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The world economy.

Section I. Recent Economic Developments

The pattern of real exchange rates has changed significantly since February. Our currency forecasts at that time were in line with the implied forward rates in financial markets, with the yen projected to appreciate slowly against the dollar, rising from 100 to the dollar in the first quarter of 1995 to around 90 to the dollar in 1997. Within Europe, we projected a further small appreciation of the D-mark and a continuing depreciation of the lira and the peseta. Overall, we expected 'real exchange rates to stay approximately stable'. In the event, the yen rose strongly in March and April to around 80 to the dollar, while the D-mark rose from around 1.50 to 1.38 to the dollar. At the same time, the lira/D-mark exchange rate fell by over 10 per cent and the Exchange Rate Mechanism was placed under renewed strain, with both the peseta and the escudo being devalued. As a result, the Japanese and US real effective exchange rates are respectively 15 per cent higher and 7 per cent lower than we had previously expected. These developments also had a wider impact on financial markets. The discount rate was cut in Japan and Germany and long-term rates rose in Italy and Spain. Equity prices fell sharply in those countries with appreciating currencies and jumped up in most of the countries whose exchange rate has depreciated.

It is likely that changes of this magnitude will have significant effects on the short-run prospects for the world economy, particularly if, as we assume, recent currency movements are not quickly corrected. In Box A we analyse the effects of augmenting our February forecasts with recent changes in interest rates, exchange rates and equity prices. Overall, the outcome is a modest boost to both growth and inflation, with the main effects being felt in 1996 and 1997. As should be expected, the countries that devalue experience more inflation than they otherwise would have, while inflationary pressures weaken in those countries which have revalued.

Our latest forecast reflects both the effects of recent changes in exchange rates and other recent developments in the world economy. In the medium term we have raised our forecast of inflation in the US and Italy, both of whose currencies have depreciated, while we are now expecting inflation in France and Germany to be lower than we had previously anticipated. Our forecast of inflation differentials implies that these real exchange-rate movements will be slowly reversed. Charts 1 and 2 plot our current forecasts for the yen and dollar real effective exchange rates, along with those from the February forecast. In both cases the real exchange rate tends to revert to the same level, albeit from a different starting point.

The extent and timing of many of the currency changes are particularly difficult to explain. We have published model-based estimates of Fundamental Equilibrium (real) Exchange-Rates (FEER) on a number of occasions. On the assumption that the US maintains a modest trade deficit and Japan a trade surplus, our latest estimates suggest that at the end of 1994 the dollar was undervalued by 10 to 20 per cent, the yen was overvalued by a similar amount, and the European currencies (with the exception of an undervalued lira) were within a reasonable margin of their equilibria. If so, then recent currency movements can be said to have pushed real exchange rates away from their equilibrium trajectories. Alternatively, it is possible that recent capital market developments have acted to force a change in the underlying target levels of the US and Japanese trade surpluses, via a change in portfolio preferences. We examine this suggested explanation in more detail below; while it is difficult to see how it can fully account for the scale of recent currency fluctuations, it does suggest that recent developments may not simply be the result of excessive speculation.

Our assumption that the recent realignments will not be quickly reversed also reflects a judgement about the monetary policy responses of the authorities in the major economies. If the US Federal Reserve adhered to a rigid monetary target then its response to an unwanted decline in the dollar would be to raise interest rates, and keep them high until the dollar had appreciated sufficiently to ensure that the exchange-rate change was reversed. If it did not do this then eventually the price level would rise [TABULAR DATA FOR TABLE 1 OMITTED] and the monetary target would be missed. At present the Federal Reserve does not appear to be particularly concerned about recent exchange-rate developments, possibly reflecting a view that a policy of 'benign neglect' may be useful in trade negotiations with Japan.

In Box B we analyse and compare the effects of realignment with 'benign neglect' in the US and unchanged monetary targets in Germany, with the effects when interest rates are unchanged in both countries. In the former case, the Bundesbank uses interest rates to keep the domestic price level approximately constant. As the realignment requires a change in relative prices, the US price level has to adjust fully. In the latter case the relative price adjustment is shared, with the Bundesbank allowing German prices to fall after the D-mark appreciation and the Federal Reserve permitting US prices to rise.

We expect the consequences of large exchange-rate movements to be much more apparent in Europe in 1995-6 than they were in 1992-3 when the ERM came under strain. At that time countries such as the UK, Italy, Spain and Sweden were in, or close to, recessions, with significant spare capacity and overvalued exchange rates. As a consequence, their currency devaluations helped to restore growth while inflation remained subdued, although at a higher level than might have been expected if the overvaluations had been maintained. In contrast, the present realignments have come at a time when the European economies have been growing for some while and are operating close to full capacity, particularly in the tradable goods sectors. In the EU as a whole, business surveys indicate that export orders in February were already at a higher level than at any time since 1988. With labour and product markets beginning to tighten, upward pressure on inflation is much more likely to emerge in the countries whose currencies have depreciated unless policy is tightened significantly, as we expect in the UK.

We expect Italian inflation to rise to around 5 1/2-6 1/2 per cent in 1995 and 1996 respectively and Spanish inflation to continue at over 25 per cent, while inflation in France, Germany, Belgium and the Netherlands is likely to fall to around 2 per cent. Growth in the latter countries is likely to be just under 3 per cent, with the effect of their currency appreciations being partially offset by the recent reduction in German interest rates, a move which was followed by many other European central banks. We now forecast Italian growth at around 3 1/2 per cent in 1995, rising to 4 per cent in 1996, nearly 1 per cent higher than in our previous forecast. Growth is also expected to be higher in the UK and Spain in the short term.

