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The home economy.



The resignation of Nigel Lawson as Chancellor of the Exchequer, and the appointment of John Major to replace him, has been accompanied by vigorous denials of any change in the aims or conduct of economic policy. There may nevertheless be some modification of the stated reliance on interest rates alone as the means of combating inflation. The previous Chancellor was heavily committed to a programme of cuts in income tax; the new Chancellor may feel less so. For that reason we are now assuming that no net change in taxation will be announced in the 1990 Budget.

The conduct of monetary policy is as obscure as ever; and the vexed question of full EMS membership remains unresolved. The earliest likely date would seem to be the summer of 1990, about the time of the next European Summit Meeting; the latest likely date would be shortly after the next general election, which could mean some time in 1992. We have assumed for the purpose of our forecasts that the date is in the fourth quarter of 1990, but that the effect on interest rates and on inflation is felt gradually over a transition period of several years thereafter. (If full membership came a year or so later, but with a wide exchange rate margin initially, the effect on our forecasts would be much the same.)

This reduction in interest rates will add to domestic demand, especially to fixed investment. For that reason it would risk prolonging and increasing the deficit on the balance of payments. To prevent that from happening in our forecasts we have assumed that there will be no further income tax cuts after 1991, and public spending will hardly grow at all so that the surplus of the public sector increases. This assumption ensures that the current account deficit continues to fall in the medium term and would be eliminated some time in the 1990s. It is possible of course that domestic demand will be reined back in some other way, spontaneously or as a result of credit controls introduced after the next election.

For the next year, or until the date for full EMS membership, the main influences on the rate of interest are likely to be the rate of inflation and the trade figures. We judge that developments during next year will be deemed to allow a cut in interest rates of one percentage point to 14 per cent by the third quarter.

Since our last forecast, interest rates have been raised by one percentage point to defend sterling, which was under attack following the publication of disappointing trade figures and an interest rate rise in Germany. Sterling was weak again immediately after Nigel Lawson's resignation. Our estimate for the fourth quarter shows the effective exchange rate down about 9 per cent since the first quarter and 3 1/2 per cent lower than we were expecting in August.

The risk of a sharp fall in sterling now comes from political uncertainty as well as the state of the economy. We assume, however, that depreciation is no more than in line with the present difference between short-term interest rates in the UK and overseas. Thus, over the next twelve months the effective exchange rate is forecast to fall by about 5 per cent. Thereafter the rate of fall slows down to just 3 1/2 per cent during 1991 (which could take place within EMS margins), and to zero by the mid-1990s.

Although our balance of payments forecasts have been towards the pessimistic end of the spectrum, the trade deficit over the last three months has again been worse than we expected. The continuing strong rise in the volume of imports is especially surprising, given the other evidence that the pressure of demand is falling. Upward revisions to the estimates of world trade earlier in the year help to explain the continued buoyancy of exports.

The Central Statistical Office has published a set of `statistical adjustments' to reduce the discrepancies amongst the three measures of gross domestic product. They have added 1.3 billion [pounds] to consumer spending, 0.9 billion [pounds] to fixed investment and 1.2 billion [pounds] to stockbuilding (all at 1985 prices) during 1988. The growth in the average estimate after these adjustments was 4.4 per cent last year, but we have decided for the present to continue using the output measure which increased by 4.7 per cent. The major problem of interpretation concerns the national accounts data for the first half of this year.

In the first and second quarters of the year the CSO has allocated 2.3 billion [pounds] (at 1985 prices) to stockbuilding. If this interpretation is correct it suggests that stock levels are now excessive, which could imply lower output levels now or in the future. The CSO adjustment helps to reconcile the national income accounts, but it is difficult to square with the results of the CBI Survey. Moreover it is not clear why producers or distributors should have been accumulating stocks on this scale. The stockbuilding equations in our model would have predicted only about 1 billion [pounds] of stockbuilding in the half year.

There are other indicators that demand and output are already slowing down. The volume of consumer spending, according to preliminary estimates, was little changed in the third quarter and only 3.8 per cent up on a year earlier, compared to a rise of nearly 7 per cent year on year in 1988. Fixed investment in the second quarter was down a little from the very high level recorded in the first. The path of GDP is distorted by the continuing disturbance to oil production in the North Sea; excluding oil, GDP was unchanged between the first and second quarters. We would guess it has not risen more than about 1/2 per cent in the third quarter.

Inflation, as measured by the consumer price index, is about 5 to 5 1/2 per cent. The rise in the retail prices index, at 7.7 per cent in the third quarter, is reflecting the effects of higher mortgage interest payments. Wage settlements are, if anything, tending to accelerate, partly perhaps in reaction to these high figures for the increase in the r.p.i. The growth of average earnings, however, may be slowing down a little in response to lower activity-related payments.

