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The economic rebalancing act is delivering the downside but not the up

High inflation and a falling pound should squeeze spending and boost exports – but the UK’s trade deficit has yet to improve

So much for the rebalancing of the economy. The government’s hope is that its squeeze on the public finances and the marked drop in the value of the pound since the start of the financial crisis will lead to a shift away from consumer spending and towards exports.

One half of the strategy is certainly working. Household budgets are buying less than they did a year ago, taxes have gone up, energy bills are dearer, and a weak housing market means it is no longer possible to use property as a cash machine. Tuesday’s data for the cost of living shows that the annual inflation rate nudged up to 4.5% last month – more than double the government’s 2% target. In part, that’s the result of the fall in the value of the pound making imports dearer.

But the supposed upside to this story – an improvement in Britain’s chronic trade deficit – is yet to materialise. In July, the UK’s trade gap in goods crept above £8.9bn, offset by a healthy surplus of £4.5bn in services. The overall shortfall remained steady at £4.5bn but was up from £4bn in May and a recent low of £2.2bn in February.

It is not hard to see why the trade performance has been disappointing. Britain’s manufacturing base has just been through its third big shake-out of the past 30 years and no longer has the critical mass necessary to capitalise on a cheaper pound. Globalised production means that the import component of exports has risen, so the benefits of currency depreciation have been blunted. Finally, Britain’s biggest export market – the eurozone – is battling for survival.

What does all this mean? It means that the short-term prospects for the economy are poor, and the medium-term prospects don’t look too clever either. The upward movement in inflation – while expected – will widen the divide between prices and earnings, putting further pressure on consumer spending. Further increases in inflation can be expected in September and October as a result of the phased rises in domestic energy bills, with the City predicting a peak at around 5%.

After that, however, the annual inflation rate should start to come down fast because the increases in energy prices and VAT seen in the past 12 months are unlikely to be repeated. That is certainly the view of the Bank of England, which is why the nine-strong monetary policy committee has not responded to above-target inflation with an increase in borrowing costs.

Indeed, the big debate at the Bank is now about whether policy should be loosened further through a fresh dose of quantitative easing – an injection of cash into the banking system through the purchase of government gilts. August’s inflation figures make the Bank’s decision harder, because a rising cost of living increases the chances of a hard landing for the economy the Bank may want to wait until inflation has peaked before announcing more QE. Most analysts in the City think November, when Threadneedle Street publishes its quarterly health check on the economy, is the likeliest date for a move. © 2011 Guardian News and Media Limited or its affiliated companies. All rights reserved. | Use of this content is subject to our Terms & Conditions | More Feeds