The UK economy is set to enjoy a gradual recovery over the next 12 months, but the possibility of a housing market correction poses a potential threat to growth in the medium term, according to a report published today by economists at PricewaterhouseCoopers.

UK growth is set to average around 2% in 2003, but is projected to pick up to around 2.5% in 2004 in the main scenario outlined in the latest edition of PricewaterhouseCoopers UK Economic Outlook report. This is based on a slowdown in consumer spending growth to around 2% in 2004, offset by continued strong public spending and a gradual improvement in investment.

UK exports should also be boosted in this scenario by an assumed US-led upturn in the world economy in 2004 and a more competitive value for sterling against the euro. These developments are also projected to allow manufacturing output growth to pick up from an average of around zero in 2003 to around 2% in 2004. In this scenario, interest rates would remain close to current levels during 2003, but might rise slightly during 2004.

Downside risks

The report emphasises, however, that there are downside risks to this main growth scenario in both the short term and the longer run. Over the next 12 months, the key risk is that the global economy could fail to revive as expected, preventing any significant recovery in UK exports and condemning manufacturing industry to continued stagnation. But looking further ahead, the report argues that the main risk arises from uncertainty as to the way in which current imbalances in the housing market will unwind over the next few years.

House price to income ratio will have to fall

In this context, PricewaterhouseCoopers analysis suggests that almost all regions apart from Scotland have now seen house price to income ratios rise to 20% or more above historic average levels, with the average divergence across the UK now in excess of 30%. History suggests that these ratios will have to fall back at some point, although the low level of interest rates, together with supply shortages in some areas, suggests that we are likely to see a more gradual correction in house prices than in the early 1990s. But a more rapid correction remains a significant downside risk for consumer spending.

To explore these risks, PricewaterhouseCoopers has developed a model that relates consumer spending to levels of employment, earnings, house prices and interest rates. This model is used to generate the following alternative scenarios for the period from 2003 to 2006:

• A base case in which house price inflation decelerates towards zero over the next year but does not suffer a sharp correction, with both unemployment and interest rates remaining relatively stable. In this case, consumer spending growth dips to around 2% in 2004 and remains slightly below trend in 2005-6.
• An optimistic case in which house prices continue to rise at around 6% per annum, with unemployment falling gradually in 2004-6, offset by somewhat higher interest rates than in the base case in response to faster growth. In this case, consumer spending growth dips less in 2004 and is stronger in the medium term.
• A housing market correction scenario in which house prices fall by 30% relative to earnings over the next three years, but unemployment and interest rates remain as in the base case. In this scenario, consumer spending growth is lower by around 0.2% in 2004 and around 0.6-0.7% in 2005 and 2006 (but note that there is little effect in 2003).
• A pessimistic case where there is a housing market crash but also a sharp rise in the unemployment rate from 5.1% now to 7% in the medium term, although in this case PricewaterhouseCoopers assumes that interest rates are cut back in response to only 2.5% by the end of 2004. In this case, consumer spending growth is around 0.8-0.9% per annum lower on average than in the base case in 2004 and 2005, although the interest rate cuts serve to boost growth to some degree by 2006.

John Hawksworth, Head of the Macroeconomics Unit at PricewaterhouseCoopers, said:

"At present, the risks to consumer spending growth seem weighted to the downside due to the possibility of a sharper than expected housing market correction.”

“On the other hand, the risk of a large rise in unemployment seems less significant at present and there is plenty of scope if necessary to soften the blow from any adverse developments through interest rate cuts.”

“As a consequence, even in our pessimistic scenario, projected consumer spending and GDP growth does not fall below around 1%, although in practice it is always possible that the outcome could be worse than this if a downward spiral of falling consumer confidence and lower spending sets in".