Growth in the US has been relatively robust but there are clear signs that the pace of the expansion is beginning to slow. Our projections show a deceleration from around 4 per cent growth in 1994 to 3 1/2 per cent in 1995 and around 3 per cent in 1996. As the economy reaches full capacity, inflation is likely to accelerate. However, the signs of significant acceleration are weak, and it may be that recent labour market developments in the US have helped reduce the speed of response of wages to labour shortages. We discuss this further in Section II.

Interest-rates and Exchange-rates

The precise scale of the recent exchange-rate movements depends on the choice of indicator. The IMF trade-weighted effective index suggests that the US dollar fell by 8 per cent in the three months to the end of April, with a particularly sharp depreciation in March. Our own estimates, shown in Tables 3 and 4, may differ a little both through allowing for the small dollar recovery in the early part of this month and because they reflect the structure of trade within the 1994 version of the OECD, and do not include the sharp appreciation of the dollar against the Mexican peso at the start of the year. This is less likely to affect the estimates of the real effective rate, since inflation in Mexico is likely to be considerably higher than in the US, with consumer prices rising by 8 per cent in April alone.

In examining the factors that may have contributed to recent currency movements, it is useful to separate the long-term factors that have affected the demand for the yen and the US dollar from the short-term factors that have also influenced the pattern of exchange rates within Europe.

In the 1980s, the persistent Japanese trade surplus with the US was largely offset by a high level of long-term capital investments in the US by Japanese companies and financial institutions. The former saw foreign direct investment as a means of ensuring market access, while the latter were attracted by the relatively high yields on US government bonds. Although a gradual appreciation of the yen meant that institutions incurred capital losses on such investments, these were more than offset by the capital gains arising from domestic asset price inflation.

In the early 1990s, Japanese asset prices collapsed and corporate profitability was reduced, leading to a reduction in foreign direct investment and the repatriation of many portfolio investments. The share of foreign currency assets in the portfolios of Japanese life assurance companies for instance fell from 15 per cent in 1989 to around 8 per cent in 1993. However, there was little change in the trade surplus over this period, reflecting the different cyclical positions of the Japanese and US economies as well as the longer-term demographic factors behind the high level of domestic saving and the need to accumulate overseas assets.

Although the level of longer-term capital investments from Japan began to recover in 1994, there was little impact on the demand for dollar-denominated assets, with foreign direct investment increasingly directed at East Asia, and some $65 billion of a net portfolio investment of $75 billion being in Euro-Yen securities. (Although these are overseas assets the currency risk is borne by the sellers.) At the same time, US pension funds began to raise the share of their portfolios held overseas, with US investment in Japanese securities rising from $2.3 billion in 1993 to $16.5 billion last year. The net impact of these developments was to bring about a rise in the long-run demand for the yen relative to the dollar, with the prime counterpart to the US current account deficit in 1994 being an inflow of $106 billion of short-term investments within the banking sector. Such investments are liable to be considerably more responsive to changes in sentiment than longer-term investments such as foreign direct investment.

It is arguable that the growing discrepancy between dollar assets and yen liabilities in many parts of the banking sector, particularly in Asia, has helped to generate much of the recent realignment of the yen against the dollar. The shift in portfolio preferences, if maintained, would be consistent with the need for the US to have a smaller trade deficit, particularly with Japan. Recent policy developments in the US and Japan that might have reduced the relative supply of dollars have proved disappointing, with the latest set of deregulation measures planned by the Japanese government being limited, and a balanced budget amendment (implying a higher level of public saving) being defeated in the US Congress in February. The changes in the bilateral exchange rate can be viewed as an alternative means of ensuring the necessary reduction in the relative supply of dollars required by the changing structure of institutional portfolios.

Elsewhere, much of the short-term currency volatility was initially triggered by the devaluation of the peso and the 'flight to quality' that the devaluation induced, with a flow of funds out of countries with large public sector or current account deficits, such as Canada, Sweden and Italy, as well as from Latin America. These funds were not, on the whole, moved to the US both because of its exposure to the Mexican problem, and because of the increased perception that the US economy was beginning to slow, reducing the likelihood of future interest-rate increases. Market interest rates drifted down in the US in the early part of the year, as can be seen from Chart 3. Within this context the relative strength of the D-mark, and closely associated currencies such as the schilling and the guilder, is relatively easy to understand. It appears that political uncertainties lie behind much of the pressures placed on sterling and the franc in recent months.
Table 2. Short-term interest rates


 Per cent


 US Japan Germany France Italy UK


1991 5.8 7.4 9.2 9.6 11.1 11.5
1992 3.7 4.5 9.5 10.3 13.0 9.6
1993 3.2 3.0 7.2 8.6 8.8 5.9
1994 4.6 2.2 5.3 5.8 7.6 5.5
1995 6.3 1.7 4.8 7.0 10.7 7.4
1996 6.9 1.9 5.3 6.5 12.3 8.6
1997 7.1 2.5 5.7 6.2 12.5 8.6
1998-2002 7.1 4.1 6.5 6.5 12.5 7.4


