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The home economy.

The forecasts were prepared by Andrew Britton, Nigel Pain and Soterios Soteri, but they draw on the work of the whole team engaged in macroeconomic analysis and modelbuilding at the Institute. Part One of the chapter was written by Andrew Britton, Part Two by Nigel Pain.

Developments so far this year have been closely in line with the forecasts we published in February and in May. As expected, output fell in the first half of the year and the prospect is still for a slight recovery by the end of the year. As expected, inflation has been falling rapidly, and the prospect is still for a rate under 5 per cent by the end of the year. The current account deficit on the balance of payments is much reduced, whilst the public sector again has a borrowing requirement. With the continued slowdown in activity, unemployment has risen sharply, and it is still expected to continue rising in 1992. Recent developments The national accounts figures for the first quarter of the year confirm that output fell, notably in manufacturing and construction. As is usual in a recession, fixed investment fell particularly sharply and there was substantial de-stocking. Consumer spending, on the other hand, was rather more resilient than we expected-partly because of anticipation of the VAT rise in the Budget, but perhaps not only for that reason. Overall the level of expenditure and output in the first quarter was a little higher than we expected in May, and that is the main reason why the fall we are now showing year-on-year is a trifle less than before.

The information we have had so far on expenditure and output in the second quarter of the year is consistent with a further decline in activity. On balance we expect to see a slight fall compared with the first quarter, thanks to the VAT effect on consumption and a continuing fall in fixed investment. Exports on the other hand will have recovered rather strongly.

The July CBI Survey has been variously interpreted by different commentators. it shows investment intentions still very depressed; the proportion of firms working below capacity rose again; and again more firms are expecting to shed labour. On the other hand the improvement in general business confidence, which was the main feature of the April Survey, was confirmed (if seasonal variation is allowed for). It was also encouraging to see another fall in the proportion of firms expecting to raise prices. We would see these results as consistent with the view that the recession is coming to an end for much of industry in the second half of this year, with relatively good prospects for exports and relatively poor prospects for domestic investment. Since our May forecasts the index of share prices expected in the third quarter of the year has risen by about 7 per cent. This may be the result of more optimism about the outlook for economic recovery. It will in any case reduce the cost of capital to some firms and also add to the value of financial assets held by institutions and some households. The CBI Survey question on business optimism and the level of the stock market are both component series in the CSO's longer leading cyclical index. This index picked up quite strongly in the second quarter. The median lead of the index relative to the reference cycle is one year. The implication would be that output would continue to fall, or to grow below its trend, until well into next year. Since the trend of output is over 2 per cent a year this is not inconsistent with our forecast of output rising weakly from the second half of the year. The shorter leading composite index, which has a median lead of 5 months, was still falling in the second quarter.

The recession seems to be having its predicted effect on inflation, although the scale of that effect should not be exaggerated. The headline figure for the 12-month rise in the retail prices index fell from 1 0 per cent in the fourth quarter of last year to 6 per cent in the second quarter of this year. The corresponding figures for wholesale prices (output prices of manufacturing) were 6 1/2 per cent and 5 1/2 per cent, a much more modest slowdown. Export prices of manufactures have fallen by about 1 per cent compared with a year ago.

It is not easy to estimate the growth rate of earnings, since a good number of settlements are being delayed and bonuses or piecework earnings are expected to be particularly hit by the fall in output. Our guess is that the rise in average earnings over the past twelve months is still around 8 1/2 per cent, but falling, with new settlements averaging perhaps 7 per cent. The slowdown in price inflation is not so much the result of a slower growth in unit labour costs as the consequence of a squeeze on profit margins and a fall in the prices of imported materials and finished goods.

The trade deficit was sharply reduced in the second quarter of the year and is now running at an annual rate of under 9-1 0 billion. The invisible balance was improved by the inflow of funds to pay for the Gulf War, and the preliminary estimates suggest that the overall current balance may have recorded a surplus in June. For the first half year as a whole the deficit on the current balance was about 1 1/2 per cent of GDP.

The public sector is now in financial deficit, to the extent of perhaps 1/2 per cent of GDP, thanks also to the low level of output. The personal sector is once again saving a substantial proportion of its income and recording a financial surplus, leaving companies with a large, and worrying, financial deficit. Policy assumptions Clearing banks' base rates have edged their way down from 15 per cent in the third quarter of last year to an expected 1 1 per cent in the third quarter of this year. One would expect interest rates to ease in response to an output recession and falling inflation, but the main issue now is their relationship to rates in the rest of Europe and the place of sterling in the exchange rate mechanism. The fall in UK interest rates has been much faster than the fall in rates elsewhere, yet sterling has been held with little difficulty close to the middle of its 6 per cent band. it could be argued that UK interest rates would have fallen even faster if sterling had not been in the ERM, bUt this is not necessarily the case since in practice international conditions have almost always played an important role in the setting of interest rates in this country.

