2018 Q1. Although the RICS survey points to an expected pickup in aggregate house price inflation in the near term, expectations for house price inflation in those regions remained subdued.

Developments in the housing market will also contribute to GDP directly through housing investment. Housing investment growth was relatively robust in 2017, contributing to above-average growth in overall private sector investment (Table 2.B). Around four fifths of housing investment consists of new house building and improvements to existing buildings. The pickup in housing starts in 2016 (Chart 2.11) pushed up housing investment substantially over 2017. However, housing investment growth is likely to be weaker in 2018 (Table 2.A). New housing starts were broadly flat during 2017 and are expected to have slowed in 2018 Q1 as snow and other weather-related disruption hampered construction activity. Reflecting that, a timelier measure of private housing starts from the NHBC — which accounts for around 80% of new builds and feeds into official data — fell substantially in Q1. In addition, growth in services associated with property transactions, which account for the remaining one fifth of housing investment activity, is likely to remain relatively subdued, consistent with the modest projected pickup in housing market activity.

• Notes
  3. As discussed in recent Reports, the fall in dividends receipts and some of the pickup in tax payments is likely to have reflected changes to the effective rate of tax on dividends in 2016 that caused many of those payments to be brought forward to the 2015/16 financial year at the expense of payments in future years.

2.3 Government

The MPC's projections are conditioned on the Government's tax and spending plans detailed in the March 2018 Spring Statement. In line with the commitment to move to a single fiscal event per year, there were no substantive new tax or spending measures announced, relative to the November 2017 Budget. Under those plans, the fiscal consolidation continues, with public sector net borrowing projected to fall to 1.3% of nominal GDP by 2020/21.

Having been broadly stable during 2014–16, new car purchases fell sharply in 2017 (Chart A). Slow real income growth is likely to have been one factor weighing on car purchases but, as this box explains, factors specific to the car market are also likely to have been a significant driver of that weakness. Consistent with that, spending on other types of durables has remained relatively resilient. As cars only account for around 5% of consumer spending, the implications of the weakness in car spending for the broader outlook is therefore likely to be limited.

Some of the recent volatility in the car market is likely to have reflected tax changes. Rises in Vehicle Excise Duty (VED) for new cars, based on CO2 emissions, came into effect on 1 April 2017. That is likely to have led to some purchases being brought forward ahead of that date, supporting registrations in 2017 Q1 and contributing to the subsequent fall. Additional rises in VED on new diesel vehicles from 1 April 2018 may have had a similar effect in 2018 Q1, although the disruption from adverse weather has probably offset some of that effect. Registrations rose in February, fell in March and then rose again in April. Contacts of the Bank's Agents also report that uncertainty around the future tax treatment of higher‑emission vehicles may have weighed on spending in 2017.

Developments in the way cars are financed may also have affected sales. In recent years, structural changes in new car finance have made it easier to replace existing cars with new ones, which will have driven some of the pickup in new registrations over that period.¹ That structural shift appears to have come to an end, with 90% of new cars now purchased with some form of car finance. As such it is unlikely to support growth in car purchases to the same degree going forward.

The effect of that maturing of the car finance market on demand has been compounded by a pickup in car retail prices since mid-2016 (Chart B). Car retailers had held prices broadly flat during 2015–16 H1, squeezing their margins, with contacts of the Bank's Agents reporting that retailers were trying to boost demand in the UK, amid relatively weak demand in the rest of Europe. Since mid-2016, however, prices have risen, in part as relatively strong demand through 2016 provided car dealers with scope to rebuild their margins, but also as the impact of sterling's depreciation during 2016 was passed on to consumers.

Overall, new car purchases are expected to remain around their current level as the factors dragging on spending persist. This, however, is not expected to be indicative of prospects for broader consumption growth, which is expected to remain around 0.3%, abstracting from recent snow-related disruption (Section 2.2).

• Notes
  1. For more information on this structural shift, see the box on pages 16–17 of the November 2017 Inflation Report.