For this forecast we are using a new version of the Institute's model, described in a note on page 47 below. This includes new `forward-looking' equations for wages and prices, and a new disaggregation of output to allow a more thorough treatment of the private non-manufacturing sectors. We are also able for the first time to include a forecast of the main items in the capital account of the balance of payments.

A significant change in our short-term forecasts since August is the slower growth of output in 1990. Year on year we now expect GDP to rise by 1.6 per cent compared with 1.9 per cent in our previous forecast. The growth of consumer spending is just over 1 per cent with spending on durables falling. In addition we expect a fall in the level of stocks after the substantial rise this year. Excluding oil output next year rises by only 0.9 per cent. The downturn in activity is concentrated in construction, where output falls by 2 1/2 per cent, and in manufacturing, where output falls by 1 1/2 per cent. The consequence is a halt to the fall in unemployment from the first half of next year, when the level will be about 1.6 million. The trade balance improves a little next year, as the growth of imports of manufactures slows down, and oil output returns to normal.

Another change since our August forecast is a reduction in the forecast of inflation for next year to 5.2 per cent by the fourth quarter. This is partly the result of using a new model. Over the next year the pressure of demand in the labour market will be falling, but the official unemployment count will not fully reflect this, as the conditions for claiming benefit are still being tightened. Our new earnings equation includes a term in employment relative to demographic change, instead of the official unemployment figures. The fall in interest rates which we expect in the latter part of next year will have a direct effect, lowering the rate of inflation. Moreover our new model of wages and prices, being more `forward-looking' gives more weight to the prospect of lower inflation in the future and less to the relatively high figures for inflation in the recent past.

During 1991 the growth rate of output should recover, helped by the reduction in interest rates. Through that year both investment and stockbuilding should again be making an important contribution to demand growth. Consumer spending should also have picked up. Output growth could even be quite brisk (3 per cent fourth quarter on fourth quarter). Despite this recovery unemployment is likely to rise during 1991, as it lags behind the growth of output. The increase in consumer prices is expected to stay at around 5 per cent in 1991, but the fall in interest rates will be reducing the growth of the retail prices index. The balance of payments will still be in large deficit on current account.

This outlook can be compared with that predicted for the rest of Europe in Chapter Two below. We expect growth to slow down next year in Italy, in France, and more sharply in Germany, but the UK growth rate will be lower than any of those in 1990. Inflation rates should be slowing throughout Europe in 1990, and the gap between our inflation rate (in terms of consumer price indices) and that of France or Germany may become a little wider. The convergence we foresee in the medium-term is the result of full UK membership of the EMS (and of the policies which go with it), not a condition which has to be fulfilled before it is possible.

Our main forecasts for the UK are set out in more detail in Part Three of this chapter. The next section is devoted to a variant forecast in which the current slowdown in the economy turns into a recession.


The term `recession' is sometimes used loosely to refer to any period in which the pressure of demand is falling, or to the phase that follows the peak of any normal trade cycle. Here we are using the word in its more precise, or American, usage as a period of two or more quarters in which gross domestic product falls. The UK economy has already passed a trade-cycle peak, probably in the summer of 1988, and the pressure of demand is now falling. In our August Review we forecast virtually no growth in GDP between the end of 1989 and the summer of 1990, but we did not actually forecast a recession. Some of the new information that has become available in the last three months has reinforced fears that the outlook for economic activity is deteriorating. In this section we try to assess the probability of a recession in the short-term, and consider the implications for the medium-term if a recession in fact occurred.

There were no recessions in the 1960s because the amplitude of the trade cycle was relatively low and the upward trend in output was relatively strong. The two severe recessions in 1973--5 and 1979--80 were both associated with oil price `shocks' which reduced demand worldwide, and they happened in a decade when the growth of productivity was much reduced. There is no reason to anticipate a comparable `shock' to the world economy as a whole at the present time, and there is evidence that the trend growth of output is now faster than it was in the 1970s. On these grounds at least there is no presumption that a cyclical downturn at the end of the 1980s need turn into a recession.

On the other hand the pressure of demand in some sectors of manufacturing was exceptionally high last year, higher for example than it was in 1979 and the balance of payments has moved into deep deficit. That in itself may argue for a more marked downturn this time. Moreover the changes that have taken place in financial markets could lead to greater instability. As in 1973 a credit boom could be followed by a credit slump. The arguments from history are not all reassuring.

Apart from external events and policy measures, there are a variety of influences which naturally tend to bring booms to an end, influences which could, if they worked with sufficient strength, result in a recession, rather than just a cyclical downturn. The growth of credit has long been recognised as an important mechanism of this kind. The traditional view was that in the upswing credit is extended to borrowers whose creditworthiness depends on the continuation of boom conditions; the longer the boom continues, the greater the accumulation of debt, and the greater the cutback necessary to restore financial stability. We do not know how relevant this view is to the current situation; but it is possible that the effect will work with added strength now that credit markets are `deregulated'.

