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The UK economy.

Section 1. Recent Developments and Summary of the Forecast

With the uncertainty induced by the prolonged run-up to the general election having come to an end and renewed signs that consumer and business sentiment has begun to improve, it now seems as if the economy is poised to emerge from the recession over the coming months. It may be some while before the evidence of any improvement emerges from the official statistics and it is quite possible that the various monthly sectoral and industrial surveys will continue to give conflicting signals as to the strength of the economy at the present time.

Both the latest industrial trends survey conducted by the CBI and the recent MORI and Gallup consumer confidence polls suggest that confidence over future economic prospects is beginning to improve. Moreover, as the latest survey evidence was partially completed before the election outcome, it suggests that an upturn may have begun at some stage in the first quarter. The balance of business optimism in the CBI Survey is shown in Chart 1, with the levels over the last few quarters well above those reported at the time prior to the onset of the recession. It is also appears as if confidence may have improved further following the election of a government with a clear majority, with financial markets being particularly buoyant in the post-election period.

Nonetheless it should be remembered that the extent and speed at which any recovery in optimism is reflected in higher expenditure remains uncertain. It is also possible that confidence may be constrained over the coming months by continued evidence regarding the impact of the recession. Whilst the quarterly rate of change in unemployment is beginning to subside, the headline figure still rose by 100,000 over the quarter to March, with more than 1 million jobs having been lost since the middle of 1990. Insolvencies also continued to rise in the first quarter, with corporate insolvencies in England and Wales some 5 per cent higher than in the last quarter of 1991 and individual bankruptcies some 10-8 per cent higher. Over the 12 month period to the end of March some 2 1/2 per cent of all previously active trading companies went into liquidation.

Uncertainty also remains as to the extent to which financial constraints will continue to impinge on the personal sector. The housing market remains stagnant, with sales and prices falling in the first quarter in spite of the temporary reduction in stamp duty and a pick-up in mortgage inquiries. With a large overhang of unsold and repossessed properties, prices at the end of 1992 are likely to be little changed from a year earlier.

However it is possible that the balance sheet of the personal sector has improved in recent months in spite of the fall in house prices. There has been a further repayment of outstanding credit card debt and the stock market has remained buoyant for some time. Thus the net financial wealth held by the personal sector may have been over 15 per cent higher at the end of 1991 than 12 months previously. Our model of consumption suggests that this rise in financial wealth should provide an upward boost to expenditure over the rest of the year.

With much of the present statistical evidence of an upturn in the economy confined to assorted leading indicators, the second section of this chapter examines the extent to which the forward-looking information embodied in financial markets and business surveys is related to future economic developments. Our results suggest that over the last two decades leading indicators have provided useful information regarding both growth and inflation over the coming year.

The projections for 1992 we derive from leading indicators alone help to confirm our main forecast of an upturn over the remainder of this year. Indeed, some leading indicators such as equity prices and output expectations derived from business surveys play an important role in determining the level of expenditure in our domestic model. A further factor of importance in generating the upturn is that the company sector has succeeded in casing the pressure on its balance sheet over the last 12 months, with the cutbacks in employment, stockholdings and investment expenditures helping the financial deficit to fail to 1-2 per cent of GDP in the second half of 1991, compared to 5.2 per cent immediately prior to the onset of the recession.

Policy assumptions

An additional stimulus to the economy should come from the recent casing in the policy stance. As we correctly anticipated in the February Review, bank base rates have recently been reduced to 10 per cent, bringing the short-term interest differential with Germany down to V4 per cent, the smallest such differential since 1981. Base rates are now 5 per cent lower than at the time of entry into the ERM. Whilst real interest rates, particularly the real cost of mortgage debt, remain high, the fail in nominal rates has cased both corporate and household liquidity problems, with many households only just beginning to experience the full effects of the recent reductions in mortgage rates.

The prospects for further significant cuts in domestic interest rates depend largely upon the policy stance of the Bundesbank and the attendant inflation risks in the German economy. We retain our previous view that interest rates may be cased there at the end of the year, permitting UK rates to fall by a further 1/2 per cent. Further reductions may prove possible in 1993, with the forecast assuming that base rates fall to around 8 1/2 per cent by the year end. The profile of interest rates is shown in Table 10.

