The Office for National Statistics (ONS) has revised the decline in real GDP in the third quarter of 2008 to 0.6% quarter-on-quarter (q/q) from the previous estimate of 0.5% q/q. This marks the first time that the economy has contracted since the second quarter of 1992, although it had only stagnated in the second quarter of 2008 and is therefore on the brink of recession (defined as two successive quarters of contracting q/q GDP). Prior to that, GDP growth had moderated to 0.4% q/q in the first quarter of 2008 from 0.6% q/q in the fourth quarter of 2007 and 0.8% q/q in the third quarter. Consequently, annual GDP growth retreated to a 16-year low of 0.3% in the third quarter of 2008 from 1.7% in the second quarter and a peak of 3.3% in the second quarter of 2007.

Service-Sector, Manufacturing, and Construction Output All Decline

On the output side, there was widespread contraction in the third quarter. Service-sector activity declined 0.5% q/q, which was the worst performance since 1990, while year-on-year (y/y) growth was limited to just 0.8%. Business services and finance activity has been hit hard by the credit crunch and financial crisis, while motor trades and wholesale services were particularly weak in the third quarter. The sharp housing-market slowdown and reduced consumer spending on services are clearly having an impact.

Meanwhile, industrial production contracted by 1.4% q/q and 2.5% y/y in the third quarter, with manufacturing output down by 1.6% q/q and 2.3% y/y. This marks the third successive q/q fall in industrial production, meaning that the sector is already in recession. Furthermore, construction output contracted by 0.2% q/q in the third quarter, after dropping 0.5% q/q in the second, thereby limiting y/y growth to 1.3%. This was primarily due to the sharp downturn in the housing market, which has hit the building of new homes.

Consumer Spending and Investment Contract

On the expenditure side, the breakdown of third-quarter GDP is particularly unappealing, with contraction in consumer spending and investment, as well as only very limited expansion in exports. Indeed, the overall q/q decline in GDP would have been even deeper but for elevated government spending (up 0.6% q/q and 3.6% y/y) adding 0.1 percentage point. Consumer spending declined a further 0.2% q/q in the third quarter after dropping 0.3% q/q in the second quarter. This limited the y/y rise to 0.7% in the third quarter. Consumers suffered throughout the first three quarters of 2008 from muted income growth, an extended squeeze on purchasing power from high energy and food prices, tight lending conditions, rising debt levels, and a depressed housing market. In addition, unemployment has been rising since February, and at an increasing rate.

In addition, total investment plunged by 2.8% q/q and 5.3% y/y in the third quarter. This followed declines of 0.9% q/q in the second quarter and 3.0% q/q in the first. Business investment contracted significantly overall in the first three quarters of 2008 in the face of deteriorating confidence, worsening cash flows, tighter credit conditions, and weaker final demand. In addition, construction investment has slumped, but government investment has increased significantly. Meanwhile, inventories (including the alignment adjustment) rose by £571 million (US$845 million) in the third quarter, which was down from a £626-million increase in the second quarter. Consequently, domestic demand contracted by 0.4% q/q in the third quarter after falling by 0.2% q/q in the second quarter.

Net trade made a negative contribution of 0.2 percentage point to the third-quarter q/q GDP performance. Exports edged up by 0.3% q/q, having fallen by 0.3% q/q in the second quarter. Exports were up just 0.1% y/y, indicating that slowing global growth has countered the beneficial impact of the weaker pound. Meanwhile, imports rose by 1.0% q/q in the third quarter, but this followed three consecutive q/q drops. Consequently, imports were down 0.6% y/y in the third quarter, reflecting muted domestic demand.

Outlook and Implications

Although contraction in the third quarter does not put the economy officially into technical recession yet, the depth of the decline and ongoing very weak data and survey evidence mean that the United Kingdom is there to all intents and purposes.

Indeed, the latest data and survey evidence point to significantly deeper decline in GDP in the fourth quarter, very possibly in the region of 1.0% q/q. Service-sector activity contracted for a seventh successive month in November, and at a record rate, according to the purchasing managers' survey. Industrial production plunged 1.7% m/m and 5.2% y/y in October as manufacturing output fell for an eighth successive month. Meanwhile, consumer confidence and spending are clearly weak.

We expect GDP to contract at least up to, and including, the third quarter of 2009 before stabilising. Recovery is then expected to be only gradual. Consumer spending is being hit by faster-rising unemployment, muted disposable income growth, tight lending practices, heightened debt levels, a depressed housing market, and substantially lower equity prices. Elevated utility bills and relatively high food prices are still hitting the lower-paid. Additionally, heightened concerns about the economic outlook and jobs are leading consumers to tighten their belts.

The Bank of England's decision to cut interest rates by a total of 300 basis points since October, with undoubtedly more reductions to come, will obviously help consumers, as will some of the measures contained in the government's £20-billion stimulative fiscal package announced in November's Pre-Budget Report (PBR). Meanwhile, inflation will retreat sharply over the coming months, helped by reduced value-added tax (VAT). Nevertheless, consumers will face serious pressures for an extended period.

Furthermore, business investment will be curtailed by sharply weaker final demand, increasing spare capacity, worsening cash flows, depressed business confidence, very tight credit conditions, and deteriorating profitability. Meanwhile, despite benefiting from a markedly softer pound, exports will be limited by muted global growth. Consequently, in our December forecast, we projected GDP to contract by 2.0% in 2009, after expanding just 0.7% in 2008. With recovery likely to develop only gradually, GDP growth is expected to be limited to 0.4% in 2010. Furthermore, we believe that there is a very real danger of a longer and deeper downturn, despite the monetary and fiscal stimulus measures. Indeed, we are likely to lower our 2009 and 2010 GDP projections in our January forecasting round.

Interest Rates Likely to Be Cut Significantly Further in January

Given the current markedly deteriorating economic performance and outlook, still-serious financial sector problems, and sharply retreating inflationary pressures, we expect the Bank of England to cut interest rates sharply further.Specifically, we forecast the Bank of England to reduce rates by at least a further 75 basis points from 2.00% to 1.25% in January. We believe that the Bank of England may want to moderate the pace at which it is cutting interest rates as they near zero and the previous large cuts take time to feed through. Even so, another 100-basis-point reduction in interest rates is certainly possible in January if the data show further serious deterioration. Further ahead, we expect interest rates to fall to a low of 0.50% in the second quarter of 2009 and to then stay there for the rest of the year. However, it is far from inconceivable that interest rates could come all the way down to zero.