Exports and domestic private sector spending therefore make up over 90% of the demand for the output of the business sector in the UK with public sector procurement and capital spending accounting for less than 10% of the total. So while the global economy continues to perform strongly and as long as private sector demand is still growing at a reasonable rate, UK plc should be well-placed to cope with the squeeze on public spending flowing from the October Spending Review (OSR). Alongside the recovery in overseas markets, domestic demand in the UK economy has also bounced back following the sharp declines seen in late 2008 and early 2009. In cash terms, domestic spending in the UK economy by consumers, government and business grew by 6.8% in the year to the second quarter of 2010. As I pointed out in a speech last month, this is relatively strong demand growth by comparison with the decade prior to the financial crisis, when the growth of domestic demand in money terms averaged 5.8%. 3 These data do not suggest that lack of demand is the main problem currently facing the private sector in the UK. We may see some slowdown in demand early next year as the fiscal measures announced in the Budget and the spending review take effect and consumers adjust to a higher rate of VAT. But this variability in the growth rate should not be confused with a genuine double dip which is still a remote possibility in my view.
12 For example, the most reliable measure of capacity utilisation in manufacturing – the CBI Industrial Trends Survey – shows capacity utilisation at around its average level, which is quite surprising at this stage of the recovery. There is more survey evidence of spare capacity in the services sector. But this does not seem to be exerting much downward pressure on inflation. The CPI measure of services price inflation has picked up from 2.4% at the end of last year to average around 3.8% in recent months. This is considerably in excess of the 2% target and also slightly above the average rate of services price inflation we experienced during the decade prior to the financial crisis, as Chart 7 shows. This does not appear consistent with the view that spare capacity in the UK services sector is serving to hold down inflation. With the economy recovering at home and abroad, inflation above target and set to rise further, I believe there are three powerful arguments for a gradual rise in interest rates which have been evident for several months. First, the main elements of demand for UK businesses – overseas markets and domestic private sector spending – have been recovering for over a year now and look set to continue to grow. The outlook for growth suggests the UK economy should be able to withstand a gradual rise in interest rates, even taking into account the impact of fiscal consolidation.