Although the present interest differential with Germany is now lower than for some time, it appears unlikely that UK rates are expected to fall below German rates for any significant period of time. Indeed long-term government bond rates in Germany remain over 1 per cent lower than in the UK (at the time of writing) suggesting that the financial markets continue to foresee a positive interest differential for some time and give little weight to the likelihood of the D-Mark depreciation that would be implied if German interest rates were above domestic interest rates.

Our forecast in February assumed that the basic rate of income tax would be cut by Ip in the Budget. In the event the Chancellor chose to introduce a new lower rate band, although the overall cost of such a measure over the years 1992/3 and 1993/4 is little different from that of a basic rate cut. There were a number of additional measures announced such as the reduction in car tax and business rate relief. Some of the cost was recouped by over-indexation of a number of excise duties and the maintenance of stamp duty on shares over 1992/3. Overall, the measures introduced in the Budget, together with those previously announced, cut taxes by some [Br pound]l .5 billion in 1992/3 and [Br pound]2.6 billion in 1993/4.

The mild demand stimulus offered in the Budget needs to be viewed in the context of the previously announced expenditure plans in the Autumn Statement, with total expenditure in the coming financial year now officially expected to be some [Br pound]6 billion higher than projected in the 1991 MTFS, and [Br pound]3 billion higher in 1993/4. Our projections assume that the planned contingency reserve will be fully allocated to expenditure, with the overall level of expenditure rising by around 9 per cent over the fiscal year.

This in part reflects the automatic nature of some components of expenditure such as transfer payments. However there is also some expansion in the volume of expenditure, with procurement expenditure forecast to rise by over 2 per cent over this year and the first half of next, and fixed investment rising by close to 10 per cent. At present it appears as if this fiscal stimulus will help to ensure a modest recovery over the year. However it is possible that the timing will turn out to be misplaced if recovery in the private sector is more robust than we presently expect.

The forecast path for the PSBR is shown in .chart 2. The PSBR is projected to be around [Br pound]28-5 billion (4.5 per cent of GDP) both in 1992/3 and 1993/4. The financial defidt is a little higher at around [Br pound]31.5 billion. Thereafter we have the borrowing requirement beginning to fall gently, with a gradual tightening in policy over the course of the cycle. We also assume that there are no net cuts in taxation. If further reductions are to be made to income tax, they are likely to be accompanied either by a widening of the tax base or by changes in indirect taxation.

Although forecasts of nominal magnitudes such as the PSBR are subject to a wide margin of error, it does seem as if borrowing is likely to persist well into the medium term. At some stage it is possible that the present policy aim of balancing the Budget over the cyde could be replaced by an alternative objective of either stabilising the debt-income ratio or setting the fiscal stance so as to maintain the net worth of the public :sector (subject to meeting the guidelines agreed at Maastricht). Such objectives could provide a greater scope for cuts in taxation.

Summary of the forecast

Our February forecast was conducted under the assumption of an unchanged administration and therefore we have not made any changes to our previous projections as a consequence of the election result. Growth over 1992 is now a little lower than before at 1 per cent, reflecting a slightly weaker first quarter, and the end year inflation rate is a little higher at just over 3 1/2 per cent, with inflation in the non-tradeable sectors of the economy appearing to fall more slowly than we had previously anticipated. Growth in 1993 could well be above trend at 2.7 per cent, with the full year impact of the reduction in income tax and mortgage rates helping to boost consumers' expenditure. The profile of output growth is shown in chart 3. Details of the composition of expenditure are given in table 1.

The main factors which depressed output in the first quarter were an adverse movement in net trade volumes and possibly the postponement of some expenditure until after the election. Import volumes rose by 2 1/2 per cent in the first quarter, although there was no obvious counterpart in domestic expenditure. This suggests that too rapid a recovery could well induce a substantial deterioration in the current account. Export volumes remained flat in the first quarter, with the slowdown in European markets offsetting some upturn in the United States. For the year as a whole we expect import volumes to rise by around 6 per cent, with export volumes growing by close to 4 per cent, in line with the projected growth in trade volumes in the UK's main export markets.