Forward interest rates for sterling in early August were suggesting a little further fall. The gap between UK and German rates is now less than 2 per cent, and German rates are more likely to rise than to fall. Our forecasts assume a base rate of 101/2 per cent in the summer of next year. By then there will have been a general election, which is more likely to slow down than to speed up the reduction in interest rates, not least if a new and relatively unknown Government takes office. The quarterly profile of interest rates is shown in Table 10 of the chapter.

For the medium term our interest-rate and exchange-rate assumptions are made, as explained in the last Review, as the mean of a range which includes a downwards realignment as a possibility to which a rather low weight is attached. The implied depreciation of the effective exchange rate is almost imperceptible by 1993 and falls to zero in 1995. All ERM countries appreciate a little against the dollar thereafter. The profile of the bilateral sterling-D-Mark and starling-dollar rates are shown in Charts 1 and 2. Base rates level off at 6 1/2 per cent around 1996. The underlying assumption is a smooth transition to economic and monetary union before the end of the decade. We see this as the most likely outcome irrespective of the political party in power.

It is more difficult to devise realistic assumptions for fiscal policy. In the past we have perceived public spending or tax cuts as both being constrained by the outlook for the balance of payments in the medium term. As interest rates come down, domestic demand will recover. It has been difficult to see how the room can be made for an expansionary fiscal policy as well. This concern remains, but it now seems that a different constraint may be binding first.

The prospects for the PSBR in the medium term are, of course, very uncertain. it is the difference between two much larger independent magnitudes, spending and revenue. Nevertheless our forecasts do suggest the possibility of a period in the mid-1990s when the size of the PSBR will again put limits to the prudent conduct of fiscal policy. For 1992, for example, our forecasts point to a public sector financial deficit of some 21 8 billion (or 3 1/2 percent of GDP). This would be financed to a small extent by asset sales if the programme of privatisation goes ahead, but presumably not if there is a change of government.

The assumptions which go with this forecast include public spending on goods and services rising in value at the same rate as GDP (but less in terms of volume because of the 'relative price effect'). Benefits are uprated in line with prices only in our main forecasts, and the implications of uprating in line with earnings are explored as a variant. All tax rates are held constant, with personal tax allowances uprated in line with prices.

The increase in borrowing during the recovery from the recession primarily reflects the lag of company taxes behind profits, and the lag of unemployment behind output. It is not necessarily a permanent increase in borrowing: our forecasts for 1997 show the public sector back to financial balance.

Summary of the forecast

The game of spotting the month or quarter of the turning point seems hardly worth playing, given the flat profile of output, and the uncertainties of both forecasting and measuring GDP. As in May, we expect a fall in 1991 of around 2 per cent, followed by a rise of around 2 per cent in 1992.

The composition of demand in the recovery is now rather different from what we were forecasting last time. The growth of consumer spending is now more modest, partly because consumer spending does not seem to have fallen this year as much as we expected. Spending is running a little below that predicted by our model equation. Possible explanations for this include the failure of the housing market to recover, and caution resulting from the fear of bankruptcy or unemployment. We argue below that the rise in the savings ratio also reflects the wish, or need, of households to restore a more normal relationship between their debt and income. Since our last forecast, moreover, it has become clear that banks are making credit more expensive or more difficult to obtain than we had anticipated.

As mentioned above, the survey evidence still suggests a sharp fall in manufacturing investment this year. This is consistent with our model, and we are forecasting a further fall in 1992. The pattern for the rest of industry may be rather similar, but we expect housing and business service investment to pick up next year.

It would be right to characterise the recovery as 'export-led'. Year-on-year we are forecasting a rise of 7 percent in the volume of exports of manufactures in 1992, keeping the UK volume share of world trade roughly constant. Our research, based on the Kalman filter technique, confirms that the trend of UK export performance continues to improve. Once the recovery gathers pace, however, the volume of imports of manufactures is likely to rise sharply as well.

