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Commentary.

* The initial response of the British economy to devaluation and the relaxation of monetary policy has been in line with expectations. Business optimism has recovered. The prospects for exports have improved. Import prices have risen sharply.

* Our forecasts for this year are virtually unchanged since November. Our central forecast for growth this year is still 2 per cent, rather above the consensus. For underlying inflation (the RPI less mortgage interest payments) our central forecast is still above 4 per cent, over the top of the target range.

* The average error for a forecast of growth year-on-year, made in February, is over 1 per cent. We would not be surprised therefore if growth this year was over 3 per cent or under 1 per cent. After four years with, in effect, no growth at all, another year with growth of less than 1 per cent would be a disaster. We therefore welcome the further easing of monetary policy that has taken place already this year.

* We recommend a neutral Budget in March. Tax increases may be indicated in December, but only if the recovery is well under way.

* In the medium term we expect rather less real growth than the Treasury, but rather more inflation. Faster inflation means more tax revenue, but it will also make it difficult to hold to the public spending plans in the Autumn Statement.

* The authorities should not make firm commitments to targets for inflation which they may not be able to keep. It would be better in present circumstances, following the devaluation of sterling, to frame targets for a different definition of underlying inflation: that is the GDP deflator, which excludes the prices of imports.

* Anxieties over public expenditure control should not stand in the way of sensible plans to stimulate growth or reduce unemployment.

Short-term Prospects for the UK Economy

1992 was a year of repeated disappointment. Looking back now output appears to have been dead flat for all four quarters, but at the time business sentiment was alternating violently between hope and fear. The CBI quarterly survey results have been swinging backwards and forwards. They began last year indicating deep pessimism, revived sharply in April, but retreated in July and collapsed in October. It is not surprising therefore that the signs of renewed confidence in the January survey this year are being greeted with a certain amount of reserve.

Our forecasts for a recovery in the economy do not rest mainly on the indications of an improvement in the level of economic activity around the turn of the year. They rest rather on our analysis of the effects of the relaxation of monetary policy beginning from last September, especially the devaluation of sterling. We would not have expected to see any marked change in the fourth quarter; what changes we do see are consistent with our analysis.

It follows from this that our forecast for the UK economy this year is little changed since last November. Our central forecast for growth at about 2 per cent is still above the average of independent forecasters, but the range of uncertainty surrounding each of us is wide enough to encompass virtually all of the rest. Our central forecast for underlying inflation, a little over 4 per cent by the fourth quarter, is similar to the average of independent forecasts; the official target for inflation is clearly at risk.

As on previous occasions when sterling has fallen sharply, we expect the gain in relative cost competitiveness to result in restored profit margins for exporters as well as a substantial gain in export volume. There is some sign of this happening already in the fourth quarter. British firms will be well placed to compete for whatever business there is to be had in the relatively stagnant European market, and for a growing share of the rapidly rising flow of imports to be expected into North America.

Slow growth in the world economy will moderate the pace at which UK exports can expand. For the Group of Seven countries we expect an average growth rate of 2 per cent this year, only a little faster than in 1992. Total world trade will be relatively strong, but much of the increase will be in markets, such as China, where as yet UK products have made little progress. In Europe market growth will be slow, but the removal of trade restrictions may increase the response to our competitiveness gain.

There is ample spare capacity, and when relative costs provide the incentive, multinational firms in particular are now able to switch production rapidly to this country from overseas. Devaluation also provides an incentive for import substitution. The classic study of the 1967 sterling devaluation (J Artus in the IMF Staff Papers, November 1975) demonstrates that even at that time the effect on import volume was an important, and easily overlooked, contribution to the subsequent rise in output and improvement in the balance of payments. The gain in competitiveness should now help to hold back import growth in the recovery.

Normally we would not expect the recent cuts in interest rates to act at all quickly to stimulate domestic demand, either from consumers or from business. Doubtless the progressive cuts since September have already made some contribution, if only by reinforcing the message from government that the growth objective takes priority. Moreover the debt burden on households and firms is such that a cut in interest rates has a substantial and perhaps salutary, effect on cash flow. If there is indeed the beginnings of a revival in the housing market and some sectors of consumer spending, this is now long overdue in view of the cuts in interest rates (from 15 per cent to 10 1/2 per cent) made between 1990 and 1991. The effects of the more recent reduction (from 10 per cent to 6 per cent) should be reinforcing recovery throughout this year and beyond.

