Spare Capacity? Not in the UK

Bank of England risks being badly behind the curve on rising prices...

 

AT TIMES when the economy is changing, business surveys provide a valuable and timely insight into the latest trends and future prospects, writes former Bank of England policymaker Andrew Sentance on his Hawk Talks blog.

 

Business surveys are available in advance of official statistics and can provide information on business plans and expectations as well as out-turns. Business surveys are also a source of information for some key variables which are not measured by official statistics – such as capacity utilisation.

 

The British Chambers of Commerce (BCC) quarterly economic survey probably has the most comprehensive coverage of the UK business surveys. It covers around 7,500 firms in services and manufacturing. The coverage of the services sector makes this a particularly important survey, as services account for close to 80% of UK GDP and over 80% of total employment in the British economy. The survey has been running for 25 years now, so the recent results can be benchmarked against the experience of the 1990s and 2000s.

 

The latest BCC survey paints a pretty upbeat picture of pace and durability of the UK recovery.

First, the survey shows that demand is strong at home and abroad. The latest results show the strongest growth ever recorded in domestic manufacturing orders and the highest reading for the growth of domestic orders we have seen in the services sector since the mid-1990s. Overseas demand also appears to be rebounding from the effects of the Euro crisis. Export orders for services are at all-time record highs according to the BCC survey, and export sales by manufacturers are the strongest recorded by 1994.

Second, the recovery in demand and output is now feeding through into business investment and employment plans in both the manufacturing and services sectors. In manufacturing, investment intentions and the expected growth of employment are both at an all-time high. In the services sector, plans to increase investment and employment are back to the levels seen in the years of strong growth before the financial crisis.

 

On this basis, we should expect to see unemployment continue to fall and investment to grow healthily this year. These are both indicators which the Bank of England's Monetary Policy Committee (MPC) is looking at to judge the sustainability of the recovery and to inform its policy response.

Third, there appears to be very little margin of spare capacity now in the UK economy – at least according to the business world.

 

Nearly half of firms in both manufacturing and services report they are operating at full capacity – which is at or close to the record levels of capacity utilisation we have seen over the last 25 years (see Chart, above). If growth continues at the current rate, there is little slack to be taken up and it will take time before new investment brings new capacity on stream.

 

There is therefore a heightened risk that continued strong demand growth will push up prices. Indeed, the BCC survey shows that is already happening in the services sector – expectations of price rises are close to the highest level we have seen since the financial crisis.

 

The strength of the UK economy shown by this latest BCC survey is consistent with other recent business surveys, from the CBI and Markit/PMI. We may not yet be in "booming Britain", but growth is robust and is gathering momentum.

 

If monetary policy does not respond soon to this evidence of strengthening demand, investment and employment alongside high capacity utilisation, the MPC is likely to find itself badly behind the curve when it does get round to raising interest rates.