One significant change to our short-term forecasts this time is for employment, resulting from re-estimation of some equations of our model using new data. We now expect a rather larger fall in employment both this year and next. This goes with a more optimistic forecast of productivity growth. Despite the recession we are now forecasting a small rise in total output per head this year, followed by a 3 per cent increase next year.

The proportion of the population not working is forecast to rise this year and next, but turns down slightly in the medium term. The claimant count is expected to rise for a year or two after that, as it did after the 1980 recession, peaking at around 10 per cent of the civilian workforce, or nearly 3 million.

As before, we are expecting the rate of inflation to be down to about 4 per cent by the end of this year. This should be true of the rpi, the wholesale prices index and the deflator for consumers' expenditure. Thereafter the slowdown in inflation is likely to be very gradual.

In the longer-term we would argue that inflation in this country may need to be a little lower-than inflation in Germany since relative prices are now rather too high in this country (see the notes on equilibrium real exchange rates on pages 45 and 51). This is achieved for much of the late-1 990s in our forecasts, but at a rate of unemployment which seems high relative to most periods in the past. The profile of the real exchange rate over the forecast period is discussed in greater detail in part two of the chapter and shown in Chart 7.

Our longer-term forecasts show the position towards which the economy appears to be moving, although of course it is inevitable that some disturbance will come to change that destination long before we get there. The long-term forecasts show output rising by about 2 1/2 per cent a year, with inflation also about 2 1/2 per cent a year. The current account balance and the public sector balance would both be small. Unemployment would still be around 8 1/2 per cent of the labour force, not very different from what it is today. More details on these medium-term projections are given in Table 12 of the chapter.

Gross Domestic Product (Table 1)

The first quarter figures for the National Accounts published in June suggest that the recession was beginning to moderate with the level of output falling by .7 per cent from the last quarter of 1990 compared to falls of .9 and 1.4 per cent in the previous two quarters. Domestic demand in the first quarter of the year was some 2.9 per cent lower than a year earlier with the initial downturn in consumer spending in the second half of 1990 now being accompanied by cuts in fixed investment and destocking.

Information about the second quarter is limited although retail sales and production industry data are suggestive of a further fall in the output level. The forecast figures in Table 1 show a quarterly fall of 0.35 per cent in GDP in the second quarter. Domestic demand is actually projected to show a further small fall in the second half of the year although the negative impact on GDP is offset by a relatively optimistic outlook for net exports of goods and services. Personal income and expenditure (Table 2) Consumer spending fell rapidly in the second half of last year with the level of consumption being some 1.2 per cent below that in the first half. We expect that expenditure in 1991 will show a further fall of some 0.7 percent from 1990. In fact the volume of expenditure rose slightly in the first quarter of the year, although evidence from retail sales figures suggests that this rise was primarily due to forestalling effects following the announced rise in VAT in the Budget. We therefore anticipate some fallback in the level of expenditure in the second quarter of the year, with expenditure remaining flat in the second half. This relatively low level of consumption ensures a further rise in the savings ratio to just under 11 per cent.

The savings ratio at the start of the recession was on a rising trend with the personal sector adjusting its financial position following the large changes in the structure of the balance sheet made possible by financial deregulation. As Chart 3 reveals the personal sector financial deficit moved from a record deficit of over 3-5 per cent of GDP in 1988 to a surplus of 1.5 per cent in 1990. The forecast implies that the surplus may stabilise in 1992 and 1993 at around 4.5 per cent of GDP.

The cutback in expenditure has allowed consumers to use income for debt repayment. Thus the net real flow of consumer credit has been on a downward trend for some time. In part this reflects the impact of high interest rates, with Bank of England estimates suggesting that the amount of debt with floating interest rates held by the personal sector has exceeded equivalent assets since 1986. The rise in the savings ratio can thus be seen as a process of correcting the debt-income ratio towards more sustainable levels. Although nominal interest rates are now on a downward trend, real interest rates remain at historically high levels. Our forecast is therefore that net new consumer borrowing will remain depressed for some time to come. In part this also reflects a widening in the spread between the savings and borrowing rates, with many lending rates, particularly on credit card debt, remaining high.

The model equation for consumers' expenditure gives an important role to consumer credit and imposes the property that all net new flows of credit feed through directly into expenditure. Thus the shallow recovery in expenditure next year may be viewed as a counterpart to the desired slowdown in borrowing. The sharpest fall in expenditure this year is likely to be on those goods whose purchase requires substantial new borrowing. Non-company new car registrations in the first half of the year were some 22 per cent lower than a year earlier and we expect the total level of expenditure on consumer durables in the 1991 to show a year-on-year fall of 9 per cent.