In a rather similar way the accumulation of physical assets by business or indeed of durable goods by households may continue during a boom to the point where they are excessive in relation to the sustainable level of output or of income, so that the subsequent readjustment deepens or prolongs the downturn. Possibly the rationalisation of stock control during the 1980s will make this mechanism less powerful, but all these relationships are tending now to stop the growth of demand, and of output. Potentially they could contribute to a recession.

Most commentary on the current situation concentrates on the sizeable rise in interest rates during 1988 and their continuing high level (with some small further increases) this year. It would be wrong to suppose, however, that the downturn is solely, or even mainly, attributable to interest rates. The truth is rather that the boom has spent its force, or in some parts of manufacturing industry has been contained simply by the limits of physical capacity.

The effects of interest rates on demand and on output, are discussed in the note on page 47 below. The estimates in that note, based on our model of the economy, provide a method of quantifying the effects of the rise in interest rates since early last year on the present level of output. Short-term interest rates rose by 4 percentage points in the latter half of 1988 and a further 1 percentage point in the first half of this year. Our model suggests that these increases have reduced the present level of consumption by about 1 per cent, of fixed investment by about 3/4 per cent. Moreover, since long-term interest rates seem hardly to have been affected at all, it is possible that even these estimates are an overstatement. In relation to the slowdown in growth already evident the estimated effects of the interest rate increases seem small.

It is a familiar proposition that interest rates influence output with a lag. This is confirmed by the estimates in our model, but the length of the lag should not be exaggerated. After about a year the effect on output may be as large as it ever will be. As the steep rise in interest rates during 1988 is receding into the past its effect on the growth of output from now on may not be very great.

Fears of recession arise on other grounds. First there is the survey evidence coming to light in recent months. The Gallup Survey of consumer confidence conducted in October showed a very sharp fall, bringing the index to a level below any recorded since the survey was begun in 1978, slightly lower even than in 1980 and 1981. The outlook for durable goods sales in particular looks grim.

The CBI Industrial Trends Survey for October was another indicator of weakening confidence (although not such an abrupt change). The response to the question about the general business situation is on balance less optimistic than at any time since 1982, although still considerably above that of 1979 or 1980. Reported capital expenditure authorisations are also down both for buildings and for plant and machinery. Stock levels are `more than adequate', although again the balance of replies to this question is not nearly as unanimous as it was in 1980. Recession has already hit private housebuilding. The figures for starts in the third quarter are 30 per cent down on a year earlier and similar to those recorded in 1980 and 1981.

Another reason for concern is the financial position of the private sector, both households and businesses. The financial surpluses and deficits implied by the national income and expenditure figures present a most unusual pattern. Not only is the personal sector still in deficit (to the extent of over 14 billions [pounds] in 1988), but industrial and commercial companies are now in deficit as well (by 6 1/2 billions [pounds] in 1988). The counterparts are the public sector surplus and the deficit on the current account of the balance of payments. To the extent that the financing of these very large balances can be identified, it seems that the banking sector is the most important route of intermediation. Although some of the lending by banks to the corporate sector is relatively long-term, there must be a risk that this financial situation is unstable. Our model of the economy identifies a demand for net liquidity by the company sector which depends on output, inflation and nominal interest rates: the level of net liquidity recorded in the first half of this year falls a long way below that demand. Our research confirms that a shortage of liquidity leads firms to reduce stocks and employment.

In the case of the personal sector we have had less success in identifying the long-run demand for liquid assets, but similar considerations may apply. The build-up of credit in relation to incomes since the abolition of direct control has continued for the best part of a decade, but it cannot continue for ever. At the present level of interest rates we would expect the savings ratio (which is measured net of borrowing) to settle at a new level, probably below that which was typical of periods when credit was controlled, but probably rather higher than we have seen in the last few years.

The political crisis of recent weeks, and the resignation of the Chancellor, must be another factor unsettling business confidence. The immediate effects on financial markets have been slight, but that may not be a reliable guide to the effect on the economy in the future. Business plans in the last twelve months or so have been increasingly based on the assumption of closer links with the rest of Europe and the likelihood of full membership in the European Monetary System. If the extent of future participation by Britain in European integration is in doubt, some of these plans may be abandoned or delayed. This is, of course, an `intangible' influence on the economy, which we have no means at all of quantifying.

In the variant forecast we have assumed that companies reduce stockbuilding and fixed investment more vigorously to improve their financial position in the course of next year. The results are summarised in Table A below.