1993 I 3.1 3.4 8.3 11.8 12.2 6.4
 II 3.1 3.2 7.6 8.0 8.7 5.9
 III 3.1 3.0 6.8 7.8 7.2 5.9
 IV 3.3 2.3 6.3 6.7 7.0 5.6


1994 I 3.5 2.2 5.8 6.3 7.2 5.3
 II 4.3 2.2 5.2 5.7 7.3 5.2
 III 4.9 2.3 5.0 5.6 7.9 5.5
 IV 5.9 2.3 5.3 5.7 8.1 6.1


1995 I 6.2 2.2 5.1 6.0 9.2 6.7
 II 6.2 1.4 4.5 8.0 10.9 7.1
 III 6.4 1.5 4.7 7.0 11.2 7.8
 IV 6.6 1.6 4.9 6.9 11.5 8.1


1996 I 6.7 1.6 5.1 6.7 11.8 8.6
 II 6.9 1.8 5.3 6.6 12.4 8.6
 III 7.0 2.0 5.4 6.5 12.5 8.6
 IV 7.1 2.2 5.5 6.4 12.5 8.6
Table 2a. Long-term interest rates


 Per cent


 US Japan Germany France Italy UK


1991 8.2 6.2 8.4 9.4 11.3 9.9
1992 7.5 5.1 7.8 8.9 12.1 9.1
1993 6.5 4.0 6.3 6.8 9.2 7.9
1994 7.4 4.3 7.2 7.8 9.4 8.0
1995 7.4 3.6 7.0 7.8 13.5 8.4
1996 7.6 3.8 6.9 7.7 13.5 7.9
1997 7.6 4.5 7.1 7.6 13.5 7.5
1998-2002 7.6 5.2 7.1 7.6 13.5 6.4


1993 I 6.9 4.4 6.6 7.8 11.2 8.6
 II 6.6 4.5 6.8 7.0 10.1 8.5
 III 6.2 3.9 6.2 6.4 8.1 7.5
 IV 6.1 3.2 5.8 5.9 7.6 6.9


1994 I 6.5 4.0 6.4 6.8 8.0 6.9
 II 7.4 4.3 7.1 7.9 8.9 8.2
 III 7.7 4.5 7.6 8.3 10.4 8.6
 IV 8.1 4.5 7.5 8.4 10.3 8.5


1995 I 7.7 3.7 7.3 7.8 13.5 8.5
 II 7.2 3.5 6.9 7.8 13.5 8.4
 III 7.3 3.5 6.9 7.8 13.5 8.3
 IV 7.4 3.6 6.9 7.8 13.5 8.2


1996 I 7.5 3.7 6.9 7.7 13.5 8.1
 II 7.6 3.8 6.9 7.7 13.5 8.0
 III 7.6 3.9 7.0 7.7 13.5 7.9
 IV 7.6 4.0 7.0 7.7 13.5 7.8


[TABULAR DATA FOR TABLE 3 OMITTED]
Table 4. Real effective exchange rates


year average US Japan Germany France Italy UK


1991 93.9 92.6 95.1 94.4 107.0 108.9
1992 93.5 96.9 98.3 96.0 105.7 106.2
1993 97.1 114.0 103.3 98.9 91.8 98.1
1994 96.7 120.6 103.5 98.9 89.5 98.5
1995 90.1 135.3 108.8 100.2 79.2 93.8
1996 89.1 141.8 109.7 98.8 77.5 92.9
1997 89.8 145.8 109.8 98.0 76.4 93.9


1993 I 98.1 104.4 103.3 100.1 91.1 95.2
 II 95.3 113.8 102.5 99.5 93.1 97.7
 III 96.6 120.7 102.9 97.6 92.9 99.8
 IV 98.3 117.3 103.7 98.2 90.1 99.6


1994 I 98.8 117.8 102.2 98.6 89.3 100.2
 II 97.9 121.1 102.8 98.1 91.4 98.4
 III 95.4 122.0 104.6 99.5 89.5 97.2
 IV 94.6 121.5 104.6 99.3 87.7 98.2


1995 I 94.1 123.6 107.0 100.1 83.4 95.0
 II 88.8 138.9 109.2 100.7 77.7 93.4
 III 88.8 139.2 109.4 100.1 77.8 93.5
 IV 88.8 139.6 109.5 99.7 77.8 93.3


1996 I 88.8 140.5 109.5 99.2 77.8 93.1
 II 88.9 141.6 109.6 98.9 77.6 93.0
 III 89.1 142.2 109.8 98.7 77.3 92.9
 IV 89.4 142.8 109.9 98.5 77.1 92.7


The recent appreciation of the yen and the D-mark could be reversed if it were possible to cut domestic short-term interest rates significantly. The Bundesbank announced an unexpected cut of 1/2 a percentage point in the discount rate in March, in spite of increasing worries about the prospective growth of domestic pay settlements. Our forecasts in Table 2, based on the present term structure of interest rates, suggests that German rates may in fact rise a little in the coming months. The Bank of Japan also cut its discount rate in April, taking the rate to 1 per cent, with long-term rates having fallen by a point since the last quarter of 1994. As we cannot envisage negative short rates, there appears to be little scope for further significant reductions. It is difficult to assess the short-term real interest rate in Japan, as commonly used price indices are often biased upwards. However, the Consumers Expenditure Deflator is not expected to fall, and hence we estimate real short rates are around 1 1/2 per cent.