Our forecast profile for the ratio of total consumer credit to income is also shown in Chart 3. We expect the gradual fall over the last two years to continue into 1992 before the ratio bottoms out in 1993. This may be viewed as a voluntary adjustment towards a more sustainable level of debt rather than as any collapse in lending associated with a 'credit crunch'.

Recent survey evidence suggests that consumer confidence remains at a low point. One factor depressing confidence is likely to be the uncertainty over future job prospects at a time of rapidly rising unemployment. Such uncertainty is probably related to the rate of change in unemployment rather than the underlying level and can therefore be expected to diminish as the growth in unemployment slows. Our forecast suggests that the peak in the annual growth of unemployment is likely to occur in the third quarter of this year with the claimant count being some 46 per cent above the level of a year earlier.

The growth of real personal disposable income is forecast to be around 1.5 per cent in both 1991 and 1992, with growth in unemployment limiting the overall rise in the wage and salary bill. The boost to disposable incomes arising from cuts in mortgage interest rates is likely to be somewhat protracted as two-fifths of all mortgage holders have annual repayment schemes. An additional boost may be given to consumption by the recent rise in the market values of equity and overseas assets. The initial effect on expenditure will be modest as much of these gains accrue to investments held by pension and insurance funds. The desire to hold down debt levels will limit the extent to which households are willing to borrow against this likely rise in their future income.

Fixed investment (Table 3)

Business investment was weak throughout 1990 and there appears to be little sign of any substantial recovery in either 1991 or 1992. indeed our forecast is for a fall of over 8 per cent in total investment this year and no change in 1992. Within this manufacturing investment (inclusive of leasing) shows a fall of 15 per cent in 1991, in line with the CSO investment intentions survey, and a further fall of over 9 per cent in 1992. The only category of investment to show any rise is that of oil and gas, reflecting the installation of new safety equipment and the delivery of new drilling platforms. Other energy and water supply investment is also likely to remain at a relatively high level, reflecting the programme of investment being undertaken by the newly privatised industries.

All types of investment are being reduced, with construction being particularly hard hit. Private residential investment in the first half of the year was some 15 per cent below that in the first half of 1990 and there is a current surplus of commercial property. Plant and machinery investment is also depressed, with home sales by engineering industries in the three months to May some 18 per cent lower than in the same period last year and the recent CBI Survey being the eighth consecutive survey in which firms predict future cuts in such investments.

The model suggests that the lower level of investment primarily reflects the shortfall in demand and the recent increase in the indebtedness of the corporate sector. The high levels of investment seen in the late 1980s together with the recent falls in output mean that capacity utilisation in manufacturing is currently an estimated 15 per cent below the peak level achieved at the end of 1988. As we explain in Box A output expectations in the late 1980s appear to have been continually over 'optimistic and therefore it is likely that many firms are currently working below capacity. With only 4 per cent of firms in the CBI Survey anticipating capacity constraints in the year ahead it is likely that the initial rise in output will be met by simply raising utilisation rates. This effect is captured in the Institute's vintage production model and helps to account for the delayed recovery in future investment levels. The profile of capacity utilisation is shown in Table 7.

Our model also suggests that investment will be depressed as the companies attempt to correct their current financial position following a corporate deficit amounting to 4.7 per cent of GDP in 1990 and a first quarter deficit equivalent to 5-9 per cent of GDP. Our current projections imply that the nominal deficit will in fact be little changed in 1991 although it will fall slightly in real terms to around 4.3 per cent of GDP. Constraints on larger companies may be eased by the recent growth of share prices which our forecast suggests will continue into 1992, with a further rise of around 10 per cent. Capital issues in the first half of this year have already amounted to some PL5 billion, close to the level for the whole of 1990.

The recovery in the stock market and a continuing decline in the level of interest rates are likely to reduce the external components of the cost of capital. However there seems little likelihood of any substantial short-term recovery in the level of retained earnings as our forecast suggests that gross trading profits in the non-oil company sector in 1991 will be over 8 per cent below the level in 1990 and some 15 per cent below the figure for 1989. As yet there are few signs of any substantial cuts in the level of dividend payouts and therefore the balance of undistributed income available for investment may well remain depressed for some time to come.