The scale of the adjustment still leaves the company sector in financial deficit, but on a much smaller scale in 1990 than in 1989. Having established a better liquidity position during 1990, in terms of the stock of debt outstanding, we assume they are able by the end of 1991 to borrow almost on the same scale as in the main case of the forecast. Thus we are making a temporary cut in company spending next year, restoring its level by the end of 1991 to the base path. This was done by enhancing the adjustments to stockbuilding suggested by the model equations, and by making an adjustment of comparable magnitude to industrial fixed investment as well.

Stockbuilding in the variant is substantially negative in 1990, more so than it was in 1982. By the end of 1991 however destocking is not much greater in the variant than in the main case. In the variant total fixed investment falls next year, but recovers sharply in 1991.

Because the marginal import content of company spending is high much of the effect is absorbed in the balance of payments. The change in imports and the change in gross domestic product (both at 1985 prices) are much the same. In the variant as a result the trade balance improves quite sharply in the early months of next year, which could take the immediate pressure off sterling in the foreign exchange markets. But the improvement is shortlived, and it may well be recognised as shortlived by the markets. If so there would be no case for changing our forecasts either of the exchange rate or of interest rates.

The path of total output in the variant does show the succession of quarterly falls which define a true recession, although there is an increase year-on-year in 1990 of 0.8 per cent. It is rather more helpful to look at the figures excluding North Sea oil, as shown in table A. Thus defined, output in the variant forecast falls over the next six months, and will not regain the level of the third quarter until the end of next year.

The outlook for 1991 in this variant is for a rather brisk recovery, helped by the revival of investment as financial pressures abate and by the interest rate reductions which feature in the variant as well as in the main case. It might be a difficult year in the foreign exchange markets, however, as sterling tries to hold its parity in the EMS despite a renewed deterioration in the current account of the balance of payments.


Forecasts of expenditure and output (table 1)

Output in manufacturing seems to have improved slightly in the third quarter of this year and there are also signs of a revival in output in the oil sector. This is broadly in line with our August forecast and we still expect total GDP growth of around 2 1/4 per cent for this year. Recent changes to our econometric model and some effects from higher interest rates since our last forecast bring our estimate of output growth for 1990 down slightly to about 1 1/2 per cent with much of this growth occurring in the oil industry. Slower consumption growth and substantial de-stocking are major reasons why non-oil output will probably only grow by around one per cent next year. The deceleration in growth next year should restrain imports and allow net exports to make a larger contribution to GDP compared to our August forecast.

Personal income and expenditure (table 2)

Total real consumers' expenditure grew strongly in the second quarter of this year but was followed by virtually no growth in the third quarter. Durables consumption actually fell slightly over the same period and has been flat since the final quarter of last year. Although total bank borrowing has continued to rise this largely reflects corporate borrowing as lending to the personal sector is becoming more subdued. This is consistent with the sharp fall in consumer confidence indicated by the October Gallup survey. Retail sales actually fell in October and seem to be more affected by the slow-down in consumption than expenditure on services (holidays, eating-out etc.) which is still growing. Falls in demand for durables are probably associated with the depressed housing market. Although partly offset by the mortgage rate rise, real disposable income in the fourth quarter will be increased by higher employment, rising earnings and the October cut in national insurance contributions. This should prevent consumers' expenditure falling in the final quarter of this year giving consumption growth of around 3 3/4 per cent for 1989 with the savings ratio declining to 4 per cent.

Next year we forecast that high interest rates will help to slow down the growth of real consumer credit to around 5 per cent. Slower growth in equity prices will probably contribute to the net wealth of the personal sector also growing less quickly during 1990. These factors combined with real personal disposable income growth of only 1.3 per cent should slow total real consumption growth down to about 1 1/4 per cent next year.

Fixed investment and stockbuilding (tables 3 and 4)

All the indicators point to a sharp slow-down in investment growth in 1990. For the first time since early 1983 a majority of CBI survey respondents expect to authorise less capital expenditure over the next twelve months than the last twelve months. Even though the latest CBI survey was largely completed before the base rate rise to 15 per cent nearly a fifth of companies reported the cost of finance as a constraint on investment.

We forecast total fixed investment to grow by approximately 1 per cent next year. In 1990 we expect the high cost of capital and considerable reductions in the growth of real post-tax profits, real share prices and output to all contribute to the slow-down in investment. The latest DTI company liquidity survey shows that the aggregate liquidity ratio for all large companies remained fairly flat in the second quarter in contrast to the large falls over the previous 18 months. This suggests a tightening of the financial position of corporations and we therefore add small negative residuals to some of our non-manufacturing investment equations to reflect the constraints imposed upon the company sector by the expected further adjustment back towards financial balance. Further fals in housing construction investment next year and stagnant distribution and business services capital expenditure are largely due to the depressed demand in the non-oil sector in 1990.

