[LONDON] Bank of England (BOE) rate-setters risk underestimating the strength of the UK economy by placing too much faith in downbeat business surveys over official growth data.
Governor Andrew Bailey revealed last week he is putting more emphasis on indicators such as S&P Global’s purchasing managers’ index, warning that “we have had more volatile, short-run GDP numbers of late”. However, BOE watchers caution against repeating the error made after the 2016 Brexit referendum, when officials eased policy in response to a sharp downturn registered in surveys.
The conflicting signals threaten to muddy the waters at a time when the BOE is deciding how much more it can cut rates, as it weighs a fresh uptick in inflation against concerns over the economy and US President Donald Trump’s trade war.
Official figures show GDP growth picking up strongly in the first quarter to 0.7 per cent – the strongest performance in a year. Yet the growth signal from the Purchasing Managers’ Indexes (PMIs), when an average is taken over the quarter, shows a more stable but stagnant picture – a view that the BOE believes is more indicative of the economy’s underlying state.
The index showed virtually zero growth in the first quarter. It then dropped into contractionary territory in April as businesses baulked at Trump’s tariffs before rebounding to a flat reading in May.
“The challenge we have at the moment is that the forward looking evidence on activity in the economy, so the surveys, are nothing like as strong as that,” Bailey told Parliament’s Treasury Committee last week. He called the gap a “disjoint” and said that BOE staff believe the private-sector surveys are a better predictor of the economy’s future than the previous GDP figure.
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“Bailey is at risk of repeating the same error made after the Brexit referendum, of taking a weak PMI as strong evidence of actual growth, when it proved to be very misleading,” said Robert Wood, chief UK economist at Pantheon Macroeconomics.
“There is strong evidence that the PMI is far too pessimistic about growth when uncertainty rises because the qualitative nature of the survey means that it captures sentiment rather than actual growth. The same will very likely apply to Bailey’s visits to firms.”
The economy grew by 1.9 per cent in 2016, in line with the average of the previous six years – despite the political upheaval caused by Britain’s vote to leave the European Union.
While the official data for the first quarter was likely boosted by temporary factors as manufacturers rushed to get ahead of US tariffs, there were also signs of strength in services, the largest part of the UK economy.
Government data have been under suspicion amid a series of statistical flaws primarily affecting the labour market data, but also covering estimates of GDP. One concern is whether they are correctly adjusting for seasonal shifts in economic output.
“There’s also some evidence to suggest that the GDP data – especially the like-for-like services PMI equivalent component – has been exhibiting some strong seasonality since the pandemic, which is not evident in the PMI,” said Chris Williamson, chief business economist at S&P Global Market Intelligence.
The Office for National Statistics dispute this is the case and found little evidence of this effect when it ran detailed testing on the possibility of residual seasonality last month.
Economists say the PMIs also have drawbacks, particularly given they do not include certain sectors, such as retail, and government activity.
“But the surveys do capture around 80 per cent of private sector economic output, reflecting spending by both businesses and households, which is what is of primary concern to both policymakers and investors,” said Williamson.
The PMI and other business and consumer surveys have also tended to drop sharply in response to political news. Brexit, Liz Truss’ calamitous mini-budget in 2022 and Labour’s first budget all triggered downturns that did not coincide with significant changes in the economic fundamentals in official data, such as GDP and unemployment.
Research by Bloomberg Economics showed that a spike in uncertainty doesn’t always result in a big near-term hit for the UK economy. Chief UK economist Dan Hanson said history shows that a spike in policy uncertainty measures “are not as well correlated with GDP growth as indicators of financial market volatility or survey measures that capture perceptions about the economic outlook.”
However, the PMI did align with the downturn seen in official data in the second half of 2023 when the cost-of-living crisis tipped the UK into a mild technical recession.
“The risk is that with different indicators sending different signals on demand, it takes longer for the BOE to understand the forces driving in the economy,” said Ruth Gregory, deputy chief economist at Capital Economics. BLOOMBERG