Our exchange-rate forecasts in Table 3 are based on current exchange rates and the profile of interest rates implied by the forward markets. Our monetary policy assumptions imply that the yen will not revert to its previously projected nominal path, with the implied overvaluation continuing to put downward pressure on inflation. Table 4 reports our forecast for real exchange rates. We are anticipating little change from the current pattern, in spite of some significant real misalignments, particularly within Europe. If these misalignments can only be corrected by inflation differentials then inevitably the process is slow, as wage and price adjustment is much slower than currency movements. This pattern of real rates has a strong influence on the prospects for developments in the real economy, with slow growth in Japan matched by stronger growth in the UK, Italy and the US.

World Trade and Commodity Prices

The continuing vigour of the US economy, along with a strengthening recovery in Europe, meant that world trade grew by over 10 per cent in 1994, the best outturn for almost two decades. There were other factors driving stronger growth, such as trade liberalisation in North America and the Asia-Pacific region. Chinese exports rose almost a third in value during the year. Overall, Asia increased its exports and imports by 15 percent. Trade also grew rapidly in Latin America, and in east and central Europe, where exports rose by 20 per cent partly as a result of changing institutional arrangements within the former Soviet bloc. However, this group of countries have been moving towards a visible trade surplus, and imports have not grown as rapidly. Trade growth was much weaker in Africa and the Middle East, reflecting the continuing effects of weak oil prices.

There have been an increasing number of trade liberalisation measures in the last two years, and fears of the growth of a tri-polar world consisting of three closed regions (Europe, North America and the Asia-Pacific rim) have receded. Policy developments in Europe have continued to encourage the growth of internal trade which rose from 53 per cent of the total trade of European countries in 1958 to over 70 per cent 1994. However, Europe appears to be the only consciously closed trading region in the world economy. Recent developments on the Pacific rim appear to be producing an 'open' trading region with groups of countries undertaking mutual multilateral tariff reductions. Countries such as Thailand significantly reduced their external tariffs in the last year. If the Uruguay round is fully implemented, then up to 43 per cent of imports of industrial goods by developed countries could attract a zero tariff under 'most favoured nation' agreements, with the rest having an average tariff of less than 7 percent. The US is also committed to more open trade, and has recently proposed significant tariff reductions for developed country trade, especially in relation to the EU and Japan. All these continuing developments are likely to keep trade growth strong for some time to come.

However, it is unlikely that overall world trade will continue to expand at 10 per cent a year in 1995, and our forecast suggests a slowdown, albeit to over 8 percent. Currency turmoil is only likely to have a marginal impact on trade. We are anticipating that output growth will be strong, apart from in Japan, helping to maintain the strong growth of trade. We expect a further slowdown into 1996 as US growth declines. We also presume that in the longer-term Chinese trade cannot continue to grow at such a breakneck speed. Our present projections have world trade growth settling at around 6.5 per cent per annum in the medium term. This is still well above the average of the last 40 years, and compares favourably with the last decade.

The strength of trade was one factor behind strong commodity prices over the last nine months. Table 5 reports our commodity price forecasts, as well as our projections for oil prices. Oil prices strengthened in the second quarter of 1995, with the Brent spot price averaging over $18 a barrel in April compared to around $16 a barrel in the fourth quarter of 1994. Oil prices rose in part because of concerns about the ability of the former Soviet Union to maintain the recent high level of exports of oil and gas, with declining production and increasing technical failures. For instance, prices rose markedly after the large gas pipeline explosion north of Moscow in late April.

Minerals and metals prices rose consistently in 1994, with strong demand for copper and other metals, especially from China and the rest of the Pacific rim. However, as can be seen from Chart 4, copper prices have been approximately constant in dollar terms since the start of the year, despite recent dollar weakness, implying falls in domestic currency terms. Other metals prices appear to have reached a peak in January, and have generally been falling since then possibly reflecting a perception that demand from North America was beginning to slow. Aluminium prices in April were over 10 per cent below their January level, and nickel and zinc prices also fell. We feel that prices have passed their peak, and are liable to fall in real terms in the next few years.

Recent price moderation has also coincided with a resurgence of speculative pressures within foreign exchange markets. In the November Review we argued that much of the increase in metals prices was driven by an inflow of funds from bond markets world-wide; these funds may have now been moved into the exchange markets.

Agricultural support policies in the developed world are gradually being scaled down, and there is some evidence that surpluses are no longer endemic. However, reductions in administered prices in Europe and export subsidies in the US may put upward pressure on free market prices in the medium term, reversing their tendency to fall. In the shorter term grain prices, which had been strong, have fallen somewhat, with wheat prices in April around 12 per cent lower than they were in October. This reflects the influence of good harvests in the Southern hemisphere. Prices are slightly lower than we anticipated in February. Coffee prices have also fallen from their high levels of last October, although it will be some time before the increases seen in 1994 are fully reversed. Frosts in Brazil a year ago badly damaged both the coffee harvest and the bushes, and output is not expected to recover for over a year. Overall, short-term inflationary pressures from commodity markets seem to be disappearing, which should help keep world inflation in check over the next year or so.