Over the year the main impetus to domestic demand comes from the expansion of public expenditure and a turnaround in stockbuilding typical of this stage of the cycle. In spite of the fail in demand in 1991, firms in the manufacturing and distributive sectors were able to reduce their stock-output ratios over the course of the year. This suggests that any upturn in demand for domestically produced goods will soon feed into output levels. Domestic demand may rise by 1.7 per cent over the year with the change in destocking from 1991 being equivalent to 0.8 per cent of GDP.

Investment remains the one category of expenditure forecast to show a fall this year, despite the anticipated rise in public sector investments. Manufacturing investment may fail by close to 2 per cent over the year in spite of a continued reduction in the financial deficit of the company sector. The main constraint is likely to be the high levels of spare capacity currently held by many firms. Chart 4 shows manufacturing output and a constructed measure representing potential output if firms were operating at full capacity (derived using information from the CBI Industrial Trends Survey). This indicates that potential output has in fact continued to rise during the recession despite the slowdown in investment levels. In contrast, companies were operating close to full capacity at the height of the boom in 198 8. Overall the present levels of capacity utilisation suggest that the upturn in demand will initially be met by raising the utilisation rates of existing equipment, implying a delayed recovery in industrial investment.

The current high levels of spare capacity also indicate that there is little immediate prospect of any upward pressure from demand on prices. Thus we anticipate further falls in inflation over the coming months, reinforced by the continued weakness of commodity prices and further falls in the growth of unit labour costs. Producer price inflation in the first quarter of the year was some 2-9 per cent and we expect that it will fall below 2 1/2 per cent by the year end, and remain at this level for much of 1993. Consumer price inflation which reflects the prices of both traded and non-traded goods and services, has proved more stubborn than inflation in the manufacturing sector and stood at around 6 1/2 per cent at the end of last year. We expect that this measure will fall quite sharply in the second half of the year as last year's VAT changes drop out of the annual figures.

The cutbacks in employment during the recession have been faster relative to the decline in output than in the previous recession in the early 1980s. Productivity began to improve in the second half of 1991 and actually showed a small year-on-year rise. Our forecasts show employment falling by a further 400,000 over the course of 1991, with unemployment reaching a peak close to 3 million in the middle of 1993 (see chart 5.) These further job losses imply that productivity should be buoyant over the coming months, with whole economy productivity possibly rising by around 3 1/2 per cent, and manufacturing productivity by over 6 per cent this year.

Medium-term projections

The projections given in table 12 for the development of the economy over the medium term provide a guide as to the underlying state of the economy over the lifetime of the present Parliament. Developments in the world economic environment are as summarised in table 1 of the world economy chapter in this Review.

Our projections show the economy growing at a rate around 2 1/2 per cent per annum, close to the long term trend observed over the last 40 years. Over the forecast period consumer price inflation begins to settle down within a range between 3-3 1/2 per cent, implying a small depreciation in the real effective exchange rate in the coming years.

In contrast, the latest projections made by the Treasury in the FSBR show GDP growing by 3 1/2 per cent per annum over the fiscal years 1994/5 to 1996/7 with inflation subsiding to 2 per cent. This output path is argued to be sustainable as it represents a 'catch-up' from the output fall over the last 2 years, with output moving toward an estimated long-term trend level.

Our projections suggest that it is difficult to see how the economy could grow so rapidly for such a sustained period of time, with the scope for any fiscal or monetary stimulus being limited by the state of the public finances and the constraints imposed by the ERM. Moreover, in contrast to previous economic cycles, the economy is unlikely to enjoy the temporary boost offered by either devaluation or by rapid depreciation of the nominal exchange rate.

One additional feature of interest in table 12 is that the UK continues to run a current account deficit over the medium term at levels close to 1 1/2 per cent of GDP per annum. Whilst deficits on this scale should be easily financed, it does imply that wealth is beginning to decumulate, at least to the extent that the borrowing from overseas is used to finance consumption rather than investment. The profile of UK net overseas assets is shown in chart 6. In real terms, net assets have fallen substantially from the peak level in 1986. This process continues into the medium term and can eventually be expected to put some downward pressure on domestic expenditure and, in turn, on prices. Thus whilst growth may be above trend in the immediate aftermath of the recession, it seems quite possible that long-standing constraints arising from the balance of payments position could once again act to check the growth rate over the medium term.

