UK Economy: Will It Suffer a Recession in 2012?

The UK economy is under significant pressure in the shadow of uncertainty cast by the eurozone debt crisis which is resulting in its losing the momentum of recovery.

The National Institute for Economic and Social Research reported last week that economy will grow less than previously forecast over the next two years. It has made the forecast that the economy will shrink 0.1 percent this year and grow 2.3 percent in 2013 compared to previous projections in October for growth of 0.8 percent and 2.6 percent respectively.

The impact of a eurozone breakup on the UK economy is extremely uncertain. Many forecasters, including the Bank of England (BoE) and Office for Budgetary Responsibility (OBR), have explicitly excluded the probability of a euro break-up from their projections.

While the uncertainty in the eurozone persists, the UK may be stuck in a paradox of thrift as all sectors try to conserve cash. To help escape this trap, the BoE has already announced an extension of Quantitative Easing (QE) in February. This should be complete in early May at which point the bank will probably pause to assess the impact of existing policy.

The QE may be more muted now than in 2009 because one way the QE worked then was by lowering policy rate expectations. Currently, the policy rate is already expected to remain close to zero until at least late 2013.

Another way the QE works is when sellers of gilts reinvest their cash in other assets, driving up their prices and lowering yields. But as gilt yields are now much lower than they were in 2009, current holders of gilts may be more interested in security than return, meaning they may just keep the cash rather than reinvest it.

Additional QE may put downward pressure on sterling, particularly if sellers of gilts reinvest the proceeds in non-sterling denominated assets.

The weak and uncertain economic outlook makes the government's task more difficult and although the OBR revised its forecasts significantly in November 2011, they still look a little optimistic. As inflation falls back and real activity slows, nominal GDP growth could fall sharply reducing the tax take and exerting more pressure on the budget deficit.

There is always a risk that politicians continually try to push the pain into tomorrow. If they succumb to this temptation too often, the UK's AAA rating will come under pressure.

The bottom line is that an uncertain environment will weigh on growth through 2012, and a recession can be expected in the first half of the year. The BoE has already responded by extending its asset purchase program. But it may need to do more to later in the year to prevent inflation undershooting its target.