TABULAR DATA OMITTED

Devaluation has already raised import prices; they were up by 9 per cent in the fourth quarter, and some further increase should be expected in the next few months. That in turn must add to wage pressure, although not necessarily straight away. After the 1967 devaluation wages were held back for a year or so by a successful episode of incomes policy, but there was a sharp rebound in 1970. By the end of 1971 the whole of the devaluation gain in competitiveness had been reversed. The conditions of 1993 are of course very different, not least because unemployment is so much higher. Even so we would expect to see wage settlements beginning to rise again in the course of this year, provided that the output recovery is significant and sustained. This is the reasoning behind our forecast that the target band for inflation may well be exceeded.

The target band is set for the increase in the retail price index excluding mortgage interest payments. An alternative definition of 'underlying' inflation would be the GDP deflator at factor cost, which refers to the prices of goods and services produced in this country, excluding their import content and indirect taxes. We expect that index to rise by less than 2 1/2 per cent this year.

The worst news since our last Review was the sharp rise in unemployment in the fourth quarter. This follows from the sharp fall in employment now recorded for the third quarter of last year, a time when business confidence was at its low point. The same surveys which now indicate hopes of a recovery in output, predict further job losses this year. We have therefore raised our forecast of unemployment, with the peak now predicted at about 3.2 million in the first quarter of 1994.

Implications for Policy this year

Policy must take account of risks and uncertainties as well as a central forecast. The average error of a forecast of GDP growth year-on-year, made in February is 1 1/4 per cent. It would not be surprising therefore if the growth rate this year turned out at under 1 per cent or over 3 per cent. After an exceptionally long recession there must be an exceptional back log of expenditure, which could produce an exceptional surge of demand when confidence returns. When jobs seem rather more secure and when house prices stop falling, consumers may feel safe again--and very 'hungry'. On the other hand the risks in the other direction are just as evident. The overhang of debt may prove more of an inhibition to expenditure than we have assumed in our central forecasts. The growth of the world economy could falter, or even come to a halt.

The uncertainty surrounding our forecasts may be symmetrical, but the risks are not. An outcome of over 3 per cent growth, even with the potential for faster inflation that goes with it, would be acceptable; an outcome of under 1 per cent growth (after four years with effectively no growth at all) would be a disaster. It appears from the most recent cut in interest rates that the government and the Bank of England are prepared to run a risk of adding to inflation in order to reinforce the recovery of output. If that is their priority, we sympathise with it.

It is possible that the government is planning to raise taxes in the March Budget this year and to cut interest rates further to compensate. Our choice, however, would be a neutral Budget, making us rather cautious about the scope for further interest-rate reductions. Within that neutral Budget more could be done (and should have been done some time ago) to ease the severity of the employment situation. Central and local government, and public corporations, should be delaying any measures which involve laying off workers until the recovery is well established, whilst bringing forward measures which involve taking on extra staff.

If the economy develops as our central forecasts predict, then we must expect to be recommending increases in interest rates by this time next year. The medium-term prospects for public sector borrowing, discussed below, may also necessitate tax increases in the December Budget this year--but we need to be sure first that recovery has actually begun.

The next few months will be a crucial period for policy. By May, when our next Review will be published, we will know broadly what the level of activity was in the first quarter. That is too late to influence the Budget, but it could be the right time to reassess monetary policy. If the change of policy following Black Wednesday is working, then industrial output and consumer spending should be rising by then. (We should also have been examining trade figures for the first three months with particular care, but by a malign coincidence the method of compiling the figures has been changed and they will not be available until later in the year.) If the indicators for the first quarter remain flat or suggest a further fall in output, then the time will have come for a further cut in interest rates, by another 1 per cent or even more.

Policy measures may also be needed in response to exchange-rate movements. If sterling appreciates strongly then the opportunity should be taken to cut interest rates again. There is no merit in going back to an over-valued exchange rate, now that the link with the ERM has been broken. It is more likely that sterling will remain weak, making further interest-rate reductions difficult to secure. Even so, we would be very reluctant to recommend higher interest rates until it is clear that recovery is well under way.