Section 11. Forecasting with leading indicators

This section discusses the use of leading indicator variables such as survey information or information from financial markets to construct alternative methods of forecasting short-term movements in both growth and inflation in the UK. Typically, mainstream forecasts are derived with the aid of a structural macroeconometric model such as that operated by the National Institute. Such models contain explicit theoretical structures to explain the behaviour of economic agents.

An alternative approach to forecasting is that of 'cyclical analysis', originally developed in the United States some 50 years ago by the National Bureau of Economic Research, and introduced into the UK by O'Dea (1975) and CSO (1975). One example of this approach is the four cyclical indicators regularly published by the CSO. The main aim of this technique is to find economic variables whose turning points are close to those of the general business cyde. The chosen component indicators are then reduced to a common scale of measurement, with the composite cyclical indicator being a simple average of the standardised components.

Recent experience suggests that there has been some deterioration in the overall accuracy of forecasts from macroeconomic models over the last few years, with few forecasters being able to claim that they predicted both the scale of the boom in 1987/88 and the extent of the recession. We have recently begun to investigate ways in which the timely sources of information used to construct leading indicators can be formally incorporated into the forecasting process.

One possibility would simply be to estimate the longrun relationship between growth and the CSO leading indicator and use recent movements in the indicator to obtain an alternative short-term forecast. However there are a number of potential drawbacks to this approach. Firstly, it is not clear that each of the series used in forming the leading indicator provides independent information of use to the forecaster. Secondly, as emphasised in Auerbach (1982), it is just as important to use leading variables that reflect the behaviour of the cycle at all times rather than simply at turning points alone.

To reflect these points we have chosen to use regressions relating both GDP growth and inflation to past movements in a number of potential leading indicator variables. The variables we have used fall into four main categories; data from financial markets, survey information, developments in the housing market and raw material prices. The financial variables we use include the growth in real equity prices, the change in a long-term interest rate and the spread between long-term and short-term rates. All three measures are not subject to revision and reflect the behaviour of forward-looking markets. In addition, asset price movements may pick up some wealth effects, with changes in the net wealth of asset holders feeding through into higher expenditure.

Two measures are used from the CBI Survey, the balance of business optimism and the proportion of firms working below full capacity. The general advantage of such survey information is that it provides an early up-to-date view of movements in the economy. It might also prove possible to use consumer confidence measures in future work, although at present the main difficulty lies in obtaining suitable data for the 1970s.

The other leading variables used are the growth in housing starts and the change in the price of raw materials and fuel input into domestic manufacturing industry. Our results so far suggest that this measure performs better than movements in world oil prices alone. The housing starts variable may capture movements in economic confidence as well as providing a guide as to future changes in housing investment expenditure in the National Accounts.

Many of these variables already form part of the CSO's leading indicators. However some of the series used by the CSO are omitted from our analysis. One example is the real financial deficit of industrial and commercial companies. It was felt that the likely scale of data revisions to this measure ruled against its inclusion in this form of exercise. It is also of interest to note that the CBI capacity measure is actually part of the CSO's coincident indicator series. Although the turning points in this measure may coincide with those in the overall economy, it does not mean that movements in the series cannot provide useful information about future developments across the cycle as a whole. Indeed it is common to find measures of capacity utilisation included in the behavioural price equations in most macroeconometric models.

The work reported here uses half-yearly data. This primarily reflects our intention of developing an approach that serves to complement the results from a quarterly structural model by providing a broad picture of likely developments over a 12-18 month period from the publication of the last full set of National Accounts data. Interest lies in any marked divergence between the direction of movement in output and inflation in the main forecast and that in this alternative approach.

Leading indicator equations for both output growth and consumer price inflation (the latter adjusted to overcome poll-tax distortions) are reported in Table A. Both equations include lagged dependent variables and allow for feedbacks from lagged inflation onto growth and from lagged changes in domestic demand on inflation. Both equations show little sign of statistical inadequacy and as charts 7 and 8 show, the predicted values appear to track developments in the economy quite successfully.