[TABULAR DATA FOR TABLE 5 OMITTED]

Section II. Developments in North America and Japan

United States

The US economy grew by 4.1 per cent in 1994, the fastest annual expansion for a decade, with the level of employment rising by some 3.5 million workers and capacity utilisation remaining well above its long-term average level. Monetary policy was gradually tightened, with the Federal Funds rate rising by 3 percentage points to 6 per cent over the year to February. However the impact on overall monetary conditions was offset by some easing in bank lending criteria and by the recent depreciation of the dollar. Recent data have sent conflicting signals about the state of the economy. Consumer confidence rose to a five year high in April, but business confidence weakened a little and unemployment showed an unexpected jump to 5.8 per cent, with a small fall in the level of employment. On balance it appears that the pace of activity has begun to slow. The provisional estimates for the first quarter of 1995 suggest that GDP grew by some 0.7 per cent in the quarter, compared to quarterly growth rates of 1 and 1.2 per cent respectively in the latter half of last year. We expect that growth will remain around this level for much of the year, giving calendar year growth of close to 3 1/2 per cent.

The US authorities have done little to influence the level of the dollar in recent months. In part this may reflect the dual desire to penetrate the Japanese market while maintaining competitiveness within the North American trade zone. We estimate that the real dollar effective exchange rate will have fallen by around 5 1/2 per cent in the current quarter, with the real depreciation against the yen and many European currencies being offset by a sharp appreciation against the peso (and many other Latin American currencies) and relative stability against the Canadian dollar. These currency changes have been accompanied by a rise of nearly 10 per cent in equity prices since the start of the year and a gradual easing in long-term interest rates, reflecting an increased perception that the pace of domestic activity has begun to slow.

The slow-down in activity was led by the personal sector, with the growth of housing starts and car sales declining markedly, possibly reflecting the impact of higher interest rates. In the first quarter of this year, personal consumption only rose by 0.4 per cent, although the volume of expenditure was some 2 3/4 per cent above that of a year earlier. Even so, consumer confidence continued to strengthen, possibly as a result of improved expectations about future employment prospects. A number of commentators have also argued that expenditure was temporarily depressed in the first quarter due to an unexpected delay in income tax repayments. We expect that expenditure will continue to grow, with real incomes underpinned by continued growth in labour income and improvements in the net worth of the personal sector following the recent changes in asset prices. Real net financial wealth is expected to grow by around 3 1/4 per cent this year, more than offsetting the decline that arose in 1994 from the rapid build-up of consumer debt and the weakening of domestic equity prices. For the year as a whole, consumption is projected to rise by a little under 3 per cent, with a small rise in the savings ratio to 5.1 per cent.

[TABULAR DATA FOR TABLE 6 OMITTED]

Corporate demand continued to strengthen appreciably in the first quarter, with further growth in inventory holdings and a quarterly rise of 4 1/2 per cent in fixed investment. Over the three years since the first quarter of 1992, the volume of business fixed investment has risen by 46 per cent, with particularly sharp growth in expenditure on computers and other office equipment, partly as a result of declining product prices. Inventory holdings rose sharply in both the wholesale and retail sectors in the second half of 1994. While this is consistent with the slowdown in retail demand, there is also anecdotal evidence that concerns were mounting about prospective delays in supply. Stocks also rose sharply in the farm sector due to favourable crop conditions. In contrast, agricultural stocks had declined in 1993 following droughts in the mid-west. Overall, inventory growth in the second half of 1994 accounted for around half of the 2.1 per cent growth in GDP from the first half of 1994.

Our forecasts for this year and next are partly shaped by the expected cycle in inventory and business investment, with expenditure slowing as final demand from the personal sector begins to moderate. Stockbuilding is projected to add only 0.1 per cent to GDP growth this year and reduce it by 0.2 per cent next year. There is some evidence that the widespread use of 'just-in-time' technology has imparted a downward trend to the inventory-sales ratio of the business sector. In the short term, stock levels may also be moderated by increased export demand following the recent depreciation of the dollar. Investment growth is projected to moderate in the coming months, with capacity utilisation declining gently from the peak levels obtained in the early part of this year.

Although the labour market tightened considerably over the course of 1994, particularly in regions such as the mid-west, earnings growth has remained subdued. With unemployment falling to around 5.5 per cent by the year end, past experience would have suggested that earnings growth should have begun to accelerate. Instead the rate of growth in the employment cost index fell steadily throughout 1994, reaching 3.1 per cent in the fourth quarter. Compensation per head rose by 3.2 per cent on a calendar year basis. Early data for 1995 suggest that earnings growth has yet to pick-up, with growth in the employment cost index continuing to moderate in the first quarter. For the year as a whole, we expect average compensation to rise by 3.4 per cent.

It is possible that recent changes in business organisation have improved the efficiency of the labour market. One notable feature of the present expansion has been the increased use of temporary supply workers, both in the service sector and in manufacturing industry. Although personal supply employment only accounts for around 2 per cent of the total workforce, employment in this sector has grown rapidly since 1992, accounting for over 15 per cent of total employment growth. It is likely that the increased use of such workers has improved the efficiency and flexibility of many industries. At the same time, marked structural changes occurred in the private health-care system, in spite of the failure of the Clinton administration to achieve its desired reforms. The proportion of employers using some form of 'managed' [TABULAR DATA FOR TABLE 7 OMITTED] health-care scheme rose to 63 per cent in 1994, from 52 per cent in 1993 and 29 per cent in 1988. Such schemes are designed to offer greater control over costs, with managing agents offering close supervision of health-care providers. The average health costs for companies with ten or more employees fell by 1.1 per cent in 1994, helping to restrain the overall growth in compensation.