The CSO's allocation of the `statistical discrepancy' to individual expenditure categories has resulted in substantial upward revisions to stock-building data. If this allocation is correct then stock-output ratios have increased in 1989 thus reversing a well established downward trend apparent since the start of the decade. Although unintended accumulation of stocks usually occurs soon after the output cycle passes it peak, the magnitude of the adjusted stockbuilding is difficult to accept. Furthermore, our stockbuilding equations all underpredict when using this revised data suggesting that there are no economic reasons for this supposed strong rise in stocks.

However, the October CBI Industrial Trends Survey confirms that there has been an increase in stocks but to a somewhat less dramatic extent; a balance of 13 per cent of respondents reported above normal levels of manufacturing finished goods stocks and these are expected to be sharply reduced over the coming months. Our forecast actually predicts substantial de-stocking in 1990--particularly in the distribution sector--due to much slower non-oil output growth and the company sector reducing expenditure as part of the readjustment process to more desirable levels of liquidity. The downward trend in stock-output ratios therefore becomes apparent once again beyond 1990.

Exports and imports of goods and services (table 5)

The deterioration of the current balance deficit to 5.9 billion in the third quarter means that the 15.5 billion deficit for the first nine months of this year already exceeds that for the whole of 1988. Both the temporarily poor oil trade surplus and subdued invisibles have made a substantial contribution to this poor performance. However, non-manufacturing exports are still depressed and third-quarter manufacturing import volumes show a resurgence in consumer goods and, adding to the evidence that investment is slowing-down, a deceleration in the growth of capital goods imports.

An incipient improvement in the trade balance is indicated by the recent presence of small residuals in both our manufacturing imports and exports equations. Using these residuals for the forecast helps give us a slight improvement in the fourth quarter current balance although a small J-curve effect resulting from the recent depreciation in sterling partly offsets this. Nevertheless, we forecast a current balance deficit for this year of approximately [pounds] 21 billion at 5 per cent of GDP. for next year exports should remain buoyant through the combination of strong world trade growth, improved competitiveness and possible opportunities for UK producers to switch from home to export markets. However, this optimism is not apparent in the October CBI Industrial trends survey which shows no growth in export orders over the past four months and not much expectation of an improvement in orders over the coming months. We believe that import volume growth will slow markedly in 1990--because high import-intensity expenditure categories, such as stockbuilding and investment, will be particularly affected by slower growth next year. In addition our optimistic view of next year's oil trade surplus and exports growth should help the current deficit to decline to around 18 billion [pounds] in 1990.

Output and the labour market (tables 6 and 7)

Manufacturing output shows some signs of growth in the third quarter of this year after being flat in the first and second quarters. As this seems to contradict the provisional expenditure-side data--flat real consumption growth combined with growing manufacturing imports--we have made a small positive adjustment to the residual error between the output and expenditure measures of GDP in our forecast. Low levels of output continue to characterise the energy sector but there were signs of the beginning of a recovery in this sector in the third quarter. In fact, much of our forecast output growth in the fourth quarter and for 1990 is attributable to the oil sector returning towards potential output after its recent spate of supply problems.

Our model has a new disaggregation of output and we now forecast the output of the construction, distribution and business services sectors in addition to oil and manufacturing. The model builds up output from the demand-side; the extent to which output categories are dependent/independent of different expenditure categories then determines their forecast growth. For example, manufacturing output growth turns negative in our forecast for 1990 as it is heavily dependent upon the manufacturing investment and stockbuilding expenditure categories which, in turn, are forecast to experience a slow-down. Business services output experiences strong growth next year continuing its trend gain in output share and benefitting from robust exports of services growth. The relative weights of these sectors combine to give just below 1 per cent non-oil output growth but the recovery of the oil sector should bring total GDP growth close to 1 1/2 per cent for next year.

The official unemployment count continues to fall; the numbers claiming benefit have been reduced by 1/2 million over the past twelve months and strong monthly falls are still being registered. However, these statistics seem somewhat puzzling as smaller rises in employment and recent falls in average earnings seem to contradict the large published declines in unemployment. Employment in the new model in the manufacturing, distribution and business service sectors is now determined via a vintage production system. The labour required by these sectors (once adjustment is complete) is therefore mainly dependent upon the technical progress embodied in the utilised capital stock, expected output and the relative price of capital, labour and raw materials inputs. In our forecast for 1990, slower output growth and lower capacity utilisation allow a reduction in the use of older vintages of capital equipment. This reduces the need for employment growth partly because a more labour saving technologically advanced capital stock accounts for a greater proportion of production. Company disequilibrium liquidity terms in our equations for manufacturing and distribution also make a contribution to our 1990 forecast of actual employment falls in these sectors as companies reduce expenditure in an attempt to move back towards financial balance.