The growth equation exhibits mean reversion, with a tendency for growth to return towards a long-term trend. A widening in the yield gap (long rates rising relative to short rates), a rise in business optimism and growth in both real equity prices and housing starts all foreshadow an upturn in GDP. For example, output growth over the present half year is related to the level of business optimism a year earlier. The negative effect from past inflation is a little harder to rationalise, although it is consistent with either a real balance effect on the level of expenditure or an adverse effect arising from changes in competitiveness. In contrast, the inflation equation does not show any direct evidence of mean reversion, although the domestic demand term will operate in this direction. The main driving force is the past growth in input prices, although movements in the long-term interest rate also appear to contain some separate information about future inflation.

As with any econometric exercise an important requirement of this approach is that it performs well outside the estimation period. We have carried out a the end of 1986 and used to forecast over 1987-1991. The Chow test statistics in table A do not reveal any significant instability in the relationship between the leading indicators and either growth or inflation. The dynamic forecasts generated by the re-estimated equations are shown in charts 9 and 10. It is clear that the growth equation succeeds in predicting the recession. The performance of the inflation equation is less successful, although it does provide a good guide to the pick-up in inflationary pressure in 1989-90.

We have also begun to assess genuine ex-ante forecasts by estimating similar equations on the historical vintages of data available at the time of the forecasts made by the Institute in the second half of 1990. The resulting projections suggested that use of the leading indicator relationships could have provided advance warning of both the recession itself and its eventual scale.

Our estimated equations may also be used to obtain forecasts of growth and inflation over the present year. (In doing this we have to rely on our second quarter projections for interest rates, equity prices and the exchange rate.) The leading indicator approach suggests that activity could in fact be more buoyant than our main forecast suggests, with year-on-year growth put at 1.8 per cent (compared to 1.0 per cent) and consumer price inflation averaging around 5.2 per cent (compared to 4.8 per cent). Growth is helped by past falls in short rates and the gradual recovery in business optimism and housing starts. There is also an important effect arising from mean reversion, with growth in 1992 reflecting the downturn in 1991. The year-on-year slowdown in inflation is helped by the past weakness of demand, the rise in the proportion of firms with spare capacity and the weakness of input prices, which fell by over 1 per cent in 1991.

Whilst the methodology described above is relatively easy to implement, its main drawback is that it has little to say about either the composition of expenditure or the prospects for individual sectors of the economy. Moreover at times it could also require interventions by the forecaster if it was felt that the equations failed to track recent events as well as could be expected. Nonetheless, the work discussed above displays a certain amount of promise and suggests that the approach could serve as a useful adjunct to the forecasting process.

Section 111. The Forecast In Detail

Personal sector (table 2)

Consumers' expenditure fell by some 1.7 per cent in 1991. With real personal disposable incomes only declining by around 1/2 per cent, there was an upturn in the saving ratio from 9 per cent in 1990 to 10 per cent last year, with many households using income for the purposes of debt repayment. Net new advances of consumer credit continued to decline in the first quarter of this year and remain lower in real terms than at any time since the mid-1970s.

There is little sign of any substantial pick-up in the levels of expenditure in the early months of 1992, with retail sales volumes remaining unchanged in the first quarter of the year. However year-on year comparisons are hampered by the expenditure switching that took place in the first quarter of 1991 following the announcement of the rise in VAT made in the Budget. New car sales were depressed in the first quarter, although they picked up by some 9 per cent in April, helped by the halving of car tax in the Budget. Elsewhere the housing market remains stagnant, with a rise in mortgage inquiries failing to prevent further falls in house prices. Prices fell by over 3 per cent in the first quaffer to be some 4.4 per cent lower than a year earlier and sales of houses were some 15 per cent lower than in the last quarter of 1991.

Despite developments in the housing market, consumer confidence has continued to improve in the most recent surveys, with the balance of respondents in the April MORI survey expecting the economy to improve over the coming year rising to 43 per cent from 4 per cent in March and minus 2 per cent in February.

Our latest forecast for this year shows little change from that made three months ago, with both consumption and income forecast to rise by around 1 per cent over the year. The forecast rise of 6.5 per cent in nominal earnings should outweigh the impact of a continued rise in unemployment on the wage and salary bill. Disposable incomes will also be boosted by the lower tax band introduced in the Budget and higher levels of benefit payments. Some improvement in disposable income could also result from the decline in mortgage rates as lenders attempt to attract new purchasers into the housing market.

