The local economy is showing some resilience despite the national outlook. John Bartlett, Bank of England regional agent for the West Midlands looks at the current climate.

The British economy is currently passing through challenging times, and the West Midlands, like other parts of the UK, is not immune from the effects of the global credit crunch and other factors such as increasing cost pressures.

First, let me look at the national picture.

The near-term outlook for inflation has deteriorated. This will lead to a squeeze on households’ real take-home pay, which in turn will slow consumer spending and output growth, perhaps sharply.

So the balancing act faced by the Monetary Policy Committee (MPC) is even more challenging than it was at the start of this year.

One of the main consequences of the turbulence in financial markets that first became apparent last summer has been tighter credit conditions across the economy.

The impact has been most apparent in real estate markets, with prices falling for both commercial and residential property.

In these circumstances, households are likely to save more of their income and spend less.

This is part of a necessary rebalancing of the UK economy away from spending and importing and towards saving and exporting — a change that is being supported by sterling’s depreciation since last summer.

So far this year, the UK economy has continued to grow, albeit more slowly than in recent years. We have seen some indicators of weakness in consumer spending and in business investment plans.

Export demand, by contrast, has been holding up fairly well, despite slow growth in the US.

In Asia in particular, the pace of expansion has remained robust, maintaining the upward pressure on global commodity prices.

Looking ahead, the central view of the MPC at the time of their May forecast was for output growth to slow sharply through 2008, reflecting the squeeze on real incomes, the tightening in credit conditions and weaker prospects for world growth.

That is a weaker forecast for economic growth than at the start of the year, because a number of downside risks have since crystallised.
Growth is expected to recover gradually through 2009 as credit conditions begin to ease and the depreciation of sterling boosts exports and reduces imports.

The risks around the near-term outlook are balanced (that is, growth is equally likely to be higher than lower) but further out the risks lie on the side of weaker growth, consistent with the possibility of a prolonged period of tight credit conditions and weak demand.

The near-term outlook for inflation has deteriorated markedly since the MPC’s February forecast.

Annual consumer price (CPI) inflation has increased this year, and rising energy and import prices will almost certainly push it higher still in the coming months.

If energy prices stabilise, inflation should start to decline around the end of this year and settle around the two?per cent target in the medium term.

There is considerable uncertainty over this profile: for example, the near-term outlook rests on assumptions about the magnitude and timing of further rises in domestic gas and electricity prices.

Nevertheless, it is likely that with inflation expected to be above three?per cent for several quarters, the Governor will be required to write a number of open letters to the Chancellor over the next year.

There are both upside and downside risks to the medium-term forecast for inflation.

On the downside, a more prolonged period of subdued demand growth could open a larger margin of spare capacity, pulling down on inflation.

On the upside, inflation could remain above two?per cent for longer if above-target inflation begins to affect the expectations of those setting wages and prices. Both sets of risks have increased this year.

To try to bring CPI inflation back down to the target too quickly would result in an undesirable degree of volatility in output.

But this emphatically does not mean that the committee will ignore the near-term rise in inflation.

The extent of that deviation from target this year is likely to affect the behaviour of those setting prices and wages.

So the committee judges that some slowing in demand growth is necessary this year in order to keep inflation close to its target in the medium term.

As I indicated at the start, the committee is facing its most difficult challenge yet. We are travelling along a bumpy road as the economy rebalances.

But interest rates must not be set with the intention of preventing that adjustment. As the committee’s remit states, “the real stability upon which economic prosperity is founded requires that inflation remain low and stable for a long period of time”.

Inflation will return to target and growth will eventually recover to a sustainable rate. But we will need to be patient.

So what does all this mean for Birmingham and the West Midlands?

Broadly, the outlook is similar to that described above for the UK economy as a whole. And we here are certainly seeing more subdued spending by consumers, alongside falling property prices.

But the mood in much of the business community is far from downbeat.

There is certainly more caution and uncertainty than there was a year ago, but many of the firms to whom I speak, and especially those that export, do still feel reasonably optimistic about prospects for the coming year and beyond.

In the important professional services sector, firms operating locally are perhaps suffering somewhat less from the effects of the credit crunch than their counterparts in London.

But cost pressures are a big concern for all businesses, especially in relation to energy, fuel, food and other commodities, and margins are under some pressure, especially when selling to consumers.

On the other hand, the weaker exchange rate is helping competitiveness and labour costs are not rising faster than in recent years.

I detect a widespread view that, if we can get through the next few months without further shocks, then prospects should start to brighten.

And the number of cranes in Birmingham certainly suggests that there is confidence for the future, both in the city and in the wider region.