Although the prices of some intermediate goods picked up sharply over the course of 1994, total consumer price inflation was unchanged from 1993 at around 2.7 per cent. The aggregate consumers' expenditure deflator (CED), shown in our forecast tables, rose more slowly, at a little over 2 per cent. The producer prices of finished goods rose by 1 1/4 per cent, while economy-wide unit labour costs rose by 1.6 per cent. Inflation rose a little in the early months of this year, with producer prices increasing by 1.6 per cent in the year to March and consumer price inflation rising to around 3 per cent. The provisional National Accounts estimates suggest that CED inflation rose to 2.65 per cent in the first quarter. It is likely that this reflects the high levels of resource utilisation in the economy. For the 1995 calendar year, we expect the CED to rise by a little under 3 per cent, implying consumer price inflation of around 3-3.5 per cent, in line with the projections of the Federal Reserve for the year-end. Import prices are projected to rise by over 9 per cent in the aftermath of the dollar depreciation. We therefore expect to see some further tightening in the monetary stance over the course of the year, with short-term interest rates rising to over 6.5 per cent by the year end, and 7 per cent in 1996.

The current account deficit rose sharply in 1994, to 2.3 per cent of GDP, with import volumes rising by around 15 per cent, helped by the strength of domestic demand. Imports of capital goods rose by over 25 per cent, largely from the newly industrialised countries in Asia and Japan. Export volumes also increased sharply, helped by the recovery in many industrialised countries and improved market access in North America. The balance on investment income shifted to a deficit of $15.2 billion in 1994 from a small surplus in 1993, primarily due to a marked rise in payments of income on inward foreign direct investment after three years of sustained growth in domestic profitability.

We expect that the current account deficit will worsen this year, possibly rising to as much as 2.9 per cent of GDP. In part this reflects the impact of the changes made to the forecast in the light of recent financial market developments. The initial impact of these changes is to widen the US deficit, both because of the stimulus to domestic demand (see Box A), and because the initial rise in import prices temporarily serves to widen the trade deficit before volumes fall back. However, it appears that trade with Mexico will also be significantly affected by the sharp depreciation of the peso and the resulting austerity measures introduced there. Over the last two years the US has had a small trade surplus with Mexico averaging around $0.8 billion per annum. In the first two months of 1995, the US had a bilateral trade deficit of some $2.2 billion.

We expect to see some significant improvement in the overall current account in 1996 and 1997 reflecting a combination of the lower real exchange rate, the moderation of import growth as the investment boom subsides [TABULAR DATA FOR TABLE 8 OMITTED] and a rise in earnings from US overseas investments, particularly in Europe.

The fiscal outlook has steadily improved over the last two years, reflecting the beneficial impact of above-trend growth on tax revenues, the expenditure controls introduced in the 1993 Omnibus Budget Reconciliation Act, and the increasing number of states with balanced budget objectives. Such an amendment has not yet been introduced at the Federal level, with the proposed legislation to achieve a balanced budget by 2002 being defeated in Congress. The draft Federal budget for the 1996 fiscal year, announced in February, simply aims to reduce the deficit in real terms over the next five years, with some additional expenditure constraints being used to finance a proposed series of 'middle class' tax reductions worth $63 billion (approximately some 0.15 per cent of GDP) over this period. We expect that the combined Federal and state deficits will amount to around 2 per cent of GDP in the 1995 and 1996 fiscal years, with higher tax revenues being partially offset by higher interest payments.

Canada

The Canadian economy grew rapidly in 1994, with the latest provisional figures suggesting that GDP rose by 4.5 per cent, the fastest annual growth rate since 1988. In spite of this, inflation continued to moderate, with the official consumer price index rising by 0.2 per cent and total home costs, as measured by the GDP deflator, growing by some 0.6 per cent, the lowest inflation rate since the early 1960s. Interest-rates have risen sharply since the early months of last year, reflecting both the rise in US interest rates over this period and increasing concern about the domestic fiscal situation. Fiscal policy was also tightened in the Federal Budget for the 1995-6 financial [TABULAR DATA FOR TABLE 9 OMITTED] year, announced at the end of February, and, with the growth of the US economy beginning to moderate, it is likely that the pace of expansion in Canada will also begin to slow. We presently expect growth of some 3.7 per cent this year and 3 per cent in 1996.

The economy grew by 1.4 per cent in the fourth quarter of 1994, with a marked increase in both consumers expenditure and business investment. In contrast, the volume of government final expenditure and residential investment both declined. Net exports also rose sharply, helped by robust overseas growth and the improvement in competitiveness resulting from the depreciation of almost 20 per cent in the Canadian real effective exchange rate over the last three years. Over the course of the year, the recovery in consumers expenditure was accompanied by a decline in the savings ratio to 6.7 per cent by the fourth quarter, the lowest level for 23 years. Consumer confidence also improved sharply, with employment rising by over 2 per cent in 1994, and the unemployment rate falling over the course of the year from 11 per cent to 9.6 per cent. Business investment was stimulated by rising capacity utilisation and improved profitability, with pre-tax profits rising by 41 per cent in 1994, following a rise of 20 per cent in 1993.

We expect some moderation in the growth of all components of domestic demand this year, reflecting the gradual impact of the rise in interest rates since the start of 1994. Private sector credit demand has already weakened, and the volume of expenditure on durable goods and residential investment has begun to contract. The volume of government consumption fell by over 2 per cent in 1994 and we expect a further (calendar year) decline in 1995.

