Chris Giles Blimey, that’s strong growth

No-one predicted that the UK economy would storm ahead quite so much in the second quarter. Initial estimates from the Office for National Statistics suggest the economy grew by 1.1 per cent between April and June compared with the previous quarter – far above the already pretty strong consensus of 0.6 per cent. The surprise came because services was measured to have stormed ahead in May, by 1 per cent.

There is no doubt that this is above-trend growth and it helps to explain the favourable tax revenue, labour market and survey data that have been a feature of the British economy for some time. Construction, business services, finance and government services were the biggest contributors to this growth rate. While government services cannot continue to contribute 0.2 percentage points to growth in future quarters, given the looming cuts, there is no reason to say other sectors will automatically fall back.

For the authorities, this unexpected good news really puts the cat among the pigeons. For the Bank of England, this is evidence the recovery is gathering steam and ultra-loose monetary policy is working. It also helps to explain a little why inflation has been overshooting. It will certainly make it much easier for the Monetary Policy Committee to argue that there is no need to loosen monetary policy in response to the tough Budget. And it will raise expectations of higher interest rates again, if this remarkable quarter of growth continues.

For the chancellor, you would think this is good news as fast growth should make everyone much more comfortable about deficit cuts. Cutting spending will now come against a backdrop of faster underlying growth, reducing the probability of a double dip. But because of the crackers way the government organises fiscal policy, unexpectedly fast growth is bizarrely bad news. How can this be? The way the logic runs, a positive surprise on growth means slower growth in future, so the current level of tax revenues appear disappointing.

Specifically, and you can miss this bit, faster-than-expected growth will mean the Office for Budget Responsibility will have to lower its output gap assumption. In turn, a lower output gap raises the estimate of the level of borrowing that will not close due to faster than average growth – the current structural budget deficit. And with a larger current structural deficit, the government will have less chance of meeting its new fiscal mandate of eliminating the current structural deficit by 2015-16. Of course, this tortured logic depends almost entirely on the estimate of the output gap, the measurement of which is neither art nor science. It is impossible. But were the OBR now to change its output gap assumption, it would prove that all the structural budget deficit numbers are made up and not worth the paper they are written on. That would be true, but would undermine the new fiscal mandate.