Stockbuilding (Table 4)

Destocking has contributed considerably to the downturn in growth in recent quarters with the fall in stockbuilding between 1989 and 1990 equivalent to around 1 per cent of GDP. Our forecast is for destocking amounting to P-3-3 billion in 1991, implying a further fall of 0.76 percentage points in the stockbuilding/GDP ratio. There may be considerable scope for further cuts in stock levels, particularly in finished goods. The CBI Survey suggests that some involuntary stockbuilding has taken place in the first half of the year due to over-optimistic output expectations. This factor is likely to moderate the strength of the upturn in the economy in the first half of next year as firms meet some of the initial rise in orders from existing stocks.

Stockbuilding in manufacturing is likely to fall further than stockbuilding in the other production industries due to a recovery in oil stocks as a number of fields reopen following the installation of safety equipment. In the medium term the downward trend in stock-output ratios observed over much of the 1980s should continue, with new investment, particularly in the retail sector enabling firms to improve their stock control systems.

Balance of payments current account (Table 5)

Growth in the volume of net exports of goods and services was positive in 1990 and we anticipate that this will continue into 1991 and 1992 before a small fall in 1993 as domestic demand growth accelerates. The current account deficit forecast for this year is some 96.5 billion, equivalent to 1.3 per cent of GDP. The forecast visible trade deficit is just over 29 billion. Chart 4 shows the growth of imported and exported manufactures along with domestic demand and world trade. The world trade measure used here is based on a weighted aggregate of import volumes in the United Kingdom's main export markets. Growth in world trade is likely to slow from over 5 per cent in 1990 to under 4 per cent this year. However, the forecast is for higher growth around 6 per cent next year with any slowdown in the European markets being more than offset by recovery in North America.

The most recent data provide signs of a genuine improvement in export performance, particularly in sales to the European Community. Chart 4 illustrates that recent growth in manufactured exports has exceeded the growth in the UK's main export markets. It is not yet clear that UK firms will retain their market share once domestic demand picks up, as some of the additional exports may simply reflect supply diverted from the home market by multiplant firms. However, there is some evidence of a 'beachhead' type effect as it is possible that the price level of exported manufactures in 1991 will show a slight fall from the level in 1990. This price discounting largely reflects the disciplines imposed by membership of the ERM. Prices have been weaker than previously expected, suggesting that profit margins are being reduced in order to maintain competitiveness as expectations of future exchange-rate devaluations diminish.

Import volume growth has recently slowed considerably, particularly in finished manufactures. The volume of such imports in the second quarter of this year was some 9 per cent below the level in the equivalent period of 1990. As Chart 4 reveals, the decline in manufactured imports is closely related to the slowdown in domestic demand. Some pick up in volume is to be expected following the resumption of growth, although the relatively low demand for consumer durables together with the continuing growth of world trade means that the recent improvement in the visible trade deficit may continue into 1992.

However some deterioration in the current account is to be expected with the likely ending of foreign transfer payments of contributions towards the cost of the Gulf War. These may amount to as much as 92-3 billion in 1991, although some uncertainty remains as to both the scale and timing of such payments. We envisage some improvement from the first quarter figure for net earnings from interest, profits and dividends, largely because the domestic recession is likely to reduce the rate of return on inward direct investments.

Balance of payments capital account (Table 6)

Last year saw a turnaround in the net flow of direct investment with a net capital inflow into the United Kingdom for the first time since 1977. This trend in direct investment is consistent with our previous forecasts which have argued that the level of outward investment was likely to decline in the short-term as firms attempted to restore their financial positions following the high level of borrowing required to finance previous investments. Little new investment is being undertaken at present with outward investment last year being financed almost entirely by means of reinvested profits in existing affiliates.

In contrast, inward investment has largely consisted of new investments, with several large takeovers reflecting corporate restructuring in advance of the completion of the European internal market. Our expectation is that there will be an additional small net inflow this year amounting to around 23 billion. This is reversed in the medium term as growth elsewhere in the world is faster than that in the domestic economy.

Despite the inflow of direct investment there was still a net outflow on the basic balance last year as net portfolio investment overseas continued to expand. Recent surveys of fund managers suggest that funds have been switched out of cash and into equities, particularly foreign equities. We therefore expect a further net outflow of portfolio investment this year and next, although the level of inward investment is likely to rise if the commitment to exchange-rate stability is thought to be credible.