Investment and Stockbuilding (tables 3 and 4)

The volume of investment fell by over 10 per cent in 1991, with declines experienced in all sectors of the economy with the exception of the North Sea. Here, a combination of the installation of new safety equipment and the delivery of new drilling platforms caused investment to rise by close to 50 per cent over the course of the year.

The cutback in investment elsewhere can be seen as part of the process by which the corporate sector has attempted to adjust its financial position. It is possible that the financial deficit will be further reduced over 1992, with the pick-up in activity and a strong growth in productivity providing a strong boost to profits. Corporate liquidity problems have been eased by the 5 percentage point fall in nominal bank base rates since the end of 1990. In addition the recent rise in equity prices may enable some extra finance to be raised by means of rights issues.

We anticipate a further fall in the volume of investment over 1992, although this may only be around 1 per cent or so. Investment in the private sector may pick up in the second half of the year, with some investment projects having been postponed prior to the election in view of the possibility of higher capital allowances under a Labour administration. In 1993 investment may rise by over 4 per cent, with the main constraint arising from the high levels of spare capacity currently held by many firms. Our projections for sectoral investment were produced using new models of investment discussed in Young (1992). These indicate that investment in all sectors is responsive to changes in the user cost of capital.

This year the total level of investment will be held up by a rise of dose to 10 per cent in general government fixed investment. This reverses a fall of close to 9 per cent in 1991, with the timing of some local authority investments being distorted by changes in capital control regimes, However some additional infrastructure investment arises from an casing of policy. The pick-up in public sector projects is beginning to emerge in the latest figures for construction orders, with the value of new non-housing orders received from the public sector (at constant prices) in the 3 months to February being a third higher than in the equivalent period a year ago.

Stockbuilding continued to fall in the fourth quarter of last year, with firms attempting to meet demand from existing stocks rather than from new production. Over the year as a whole destocking amounted to some [Br pound]2-9 billion, close to 0.8 per cent of GDP. As chart 11 illustrates the cutback in stock levels in the last year has been close to that experienced in the earlier recessions. In fact the experience of different sectors has been far from uniform, with stock levels rising outside the manufacturing and distributive sectors due to a recovery in oil stocks and a continued build up of unsold dwellings and commercial property. We expect the extent of the turnaround in overall stockbuilding to be limited by gradual property sales over the second half of 1992 and 1993.

The latest CBI survey evidence suggests that there was a further rundown of stocks in the manufacturing and distributive sectors in the first quarter of the year, even though the cutbacks in 1991 were sufficient to reduce stock-output ratios in those sectors over the year as a whole. We anticipate that the rate of destocking will diminish over the coming months, with some positive additions to stocks in the second half of the year ensuring that stock levels will show little year-on-year change. As chart 11 illustrates, such a turnaround is typical of this stage of the cycle with stocks of raw materials and work-in progress beginning to recover.

Balance of Payments (tables 5 and 6)

The latest figures indicate that the deficit on the current account fell from [Br pound]15.4 billion in 1990 to [Br pound]4-4 billion in 1991, a level equivalent to 0.8 per cent of GDP. This drop reflected improvements in both the trade and invisible balances. The latter was boosted by contributions of [Br pound]2-1 billion by foreign governments towards the cost of the Gulf War and a decline of over [Br pound]2 billion in net contributions to EC institutions. Both of these favourable influences will disappear in 1992 and thus the deficit on net transfers may rise by over [Br pound]3 billion, a deterioration reflected one-for-one in the financial position of the public sector.

The visible trade balance improved by some [Br pound]8 billion in 1991, in part due to the recession, with import volumes falling by close to 3 per cent, in line with the fall in domestic demand. In contrast, export volumes rose over the year in spite of the slowdown in some of the UK's main export markets. Exports of goods grew faster than service exports due to a decline in tourism expenditure in the UK. Overall, the turnaround in the trade balance over the recession appears greater than in 1980/1, but smaller than in the aftermath of the 1974/5 recession.

The prospects over the coming months are for some deterioration in the visible trade balance in spite of our continuing assumption (see the November 1991 Review) that the share of world trade captured by UK manufacturers continues to rise. In the first quarter of the year there was a marked upturn in import volumes, with imports of goods some 2 1/2 per cent higher than in the previous quarter. However, the impact on the trade balance was limited as import prices fell by 1 per cent in the quarter. Manufacturing imports showed the biggest jump, with finished manufactures up by 4 per cent (including a rise in car imports of over 20 per cent). The reasons for this pick-up are unclear as there is not yet evidence of any substantive growth in domestic demand.