Demand Management

It is remarkable how the debate over economic policy has reverted to issues of demand management. The level of real activity seems indeed to be the main policy issue at present. From about the mid-1970s until last year it was at least mildly heretical to advocate discretionary counter-cyclical policy, whether fiscal or monetary instruments were to be used. Now everyone seems to assume once more that it is the government's job to encourage and foster economic recovery. One could argue whether demand management need be a continuous concern of government, or whether it is a reserve power needed only to counter extreme or persistent booms and slumps. But we have never accepted that the economy can always be relied on to right itself.

The issue is partly one of timing: the economy should eventually tend back towards some kind of equilibrium when disturbed. If we were prepared to wait long enough the recession should end of its own accord, although it might take an unacceptably long time. But demand management may not just be a matter of bringing forward an inevitable recovery. It is possible to argue that some of the effects of a recession are never reversed. The establishment of something of a consensus in favour of expansionary measures in a recession is, therefore, to be warmly welcomed.

There are, however, two points which advocates of demand management are duty-bound to recognise. The first is simply that demand management is necessary to damp down booms, when it will be unpopular, as well as to end recessions, when it will be popular. The second is that demand management, designed to stabilise the economy from year to year, must be set in the context of a sustainable medium-term strategy.

The Economy in the Medium Term

Medium-term forecasts assume an environment with no shocks at home or abroad, and an end to the cycles in activity. This apparent stability is the result of ignorance as to the nature of future shocks and as to the timing of the cycle; we do not actually expect the real world to be stable. On the contrary it is quite likely that the next five years will include another boom and the beginning of another recession.

Over the last twenty years the growth rate in the UK has averaged about 2 per cent a year. The acceleration in the 1980s can be interpreted as a kind of catching up after the exceptionally slow growth of the 1970s. Starting from 1993 we should be able to achieve rather faster growth than this long-term trend for a few years, taking up the slack. But the experience of the last two recessions suggests some 'ratchetting down', such that the subsequent growth never compensates fully for the momentum lost. The average rate of growth in our medium-term projections for the three years 1994, 1995 and 1996 is 2 1/2 per cent. This is above trend but lower than the growth rate projected by the Treasury for the financial years 1994-5 and 1995-6 in the Autumn Statement.

Projecting inflation into the medium term is a more tendentious business. We must in effect be assessing the credibility of the monetary authorities' commitment to 'price stability'--or to 'lower inflation', as it has more recently been expressed. The gap between the yields on indexed and conventional gilts is now about 5 percentage points. Maurice Scott in his article in this Review assumes that conventional gilts pay a premium because their real yield is uncertain, and he puts the current market expectation of long-term inflation at about 3 1/2 per cent a year. A simple averaging of inflation over the past ten years works out at 5 1/2 per cent a year. Our central projection is just under 5 per cent a year.

This contrasts with the Autumn Statement assumption of inflation at about 3 per cent in 1994-5 and 1995-6, and with the government's aim of inflation at 2 per cent or less. We are not suggesting that the Treasury figures are unrealistic as objectives, but rather than the risk of over-shooting them on average is much greater than the likelihood of under-shooting.

The point is often made that a sustained recovery now will inevitably founder, because the resulting growth of imports will create a balance of payments deficit too large to finance. The concern is understandable, and we share it. Last year when the UK was still a member of ERM, and possibly heading towards membership of a monetary union, we thought that a sustained recovery might be incompatible with a fixed exchange rate for much the same reason. Now that sterling is no longer in the ERM the most likely consequence of a growing external deficit would be further depreciation. (It is notable that the sustained recovery of the 1980s was accompanied by a progressive depreciation in sterling.) The consequence would be faster inflation, and ultimately slower growth correcting the deficit. But so far as the next few years are concerned the point is simply that the external constraint need no longer be so immediately a binding one. But the chances of inflation well in excess of the official projections are increased.

If, in the medium term, inflation is faster than assumed in the Autumn Statement then tax revenue will be higher. If the public spending plans are unchanged in nominal terms then the problem of the public sector deficit will not be as acute as it now seems. Commentators who discount the Treasury's revenue projections because their growth assumptions seem too optimistic, should note that their inflation forecasts seem too optimistic as well. The problem facing the government next year and subsequently may be one of holding the line on nominal spending as prices rise. The implication would be a severe 'volume squeeze' on all programmes and a continuation of the unpopular restraints on public sector pay. In our projections we assume that the problem of the PSBR cannot be solved in full without further increases in rates of taxation.