Aggregate consumer prices in the fourth quarter of last year were unchanged from a year earlier; excluding food, energy and indirect taxes, underlying inflation was around 1 1/2 per cent, in the middle of the target range of 1-3 per cent set for the end of 1995. Headline inflation subsequently rose to 2.2 per cent in March, with last year's reduction in tobacco taxes dropping out of the annual figures after February. Industry selling prices rose by 9 1/2 per cent in the year to the first quarter of 1995, largely driven by higher commodity prices, with paper prices rising by over 18 per cent. It is likely that the rise in producer prices will have a stronger effect on export prices (and the aggregate GDP deflator) than on the price of domestically consumed goods. However, we do expect some further pick-up in aggregate consumer price inflation over the course of the year, helped by a rise of 8 1/2 per cent in import prices and the increase in petrol duties in the Federal Budget. It is likely therefore that underlying inflation will be close to the top of the target range, inducing further upward pressure on interest rates. Long-term interest rates are expected to average 8.6 per cent this year and 8.8 per cent in 1996.

As in the United States, wage growth continued to moderate while the economy expanded rapidly. In the three months to February, industry earnings per week were some 1.8 per cent higher than a year earlier. In 1994 as a whole, average compensation per employee rose by only 1 per cent. With productivity rising by 2.3 per cent, unit labour costs fell by 1.3 per cent. We expect some pick-up in compensation growth in the latter part of this year as the labour market begins to tighten, with unemployment possibly falling to around 8.7 per cent by the year end, the lowest level for five years.

The Canadian dollar came under pressure at the start of the year in the aftermath of the devaluation of the Mexican peso, amidst investors concerns about the sizeable public and external deficits. More recently the triple A credit rating of Canada's debt was downgraded by Moody's, the major US credit rating agency. Canada is particularly vulnerable to changes in sentiment, with over a quarter of total public debt held by foreign investors. The outstanding debt of both the Federal and provincial governments has risen sharply in recent years to an estimated 92 per cent of GDP in 1994. With much of the debt being short term, changes in market interest rates can have a significant impact on the public finances. Federal government estimates suggest that each one percentage point rise in interest rates initially adds around $1.9 billion to the fiscal deficit (0.25 per cent of GDP).

The Federal Budget announced at the end of February confirmed the authorities' previously stated intention of achieving a budget deficit of 3 per cent of GDP in the 1996-7 fiscal year, from an estimated deficit of around 5 per cent of GDP in the 1994 fiscal year. With interest rates having risen by some 3-4 percentage points since the plans made in the 1994 Budget, a number of new fiscal measures were announced, designed to raise an additional C$29 billion over the next three fiscal years (equivalent to nearly 1 1/4 per cent of GDP over this period). Over C$25 billion was obtained from expenditure savings, with a planned reduction in the level of business [TABULAR DATA FOR TABLE 10 OMITTED] and transportation subsidies and defence expenditures. Additional tax revenue is to be raised from petrol duties and corporate tax surcharges. Changes were also made to the system determining transfers to provincial governments, with block grants to replace the existing system of 'cost sharing' in which transfers were effectively determined by provincial expenditure decisions. It is likely that the additional fiscal measures will help to slow the pace of economic activity, with the Federal work-force planned to be reduced by 45,000.

Fiscal consolidation is also being pursued by many provincial governments, with six out of ten administrations having tabled balanced budgets for the 1995 fiscal year. We estimate that the total public sector deficit may fall to around 3.3 per cent of GDP in the present fiscal year and 2.1 per cent of GDP in 1996-7, helping to stabilise the debt stock at around 90 per cent of GDP.

We also expect some further improvements in the external deficit over the next two years, with the surplus on the visible trade rising to 3.1 per cent of GDP and the current account deficit falling to around 2 1/2 per cent of GDP. Export and import volumes both rose by over 13 per cent last year, with cross-border trade with the United States growing more rapidly than trade with other nations. We expect further sizeable growth this year, with net exports continuing to benefit from the depreciation of the Canadian dollar over the last three years.

Japan

The Japanese economy remains fragile. Although the trough of the recession has officially been dated at October 1993, output growth is still hesitant, with a surprise fall of 0.9 per cent in GDP in the fourth quarter of 1994. Over the year as a whole, output rose by a little over 0.5 per cent, a considerably slower recovery than from the previous recessions in the late-1970s and mid-1980s. Industrial production rose by 3 per cent in the 1994 fiscal year, but was accompanied by a gradual rise in stocks of unsold goods, with domestic demand remaining subdued and export performance constrained by the continual appreciation of the real exchange-rate. This rose by some 20 per cent over the two years to the start of 1995, and we estimate that the recent turmoil on the currency markets has resulted in a further appreciation of around 15 per cent. This, along with the sharp drop in equity prices in the last four months, can be expected to slow the pace of recovery considerably in the coming months, in spite of the reduction in the discount rate to 1 per cent in April.

We have made significant revisions to our forecasts for 1995 and 1996, with growth now projected at 0.8 and 3.1 per cent respectively, compared to 2.2 and 3.7 per cent in February. In part this reflects the estimates of the effects of the recent changes in financial markets, as shown in Box A. However the immediate outlook for the economy has also been affected by the unexpected drop in GDP in the fourth quarter of last year, suggesting that domestic demand remains weak, and the slow official response to the damage caused by the Kobe earthquake in January.