Wage and price inflation (tables 2 and 8)

Recent provisional data indicate that the underlying growth rate of average earnings has slowed down to 8 3/4 per cent. It is difficult to reconcile this deceleration with wage settlements currently edging upwards to around 8.5 to 9 per cent per annum. This apparent reduction in `wage drift' seems hard to explain given that there is very little evidence to suggest that recent reductions in overtime hours or disproportionate increases in part-time employment have occurred. The recent slow-down in activity may have reduced output related payments but the changes to the method of average earnings calculation may also explain some of the discrepancy. Given these factors and the probability of key sectors (for example, Ford manual workers) pushing wage settlements fractionally higher it seems likely that average earnings will be rising by around 9 per cent at the end of this year. Next year we expect falls in productivity growth and an easing of demand pressures in the labour market to bring year on year earnings growth down to around 8 per cent. Our proxy for excess labour supply is the proportion of the population of working age that is not employed and in our forecast this stops falling before the official unemployment count. We found the latter measure a less accurate indicator of wage pressure as claimant status and the desire for employment are not always equivalent.

Weaker sterling has contributed to recent underlying increases in manufacturing input costs (fuels and raw materials) but manufacturing output prices have remained stable. The implied fall in profit margins suggests that firms are reluctant to risk losing market share in the competitive environment of slowing domestic demand. Even though the company sector is in financial deficit, further squeezes on profit margins may be possible given the current exceptionally high levels of profitability. The retail price index is showing some underlying growth but the effect of the mortgage rate increase in November (due to the recent increase in base rates to 15 per cent) will be mitigated by previous rises dropping out of the calculation in October.

Import prices will continue to rise next year as sterling falls in line with interest rate differentials between the UK and overseas. Although this inflationary effect from import prices is greater than we forecast last time we now actually have a lower forecast for the other price indices for 1990. Growth in manufacturing wholesale prices is now forecast at around 6 per cent which is partly a result of our lower 1990 prediction for non-oil GDP which should ease demand pressures via further reductions in manufacturing capacity utilisation. For next year, consumer price inflation will probably be around 5 1/2 per cent subdued by the slow growth in consumers' expenditure. We now expect retail price inflation of approximately 6 per cent for 1990. New forward looking model equations have contributed to making the inflation forecast more optimistic as economic agents are now deemed to anticipate the future lower inflation achieved by EMS membership.

Public sector finance (table 10)

Recent data suggest that the PSBR surplus for this financial year will be less than the 14 billion [pounds] forecast by the Treasury. Half-way through the financial year the total surplus is only 500 billion [pounds], and excluding privatisation proceeds the PSBR would have been around 2 1/2 billion [pounds] for the first half of the year. These figures reflect robust Government expenditure growth and slower demand growth resulting in lower total tax receipts than expected. A not insubstantial take-up of private pensions may also have reduced employees national insurance contributions. Next year revenue will grow less rapidly as employment begins to fall and earnings growth slows down. We expect approximately 12 1/2 billion [pounds] and 15 billion [pounds] as likely PSBR surpluses for the 1989/90 and 1990/91 financial years respectively. In the medium-term our assumptions of no tax cuts and lower public expenditure growth combined with reasonable GDP growth should ensure a substantial continuing surplus. The Government's newly announced 1 billion [pounds] subsidy to soften the impact of the poll tax will slightly offset this.

Nigel Lawson has re-iterated in his Mansion House speech adherence to the full-funding rule but it will not necessarily be implemented rigidly year by year. Recent intervention means that some overfunding is probable this year.

The medium term (table 11)

Joining the ERM allows a higher rate of GDP growth in the medium-term as interest rates can now be reduced. The buoyant demand released by lower interest rates results in a somewhat larger trade deficit. We have therefore had to assume some degree of fiscal restraint is necessary for sustainability of the deficit.

The combination of a public sector surplus and large imports of capital goods resulted in some commentators describing the UK trade balance as a `benign deficit'. This view attributed a large part of the movement into deficit to private sector borrowing from overseas for capital investment purposes. It was argued that the deficit would then be somewhat self-correcting as the investment would subsequently considerably improve UK competitiveness. Although in our medium-term forecast imports are directly reduced by the increase in capacity arising from new investment there is little evidence of self-correction of the deficit via improving price competitiveness. In our econometric model, supply-side effects of increased investment will increase labour productivity directly through our vintage production system. The extra investment will help reduce capacity utilisation and the subsequent increase in use of labour-saving newer machinery relative to labour-intensive older machinery will boost average labour productivity. Unfortunately, the improved productivity growth feeds directly into average earnings with the result that the benefits to UK competitiveness through this route are much reduced. Consequently, some fiscal restraint is required to bring the trade deficit back towards balance.