Policy in the Medium Term

Our medium-term projections, based on an econometric model, can be seen as a relatively sophisticated extrapolation of past trends. Inevitably the future looks rather like some average of the past. The more interesting questions concern the policies needed to improve on past performance.

So far as inflation is concerned there has been a serious set-back following the failure of the strategy based on UK membership of the exchange-rate mechanism. We supported that strategy because we saw it as a package offered to this country by the rest of Europe, a deal which on balance we should accept. But the deal is not on offer in the same form now.

Whatever approach the government now adopts any attempt to precomit itself will lack credibility. One of the attractions of the ERM regime was that it amounted to a 'precommitment club', in which the various members could in some measure reinforce for each other the discipline which each intended to observe when it joined. In this context, the commitment by the British authorities to low inflation and a fixed exchange rate was generally accepted. By breaking that commitment the British authorities have weakened the ERM as a system. They have also damaged the credibility of any future commitments they may make themselves, whether in the context of rejoining the ERM, or of attempting to establish a purely domestic framework for monetary policy.

The proposal to set up an independent Bank of England with full responsibility for monetary policy and with a statutory duty to maintain price stability can be seen as an attempt to create a kind of British Bundesbank. But in fact the intransigence of the Bundesbank has been one reason for the disruption of the ERM. Andrew Blake and Peter Westaway contribute to the debate in their note on page 72. The New Zealand case is also relevant, and the implications of central bank independence is amongst the issues raised in the note by Alan Bollard and David Mayes on page 81. A central bank should be independent enough to make credible commitments. But its priorities in making such commitments (as between say growth and price stability as final objectives) should not differ from those of the government, or indeed from those of the electorate.

The Bank of England is now in danger of being held responsible for a commitment to keep underlying inflation below 4 per cent, which does not really reflect the priorities of the government, or the population at large, or even necessarily of the Bank itself. There is no harm in setting a rather ambitious or optimistic target, but it would be wrong for the authorities to promise that it will be hit. There are also obvious disadvantages in separating responsibility for monetary policy from responsibility for borrowing by the public sector.

The model of monetary policy now used by many theorists includes a 'punishment mechanism' by which monetary authorities who break commitments are obliged thereafter to adopt 'suboptimal' policies which are 'time consistent'. In other words, the penalty for the failure of the ERM strategy is that no-one will now expect price stability to be maintained, and--given that expectation, which the government cannot now change--the cost in terms of lost output needed to enforce price stability simply will not be worth paying.

Despite this, of course, the authorities must continue to give weight to the inflation prospect in managing demand, as well as the prospect for economic activity. Next year, if our forecasts are correct, inflation will be a much more important political issue than it is now. Gradually the authorities should be able to feel their way towards a new counter-inflation strategy, which will involve new commitments of some kind--to inflation targets, to a path for monetary aggregates or to a fixed exchange rate. But whatever approach they follow it will take many years to rebuild the confidence that was lost last year.

There would be much more popular support just now for a new medium-term strategy to promote growth. The rhetoric of both government and opposition parties has responded to that demand, but as yet no very substantial policy changes have been made, or even proposed.

One kind of industrial policy which would command strong support is a policy to improve education and vocational training. This is a theme to which we have often returned, and it is one worth repeating. But of course it is a policy for the long term, not the short or even the medium term.

With that exception the most fruitful approach to industrial policy may be somewhat piecemeal. There may be scope for joint ventures between private sector companies and public sector bodies, whether that means central government, local government or public corporations. These are being advocated nowadays by some commentators as a device to circumvent a constraint on total public spending or the PSBR. As such they would be too transparent to succeed, but the economic case for enterprise of this kind is in fact a strong one.

Industrial policy tends to be expensive in public expenditure terms. The same is true of effective action to improve job prospects or to help the long-term unemployed. An understandable concern for the control of total public spending may be holding back initiatives which would favour the growth of both output and employment. When this happens the Treasury's role as keeper of the purse-strings conflicts with its role as the lead department in making economic policy.
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Title Annotation:The Economic Situation; UK economy
Publication:National Institute Economic Review
Date:Feb 1, 1993
Words:3856
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