For the year as a whole, we expect a rise in import volumes of close to 6 per cent, although this is dependent upon the strength of the recovery in activity. The rise in export volume may be slightly lower at just under 4 per cent, in line with the projected growth in world trade. Year-on-year, world trade growth is little changed with the slowdown in Europe being offset by the recovery in the United States. Overall the current account deficit may rise to [Br pound]8.3 billion this year and [[Br pound]10.5 billion in 1993 as the recovery in consumption generates an acceleration in manufacturing imports.

Recent trends in the capital account of the balance of payments are shown in chart 12, with our forecasts given in table 6. Last year the level of direct investment outflows fell to 1.7 per cent of GDP, well below the level of 4.5 per cent invested abroad in 1988. This decline is partly due to some companies using available undistributed profits to improve their liquidity rather than to finance additional investment in foreign assets. Evidence on cross-border acquisitions and mergers suggests that investment in the United States fell sharply in 1991, although investment in Europe was maintained with UK companies continuing to strengthen their position in Europe in advance of the single market. Direct investment in the UK also fell back last year, although this may turn round over the coming year, with the ending of political uncertainty and the recovery in domestic profitability. Our research suggests that investment in the UK is seen by many foreign companies as offering access to a European wide market and as a means of bypassing barriers to trade.

Employment and Output (tables 7 and 8)

Unemployment has continued to rise quite sharply over recent months to a current level of 2-65 million, over 1 million higher than immediately prior to the onset of the recession. Although activity may begin to pick up over the course of the year, we do not expect that unemployment will begin to fail before the end of 1993, at which time it will stand at close to 3 million, some 10.8 per cent of the civilian labour force.

All sectors of the economy have experienced some downturn in employment, with manufacturing and construction being particularly badly hit. This reflects the changes in sectoral output, with manufacturing output falling by 5 per cent in 1991 and construction by close to 9 per cent. In contrast to the recession in the early 1980s, the labour shake-out has kept pace with the fail in output and productivity began to rise in the second half of last year in spite of a continued fail in output.

The productivity improvement also reflects the high levels of capital investment in the late 1980s. These investments may have embodied the latest technology and therefore induced a rise in average labour productivity. In turn this may have enhanced the speed and scale of job losses, with a fail in the average age of the utilised capital stock reducing the amount of labour required to produce a given level of output.

Over the current year we expect output to rise by around 1 per cent, with manufacturing output rising by around 1/2 per cent. Output growth in distribution and business services may prove a little stronger, particularly if there is some pick-up in activity in the housing market. Prospects are better for 1993, with the recovery in consumers' expenditure helping the retail sector.

Average Earnings (table 2)

The latest data on pay settlements suggest that there is continuing downward pressure on pay within the economy. The median pay rise (weighted by employee numbers) recorded by the Industrial Relations Service over the year to February was 6 1/2 per cent, some 3 per cent below the level a year earlier. Manufacturing pay settlements recorded in the CBI Pay Databank in the first quarter averaged 4.3 per cent and a number of renewed pay freezes were also reported.

The full impact of the lower level of settlements has yet to show up in the official whole-economy earnings index, with the underlying annual growth up to the first quarter currently estimated to be 7 1/4 per cent. We expect this measure to fail quite sharply in the coming months as the remaining high settlements from the first half of 1991 drop out of the year-on-year comparison. Our forecast is that earnings growth will be around 6 1/2 per cent in 1992, with growth falling to around 6V4 per cent by the end of the year.

Both the continued rise in unemployment and the cut in direct taxation may help to hold down settlements over the course of the year. In the medium term these effects are reversed, with a gradual fail in the unemployment rate (see table 12) and an assumed indexation of income tax allowances in line with retail prices rather than earnings resulting in a degree of fiscal drag.