The labour market and output (Tables 7 and 8)

The total number of employees in employment peaked in the second quarter of last year and has since fallen by an estimated 492,000 to the first quarter of this year. Our forecast suggests further falls of around 340,000 in the remainder of 1991 and around 200,000 in 1992. Chart 5 shows the changes in different sectors of the economy. It is clear that all sectors experience a downturn in employment, although falls are especially marked in manufacturing and the service sector. The fall in other employment primarily reflects a downturn in construction employment. The decline in employment is matched by a further step up in claimant unemployment to a level averaging just under 2.6 million in the last quarter of this year and to 2.8 million by the end of next year. It is possible that the claimant count will show a further small rise in the medium term as unemployment following the 1980 recession did not peak until 1986. The unemployment rate is shown in Chart 6.

The rise in unemployment may help to slow the growth of average earnings by providing a larger pool of potential recruits from which employers can choose. Some evidence of this is provided by the CBI Survey where the numbers of firms citing shortages of skilled labour as a factor likely to limit output has fallen by two-thirds over the last year.

In the Institute model, past changes in employment are associated with the profile of output expectations discussed in Box A. Our model uses vintage capital models for manufacturing, distribution and business services in which costs of adjustment mean that both employment and investment depend upon output expectations. The high level of output in the second half of the 1980s resulted in the installation of large quantities of new capital goods. This capital embodied the latest technology and therefore raised average labour productivity. Such productivity improvements imply a fall in the amount of labour required to produce a given level of output. The fall in employment over 1990-2 may therefore be seen as part of a process in which firms are adjusting towards a lower labour requirement following both the downturn in output and a fall in the average age of the utilised capital stock. The severity of the recent falls in employment may partly reflect the continued overoptimism of output expectations well into 1990, with employees being retained up until then in the belief that recession could be avoided and that skilled labour shortages would persist.

One corollary of the continued employment decline in 1992 is that we are anticipating productivity improvements of 3 per cent in the economy overall and perhaps 6 per cent in manufacturing. Estimates of productivity and sectoral output are provided in Table 8.

Excluding oil, the fall in GDP this year is slightly enhanced. We anticipate that much of the extra oil output arising from the reopening of several North Sea fields will go into the rebuilding of stock levels as domestic oil consumption is likely to remain depressed for the remainder of the year. Developments in other categories of output largely reflect the composition of expenditure, with those categories relying on consumers' expenditure remaining relatively depressed. Some recovery is however expected in manufacturing output levels although initially this is likely to be export driven. Business services output is also likely to recover next year with the increased demand for financial services as the domestic economy picks up.

Average earnings (Table 2)

There has been a continued downturn in earnings growth with the level of new settlements recently reported by Incomes Data Services falling between 6 and 8.9 per cent compared to a range of 8-10.9 per cent in the first quarter of the year. This downward trend in settlements is reinforced by a continuing fall in wage drift arising from bonuses and overtime payments. As a result the underlying rate of increase in whole economy average earnings in the year to May is estimated at 8.5 per cent, a lower level than at any time in the last two and a half years. However the decline across different sectors is far from uniform with rises reported in production industries, particularly energy supply and sharp falls in the service sectors.

The trends in price inflation and unemployment should mean that settlements continue to fall and we therefore envisage the annualised growth of whole economy earnings falling to around 7.9 per cent by the end of the year, with a further sharp fall to around 7 per cent in the first half of next year as the high settlements in the first quarter of 1991 drop out of the figures. The productivity improvements anticipated in 1992 may mean that the decline in real wages is less marked than that in nominal earnings.

Costs and prices (Table 9)

Recent inflation data suggest a severe squeeze on profit margins as weak demand at home together with the need to retain competitiveness abroad place downward pressure on prices. The main source of the profits squeeze has been the recent rapid growth in unit labour costs, with the annual growth of whole economy costs reaching 1 1 per cent in the third quarter of 1 990 and remaining at around 1 0 per cent in the first quarter of this year. In the short run we expect costs to continue to behave counter-cyclically with the productivity growth discussed above causing the growth in labour costs to fall below 4 per cent by the second half of next year.

Manufacturers' input prices have been relatively depressed over the past six months with growth in the year to June put at 1.2 per cent. Although many commodity prices are currently weak (see the World Chapter for further details) we anticipate some temporary pick up in sterling prices with sterling having depreciated against the dollar by some 15 per cent since February, as shown in Chart 2.