In the medium-term the financial position of the company sector moves back towards balance as robust output growth sustains profits, investment slows down to a sustainable rate and interest payments are decreased. Subdued consumers' expenditure growth prevents further falls in the savings ratio in the early 1990's but the personal sector remains in substantial deficit. The public sector surplus persists in the medium term through both fiscal restraint and buoyant revenues and helps offset the personal sector imbalance. The public sector surplus, combined with fairly stable inflation and declining long-term interest rates, should allow corporations to continue to borrow at fixed rates by issuing bonds. Such a development should have desirable consequences for the sustainability of the trade deficit as portfolio investors, faced with a dwindling supply of UK government gilts, can switch to private sector UK bonds.

Although average earnings remain buoyant throughout the medium-term consumer price inflation remains lower partly because the lowering of interest rates substantially reduces the cost of stockholding. Lower interest rates also help fixed investment to maintain reasonable growth after 1990 which keeps capacity utilisation at a tolerable level. [Tabular Data A, A1 and 1 to 11 Omitted]


Forecasts produced with a behavioural model reflect a combination of the properties of the model itself, judgemental intervention, and `exogenous' variable projections. In the case of the Intitute's domestic forecast this last category comprises almost exclusively world variables forecast using our world model, GEM, and policy judgements. In the past, a cynical view has been that forecasts owed rather more to the forecasters than the model, with judgemental intervention being extensive. In the last few years this has not been true of the Institute's forecast, which has been heavily model bases.(1) This appendix outlines the important interventions (residuals) in this forecast, sector by sector. A printout showing all the residuals in all equations is available on request.


There are no residuals on either total consumption or the consumer durable equations. Equations determining consumer credit and net wealth are also free of intervention.


There is a small positive residual in 1989 and 1990 for manufacturing, reflecting survey evidence. From 1991 onwards the residual is zero. Distribution and business service investment contain growing negative residuals, which roughly offset positive time trends in the estimated equations. This is consistent with a view that these estimated trends in investment/output ratios in these sectors in in the past reflected technological developments (eg computerisation) which will not continue in the 1990s. A small positive residual on `other' investment reflects projected investment in the water industry. The net result of these interventions is to reduce the medium term growth of investment in the forecast; without them, the company sector financial deficit would grow and the current account would show less improvement in the 1990s.


In all three sectors, our equation's residuals have been moving in a positive direction in the recent past. This may reflect unintended stockbuilding, or invalid adjustments by the CSO. As a result, we have imposed residuals reflecting 87/88 values. This involves a small negative residual throughout for manufacturing and `other' stocks, and a phasing out in 1990 of a positive residual to distributive trade stocks. As these residuals are applied to the stock level, they have little effect on the medium term outlook for growth.

Trade volumes

The average residual over the last year for manufacturing exports is above 2 per cent, and this has been projected forward flat for the whole forecast period. In contrast, negative residuals on other exports have been phased out by 1991. Small negative residuals on all the import categories have been projected forward. In every case intervention improves the outlook for the current account.

Output, Employment and Unemployment

There is a flat positive residual on manufacturing output which adds about 2 per cent to its level throughout the forecast period, and a negative residual of roughly equal size on public service output. In both cases these reflect residuals in the very recent past. All other output categories have zero residuals. This is also true for all the model's employment equations, apart from a small negative residual on manufacturing in 1990. A decreasing negative residual on unemployment in 1990/91 reflects changes in eligibility criteria.

Exchange Rate

This is kept exogenous in the forecast, but at levels designed to reflect the theory behind the model's equation. Movements in the exchange rate over time reflect interest rate differentials through the `open arbitrage' condition. The current account by the end of the model run (1999) is near balance.

Price and Wages

The two key price equations in the model, manufacturing wholesale and consumer prices, have zero residuals throughout. There is some small positive intervention on average earnings in 1990, reflecting information on settlements in the current wage round, but residuals are zero thereafter.

There are some fairly small residuals on the more minor price equations (eg investment deflator, house prices), which generally reflect prediction errors in the past and have been projected flat. Our equation for share prices is currently overpredicting by over 10 per cent. This could be because the equations' terms in profits and dividends are lagged, while in reality the market is forward looking. This explanation suggests phasing out these negative residuals through the forecast period.


The new version of the Institute's domestic model contains a full model of the capital account for the first time. The purpose of this note is to provide a brief discussion of the short to medium term projections of capital flows. Analysis of the capital account is of importance not only for the forecast of net interest, profit and dividend receipts from the overseas sector, but also in order assess the argument that in a world free from exchange controls, persistent current account deficits may be readily financed by flows of long-term capital investments from economies with excess savings.