Costs and Prices (table 9)

The recession has enabled substantial progress to be made in reducing inflation within the economy, although there is still some evidence that inflationary pressures have not yet subsided to levels consistent with those in the main European economies. In particular, inflation in the service sector is proving stubborn, with consumer price inflation (adjusted to overcome distortions arising from the poll tax) standing at 6 1/2 per cent in the final quarter of 1991. In contrast, prices in the manufacturing sector have fallen much faster, with producer prices (excluding food,drink and tobacco) rising by 2.8 per cent in the year to April.

We expect a further easing in inflation over the course of the year with cost pressures within the economy being held in check over the coming months by a combination of the procyclical pick-up in productivity and the weakness of import prices. In fact productivity began to improve in the second half of last year and rose very slightly over the course of the year despite the decline in output. For 1992 we anticipate that the growth in wholeeconomy productivity could reach close to 3 1/2 per cent, with productivity in the manufacturing sector improving by over 6 per cent. Thus unit labour costs will continue to move in a counter-cyclical manner, with growth in whole economy costs possibly falling to close to 2 per cent by the end of the year.

Commodity prices on world markets have been weak for some time. Prices of raw materials and fuels input into manufacturing fell by 1 per cent in 1991 and have remained weak in the early months of this year. The research discussed in section II suggests that this has contributed significantly to the recent easing in inflation. Our forecasts assumes a further fall in import prices over the course of 1992, with oil prices averaging $17 dollars per barrel. The rise in the effective exchange rate in the period subsequent to the election will also help to weaken import prices.

The profiles of producer and consumer price inflation in the short-term are shown in chart 13, with sharp falls being observed in consumer price inflation in the second half of the year with last years VAT rise dropping out of the inflation rate. In contrast, there may be a slight temporary pick up in the retail price index (which includes the poll tax) in the coming months as the poll-tax/VAT switch in the 1991 Budget actually cut prices a little. The forecast shows consumer price inflation subsiding to just above 3 1/2 per cent by the year end and remaining a little below that level throughout 1993.

Public Sector Finances (table II)

Our latest projections show the PSBR at [Br pound]28.5 billion in both 1992/3 and in the following fiscal year. This rise from the [Br pound]13.9 billion deficit recorded in 1991/2 reflects the fact that the PSBR typically lags behind the economic cycle, due in part to the lags in the corporate tax system, accruals of PAYE from the self-employed and a rise in cyclical expenditures such as unemployment benefit.

The present forecast for 1992/3 is some [Br pound]6 billion higher than in the February forecast, even though we correctly anticipated the overall size of the tax reduction in the Budget. In part the difference from the previous forecast reflects our decision to incorporate a number of technical assumptions made in the FSBR regarding accruals adjustments and miscellaneous financial transactions. However we have also raised our forecast of the financial deficit by some [Br pound]2.5 billion to [Br pound]31.3 billion, with economic growth over the year now forecast to be a little weaker than before.

The rise in borrowing is not solely a reflection of cyclical factors as there has been an additional discretionary easing in fiscal policy over the past year. Procurement expenditure rose by 10-2 per cent in 1991/2 and is projected to rise by a further 8 per cent over the coming year. Investment expenditure is also likely to rise by some 5 per cent or so. Our projections assume that the present contingency reserve for 1992/3 of [Br pound]4 billion is fully allocated to expenditure. There is also likely to be an additional rise in current transfers overseas of some [Br pound]3 billion, reflecting the ending of foreign contributions to the cost of the Gulf War and a rise in net contributions to the EC.

On the tax side, Inland Revenue tax receipts are likely to show little growth over the coming year, with the income tax changes announced in the Budget reducing revenue by some [Br pound]1.3 billion in 1992/3 and [Br pound]1-7 billion in 1993/4. Our new corporate tax system (described in the note by Garry Young elsewhere in this Review) suggests that tax receipts will fall by dose to 7 per cent in the present fiscal year, in part due to a rise in the number of companies which are tax exhausted.

In the medium term there is little room for any substantive net reductions in total taxation. Indeed one of the main factors which enables the PSBR to be reduced over the medium term is our assumption that tax allowances are indexed in line with retail prices. With earnings rising faster than prices, this implies a degree of fiscal drag, reinforcing the extra revenue that is likely to arise from the failure to adjust the upper rate threshold in this year's Budget.
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Title Annotation:United Kingdom
Author:Pain, Nigel
Publication:National Institute Economic Review
Date:May 1, 1992
Words:7493
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