Domestic price expectations of UK manufacturers have been weak for some time. The balance of firms expecting to raise prices over the coming four months in the latest CBI Survey is the lowest since 1967. Signs of moderation have already appeared in the wholesale price data with the rate of inflation for all manufacturing industries excluding food, drink and tobacco falling to 5.2 per cent in June and July from a peak of 6.5 per cent in the first two months of the year. Our forecast is for further falls later in the year with the annual rate dipping below 4 per cent in the last quarter and continuing to fall into 1992. The lack of firms citing capacity constraints at present suggests that the rise in capacity utilisation once demand picks up is unlikely to lead to a quick restoration of profit margins.

Retail price inflation fell sharply in the second quarter of this year due to favourable community charge effects. The continuing fall in both wholesale price inflation and mortgage rates suggests that the RPI is likely to average around 4 per cent in the fourth quarter of the year.

In the medium-term there is less prospect of a renewed growth in unit costs due to the disciplines exerted by membership of the ERM. Wage bargainers and price setters are likely to realize that any cost or price escalation will not automatically be validated by exchange rate depreciation. Changes in profit margins are related to international competitiveness as well as capacity utilisation. They are less likely to rise strongly as domestic demand picks up, particularly in industries whose main competitors are European based.

Public sector finance (Table 11)

The PSBR has recently followed the economic cycle moving from a surplus of 3 per cent of GDP in 1988-89 to balance over the last financial year. Borrowing in the first three months of the latest financial year amounted to L4.7 billion, although this figure is somewhat distorted by the timing of poll tax and VAT payments. For the year as a whole our forecast is for a deficit of 28.6 billion (17 per cent of GDP) with a possible further rise to around 21 5 billion in the year 1992-93. This deterioration reflects both the operation of automatic stabilisers, notably transfer payments, and a decline in the rate of growth of tax revenues especially from the corporate sector.

At around 3 per cent of GDP the deficit returns to a level last experienced in the early 1980s. In the medium term (see Table 12) our forecast has the public sector returning to financial balance, with the growth rate of real expenditure held below that of GDP. Box B investigates the possibility of allowing all current grants to be uprated in line with average earnings rather than retail prices as assumed in the forecast.

Medium-term projections (Table 12)

Our medium-term projections are built around the assumption that the main European economies converge to a Monetary Union by 1997. Thus the nominal interest differential between the UK and Germany continues to decline over the mid-1990s with short-term rates in both countries falling to around 6.5 per cent by 1996. Subsequent to 1996 there is a small appreciation in the UK effective exchange rate as the European currency bloc appreciates slightly against the dollar.

Growth in these medium-term projections averages just over 2.5 per cent. The growth of domestic demand is above the growth of output and consequently there is some deterioration in the current account although the resulting deficits do not appear unsustainable as they average under 1.5 per cent of GDP.

Although growth is high by recent standards it may still be below potential due to the constraints imposed by the need to adjust relative prices within the Exchange Rate Mechanism. The note on FEERs and the second quarter of this year. Even then it will still be some 6 per cent above the average level between 1966 and the time of entry into the ERM.

With overall growth at around 2.5 per cent, claimant unemployment may well remain at a high level for some time to come. Movements in the unemployment rate since the early 1970s are shown in Chart 6, with the rate currently rising, but still below the peak last experienced in the 1980s.


The institute's domestic econometric macromodel is now available for use on a IBM PS/2 (or on a close clone). The model comes with a user friendly menu driven 'front end' in the same style as that available with the Institute's world economy model GEM. This allows the user to do either forecasts or simulations using the model, using as a starting point the institute's own forecast which is updated every quarter.

The package requires a 80386 based PC, such as the IBM PS/2 Model 70 or 80, with a minimum of 4 megabytes of memory. A maths co-processor (80387) is also recommended. The computer should also have at least 1 0 megabytes of hard disk, an EGA or VGA graphics card and if it is part of a network it must be possible for it to be isolated.

The institute's domestic macromodel can claim to be the most advanced large econometric model of the UK economy. it incorporates rational expectations in a number of areas including the foreign exchange markets. The model has a well developed supply side including a vintage technology in each of the manufacturing, distribution and business service sectors. The model is firmly data based, in the sense of incorporating very few imposed behavioural parameters.

The annual subscription is E4,000 plus VAT, or 23,000 plus VAT for those already subscribing to the world model GEM. For details of GEM see insert.


Current grants to the personal sector are transfer payments which mainly comprise of pensions, child benefit and income support schemes. Increases in such payments will tend to redistribute income towards lower income groups. We assume this variant begins in the second half of 1992.

