Exports could lead to recovery.

OPTIMISTS have had to put the bunting back into storage after official statistics showed that the UK economy continued to shrink in the third quarter, declining a further 0.4%.

This was the sixth consecutive quarter of decline, the longest run since statistics were first collected in 1955, taking the cumulative fall in the economy since the start of the recession to almost 6%.

It is at odds with the increasingly confident mood of the stock market. Analysts expected a small rise in output, based on improving business surveys and an increase in industrial output in other economies.

As a result, markets were starting to anticipate an end to the Bank of England''s (BoE''s) quantitative easing (QE) policy, which has been boosting the money supply since April.

It is possible that this flash estimate will be upgraded when the full suite of statistics for September becomes available. Parts of the service economy, in particular, are hard to estimate and statistics tend to be less timely than those for manufacturing output. If activity is in step with the recovery in confidence reflected in financial markets and beginning to be reported by companies, then it seems likely that a turning point for the economy was reached during the summer.

However, this may not have neatly coincided with the calendar quarters.

The principal headwinds for the economy remain the deadweight of consumer debt, which tighter credit terms and economic uncertainty are encouraging borrowers to reduce, and the need to rein in the budget deficit, which may already be leading to a slowdown in the government outlays that had previously supported growth.

The fiscal tightening already programmed for 2010 and beyond is likely to restrain growth, while consumers are unlikely to shift from saving to spending mode while unemployment is still rising and the stock of debt remains largely undiminished.

Much of the heavy lifting in the economy will have to be done by international trade, whether goods or services. As well as making use of the UK''s competitive advantages, such as financial sector expertise and an attractive historical and cultural legacy for tourism, the exchange rate is likely to remain on the cheap side of competitive for as many years as it takes to sort out the structural problems in the rest of the economy.

The BoE extended its QE programme in August, but reduced the monthly rate from pounds 25bn to pounds 17bn.

The fruits of the stimulus are only likely to appear after a lag, so the absence of statistical evidence of recovery is unlikely to panic the BoE into more aggressive measures.

However, the anaemic signs of recovery confirm what would be expected from a recovery with debt-related headwinds and suggest the patient is still in need of oxygen.

So, it seems possible that the BoE will chart a course between complacency and anxiety, extending its QE boost to the economy but reducing the monthly rate - taking some pressure off the accelerator but straying nowhere near the brake.

Andrew Bell, Head of Research, Rensburg Sheppards

CAPTION(S):

Cultural assets like the Tower of London, along with a weak pound, could stimulate economic growth