The issue of sustainability is often related to the extent to which the counterpart to the current account deficit consists of short-term accommodating flows of so called `hot money' within the banking sector. However this ignores the additional financing pressures coming from within the capital account. It is helpful to distinguish between two forms of capital flows; structural flows, such as direct and portfolio investment, based on long-term investment decisions and accommodating short-term financing flows. (This distinction is not clear cut as some portfolio flows may be for speculative purposes.) Structural flows are effectively independent of the current account and may either exacerbate or alleviate the need for accommodating flows. Sustainability should therefore be related to the deficit on the basic balance (current account plus net structural flows) rather than the current account alone.

Short-term financial inflows may be destabilising if overseas residents have a lower propensity to hold sterling than domestic residents. The transfer of financial wealth associated with the basic balance deficit can then lead to downward pressure on the exchange rate as overseas residents attempt to restore the desired currency composition of their assets. This point is discussed further in Westaway and Pain (1989).

In contrast to the United States where the deficit on the basic balance was small in 1988 at around 2.3 billion [pounds] (the current account deficit being offset by net inflows of structural capital), the UK basic balance was in deficit by 27 billion [pounds], although it is important to note the uncertainty associated with the large positive balancing item in the sectoral accounts. As table A1 reveals inflows of short-term capital within the banking sector amounted to 14 billion [pounds] in 1988 and are forecast to nearly double in 1989 to 27 billion . Financial inflows on this scale are likely to weaken sterling. Official intervention has been heavy this year as shown by the large net inflow under `net other investment' in the table.

The primary reason for the forecast short-term deterioration in the basic balance is the net outflow of long-term portfolio investment capital, continuing a trend in evidence throughout much of the 1980s. Domestic financial institutions are forecast to invest heavily in overseas equities and gilts in both 1989 and 1990. There are two main factors here -- the relative returns on domestic and overseas investments and the absence of suitable investments in the domestic market. Overseas investment was made considerably more attractive in the first half of 1989 with world equity prices growing at an annualized rate of over 20 per cent. Potential returns were boosted further by the prospect of sterling gains from exchange-rate revaluations. In 1990 the decline in corporate profitability is projected to cut the growth in UK equity prices to under 5 per cent compared to a growth in world prices of around 7 1/2 per cent. As mentioned above, institutions have also lacked suitable investments in the domestic market with firms issuing little new equity and engaging in takeovers financed by bank borrowing and the public sector continuing to repurchase gilts. Much of the annual cash flow of over 20 billion [pounds] into life assurance and that capital issues are related to the growth in GDP.

The portfolio outflow is projected to fall in the medium term, helping to improve the basic balance. Outward capital flows from the main domestic financial institutions fall as exchange rate and asset price revaluations increase the share of overseas assets within their portfolios. Flows are assumed to adjust in order to maintain the portfolio share within the prudential limits dictated by regulations limiting the extent to which the currency composition of assets and liabilities may diverge. Investors are also attracted back to the UK market by the continued stream of privatisations, corporate bond issues and the relative strength of domestic equity prices. Entry into the EMS is assumed to help stabilise sterling, thereby restoring the confidence of overseas investors anxious to avoid currency losses on their investments. Growth in the sterling value of world financial wealth averages around 8.5 per cent over the medium term, providing a further boost to inward investment.

Turning to direct corporate investment, the estimated average net outflow of 8.2 billion [pounds] in 1988-9 is projected to fall sharply in the 1990s. This is consistent with the view that cross-border corporate activity in both directions will rise on completion of the European internal market. In the short-term outward investment is forecast to decline substantially in 1990 as companies attempt to restore their liquidity following the cut in corporate profitability. In the medium term there are small net outflows of corporate investment reflecting the relative growth rates of domestic and foreign activity and the recovery in domestic profitability, providing companies with investment finance.

Flows of `net other investment' primarily consist of official intervention and net borrowing by domestic residents from overseas banks. The entry into the EMS and the projected improvement in the basic balance should reduce the need for th use of the reserves. Some net borrowing by domestic residents may persist, particularly in view of the continued location of industrial production overseas.

Taking the basic balance deficit as an indication of exchange market pressures on sterling, table A1 shows that such pressures are maximised in 1989. However while the forecast basic balance deficit falls in 1990, it still exceeds that experienced in 1988, suggesting further speculative trading in sterling and the need to rely upon short-term financial inflows. In the medium term the deficit declines helping to moderate exchange rate pressures.

NOTES (1)The ESRC Macromodelling Bureau at Warwick has regularly carried out an analysis of the extent of of judgemental intervention in the main model-based forecasts. Turner (1989) contains a detailed comparison of the role of judgement in the LBS and NI forecasts made this time last year.
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Title Annotation:Chapter 1; Great Britain
Author:Britton, Andrew; Anderton, Bob
Publication:National Institute Economic Review
Date:Nov 1, 1989
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