The purpose of conducting this variant on the main forecast is to examine the likely consequence of increasing the rate of growth of current grants by linking them to changes in whole economy average earnings instead of the RPI whilst all other policy assumptions remain unchanged. The nominal exchange rate and interest-rate path have also been fixed to their base run values. The results are shown in table B1 where they are expressed as percentage changes from the main forecast (unless indicated otherwise).
 1993 1995 1997 1993
 1995 1997
Current grants 3-7 11.0 16.4
GDP (output measure) 2 -5 0.9
Consumers' expenditure (volume) 3 1.3 2.5
Gross fixed investment volume) 4 1.2 1.9
Exports of goods and services (volume) 0.1 0.3 -0.4
Imports of goods and services (volume) 4 1.3 2.2
Average earnings 6 1.9 2.7
Consumer price index 4 1.4 1.8
Employment (000s) 6.0 38.0 81.0
Current balance (L9 billion) 0.6 2.9 5.7
PSBR (L billion) 2.2 5.8 8.0

The higher level of current grants throughout acts as an increasing fiscal boost. Hence, it is not surprising we obtain a higher level of output and employment throughout. The more interesting points to observe are the implications for the current balance and public sector debt. Both experience a considerable change relative to the main forecast.

A high proportion of current grants are presently paid to the retired population whose expenditure patterns differ from the average household. It is typically noted that pensioners have a higher marginal propensity to consume and a lower propensity to import. Hence, we may expect our variant forecast to slightly underestimate output growth and overestimate the deterioration in the trade balance.

The variant indicates that public sector borrowing is estimated to increase by E8 billion within five years. This effect is less than the gross cost of higher benefit payments for two reasons. Firstly, the higher level of activity enhances tax revenue and reduces the unemployment level. Secondly, approximately 40 per cent of those who receive current grants are tax payers and hence we expect at least 10 per cent of the additional payments to feed straight back into government revenue. This assumption is embodied within the National institute model.

The consequences for the current balance however, seem to be considerably unfavourable, with a deterioration close to 96 billion within five years. This is estimated to raise the current account deficit to GDP ratio from 1.3 to 2.0 per cent.


The CBI Survey is published four times a year at the beginning of each quarter. This is convenient as it provides information about expected developments over the coming quarter before any official data for that quarter become known. The institute. s domestic model has for some time made use of information in the CBI Survey to derive measures of manufacturing output expectations used in econometric research into employment, stock levels and fixed investment, This Box discusses the construction of such measures and looks at the profile of expectations over the second half of the 1980s.

In constructing the series for output expectations, use is made of the answers to the CBI Survey questions relating to expected output growth over the coming four months, perceived output growth over the past four months and general business optimism. Answers to this question are likely to reflect longer-term expectations and the measure is used in the construction of the long-run CSO cyclical indicator. The methodology for translating the answers to these questions into a quantitative series for output expectations is described in detail in Wren-Lewis (1986).

Having transformed the survey answers it is possible to obtain an estimate of expected output in the current quarter using actual output in the last quarter and expected output growth with:

[FORMULA[S] HAVE BEEN OMITTED] where CBIF denotes the transformed answers to the question on expected growth.

The weighting on CBIF is due to the CBI Survey questions relating to four-monthly intervals. Longer term measures of expectations can be obtained from the chain rule of forecasting by making use of a model for CBIF and assuming that the same model is used to generate short and long-term expectations. Thus expected output 4-6 months hence is given by:


Chart A below shows the profile of output expectations generated from (1) and (2) along with output over the recent past. For example the 1985Q1 numbers show actual output in 1984Q4 plus expected outputin 1985Q1 and Q2. The Chart illustrates that future output was continually expected to rise over the period from 1985-9 although there were some signs that output was expected to level off at the start of 1990. Data from mid-1990 show that output was expected to fall although the last two figures suggest that further falls may be limited.

The second chart shows the difference between the annualised expected and actual growth rates of output using expectations generated from (2). Between the end of 1986 and the end of 1990 expectations of growth appear continuously over-optimistic with the exception of the first quarter of 1990. This is in line with earlier findings that expectations were consistently optimistic in the late 1970s before the previous recession.

With investment and employment decisions being partially based upon over-optimistic expectations regarding future demand it is likely that the build up of capacity in the late 1980s resulted in employment levels in excess of the amount required to produce the observed level of output. This suggests that there is scope for significant improvements in productivity as the economy moves out of recession. The implications for future investment and employment are discussed in more detail in the chapter.
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Title Annotation:Chapter 1; economic forecasts for Great Britain
Publication:National Institute Economic Review
Date:Aug 1, 1991
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