By Max Clarke

The UK economy will continue to lag during 2011, as a major business organisation downgrades their growth forecast from 1.8% to 1.7%.

Despite a squeeze on household income and public spending cuts, a leading UK business group, the CBI (Confederation of British Industry) expects this year’s GDP growth rate to be 1.7%, marginally lower than the previous forecast of 1.8%. Growth of 2.2% is expected in 2012, down slightly from February’s forecast of 2.3%.

Stronger net exports are expected to make an important contribution to the UK economy both this year and next. Export growth of 8.6% in 2011 and 7.6% in 2012 is expected to outpace the rise in imports over the period, resulting in a net positive impact on GDP.

Business investment is also expected to help drive economic growth. Survey evidence shows historically strong investment intentions, with growth of 8.8% in 2011 and 8.7% in 2012 forecast.

“Although there are a number of risks to the UK’s economic outlook,” said John Cridland, CBI Director-General, “we continue to expect that the recovery will make further headway this year and next, but the pace will be sluggish.

“The economy is battling headwinds of squeezed household budgets, weak wage growth, high inflation, and necessary public spending cuts. Concerns also remain over the volatility of oil prices, and the impact of the earthquake in Japan on UK supply chains.

“But there are some brighter spots in the forecast. Global economic conditions remain upbeat, and we expect to see a stronger performance by UK exporters. Business investment will also make a firm contribution to growth in 2011 and 2012. But the rebalancing of the economy is going to take time to feed through, and domestically it may not feel like much of a recovery for some time yet.”

Quarter-on-quarter growth rebounded at a modest rate of 0.5% in the first quarter of this year, following a decline of 0.5% in the final quarter of last year. The CBI’s forecast for the remainder of 2011 is broadly unchanged, with steady but modest growth of 0.6% expected over each of the three remaining quarters.

Inflation is anticipated to be higher throughout this year and into early 2012 than previously forecast, largely due to the effect of higher commodity prices, oil in particular. But as the impact of the VAT rise falls away, inflation is expected to fall back closer to the Bank of England’s 2% target rate next year.

Nevertheless, with inflation expectations edging upwards, the Bank is expected to begin the process of normalising monetary policy later this year. Modest interest rate rises are likely from Q3 2011 through to mid-2012, followed by a slightly faster monetary stimulus withdrawal over the second half of 2012. This would take the Bank rate up to 2.5% by Q4 2012.

Ian McCafferty, Chief Economic Adviser at the CBI also commented:

“The recovery continues to be choppy and lacking in vigour. Expansion in certain sectors is being offset by weaker performance in others. What remains striking is how little we expect the pace of growth to accelerate in 2012, and that it will be far less robust than we’d normally expect in the second and third years of a recovery.

“Of particular concern are rising commodity prices, which are putting more intense upward pressure on inflation. By acting sooner rather than later, the Bank of England will be able to keep inflation expectations under control, and we expect interest rates to start edging up from their record low in the third quarter of this year.”

Unemployment is expected to peak in Q4 2011, at 2.62 million. And while it will remain stubbornly high next year, it will fall back to 2.52 million by Q4 2012.

Pay growth is expected to pick up somewhat over the coming two years, but remain subdued. Accordingly, the outlook for consumption is also subdued, with household spending forecast to grow more slowly than previously thought, by only 0.2% in 2011 and 1.1% in 2012. This reflects the further erosion to consumer spending from higher inflation and VAT, weak wage increases, higher mortgage interest rates, and ongoing concern over unemployment.

A decline in public sector net borrowing (excluding financial interventions) is forecast over the next couple of years, from £122.9bn in 2011/12 to £105bn in 2012/13.