The scale of the disruption arising from the earthquake has become clearer since our last forecast, with official estimates suggesting that the eventual reconstruction costs will be around Y10 trillion (2 per cent of GDP), implying that around 1 per cent of the national capital stock was destroyed. The short-term impact on the economy was marked, with export volumes in January being some 6 per cent lower than a year earlier, with the closing of Kobe estimated to be responsible for over 80 per cent of this shortfall. The scale of the eventual government response remains unclear; a second supplementary budget for the 1994-5 fiscal year was passed at the end of February containing additional measures worth Y1 trillion. These included details of tax relief for earthquake victims and subsidies for housing construction and small firms. More recently, the Cabinet proposed another package of measures worth Y2.7 trillion to finance reconstruction expenditure. However, it appears increasingly unlikely that any such measures will get underway until the latter part of the year. We continue to assume that the public sector will eventually take measures to meet around Y4-5 trillion of the cost of the earthquake. However, in contrast to our February forecast, we now expect that the earthquake will have a negative impact on growth this year, although it is to be expected that the reconstruction effort will add significantly to growth in 1996.

There have also been demands for further fiscal measures from many industrialists in the aftermath of the recent exchange-rate movements. The government recently proposed a package in which some of the expenditure in the planned ten year public works programme would be brought forward, but did not announce any detailed actions. As with the response to the Kobe earthquake, it is likely that this does not simply reflect the difficulties in reaching agreement between the partners of the present coalition government. It primarily reflects the limited scope for additional measures, since much of the public capital expenditure originally planned for this year and 1996 had already been brought forward in order to support activity in the recession. Thus 1995 and 1996 were intended to be periods of fiscal consolidation after an estimated deficit of 2.3 per cent of GDP in the 1994 fiscal year, equivalent to a deficit of around 6 per cent of GDP if the present surplus of the social security funds is excluded. Instead, we now expect deficits of over 3 per cent of GDP in both the 1995 and 1996 fiscal years, with outstanding debt rising to 84 per cent of GDP. It is already intended that the sales tax be raised in 1997; we expect that additional tax measures will also be introduced, given the pressing need to obtain sound public finances before welfare payments rise sharply in the next century as the population ages.

Asset price deflation continues to have a deleterious impact on the health of the economy. Property prices are estimated to have fallen by 10 per cent in 1994, the fourth consecutive annual decline. Equity prices have also fallen sharply this year, reflecting concerns about the impact of appreciation of the yen, with prices at the end of April around 20 per cent lower than at the start of the year. Many financial institutions have also suffered marked reductions in the value of their overseas assets, although this was partially offset by capital gains from domestic bond holdings, with the rate of return on five year government bonds falling from 3.9 per cent at the end of January to 2.6 per cent at the end of April. Overall, it is likely that this series of price adjustments has induced significant further pressure on the balance sheets of the banking sector and parts of the corporate sector that have historically relied on high earnings from financial asset holdings. Total bank lending in the latter half of last year was some 0.3 per cent lower than the year before. The Bank of Japan attempted to restore confidence in the financial system by reducing the official discount rate from 1.75 per cent to 1 per cent in April, the first change since September 1993. There is clearly little scope for any significant further relaxation in policy, even though current real interest rates remain high as goods price inflation is negligible.

The prices of many consumer and producer goods and services have declined over the past year. Aggregate producer prices in the first quarter of 1995 were some 0.9 per cent lower than a year earlier, after a decline of over 1 1/2 per cent in 1994. National consumer price inflation was estimated at around 0.1 per cent, although the index is widely believed to overstate inflation as it excludes many of the new discount stores. The National Accounts data suggests that the overall consumers' expenditure deflator, taking account of a broader range of expenditure, rose by 0.3 per cent in 1994, some 0.4 per cent below official consumer price inflation. We expect that the CED will be little changed in 1995, with import prices falling sharply and continued moderation in the growth of labour costs. Import prices fell by 3 1/2 per cent in March, although they remained some 2 1/2 per cent above their average level a year earlier.

Whilst wage growth has steadily moderated over the past few years, stable prices have helped to support personal income in real terms. Incomes have also been raised by the reductions in personal taxation introduced last year. Thus consumption has grown with little change in the personal savings ratio. We expect that consumers expenditure will grow by 2 per cent this year, although there is a risk that this will prove optimistic if consumer confidence does not recover from its subdued level in the aftermath of the Kobe disaster. With many households having foregone building insurance, it is also possible that the growth in disposable income will be constrained if government support is more limited than presently expected. Expectations of short-term prospects may also have been influenced by the weak labour market. Unemployment rose to 3 per cent in March, the second highest monthly rate on record. A clearer picture of labour market [TABULAR DATA FOR TABLE 11 OMITTED] slack is provided by the ratio of job offers to applications which has stabilised at 0.64 (3 applicants for every 2 jobs) over the course of the last 12 months, compared to a peak of 1.41 at the height of the boom in 1990-1.

Over 1994 as a whole there was some growth in all categories of domestic demand, with the exception of corporate investment. However expenditures by the personal sector and the government declined in the fourth quarter, with private housing investment falling by 5.9 per cent and public sector investment falling by 0.5 per cent, reflecting the extent to which the fiscal measures that supported activity throughout the recession were brought to an end. Net imports of goods and services continued to rise, reflecting the impact of the continual appreciation of the real effective exchange rate and the gradual deregulation of domestic markets. There are some signs that the prospects for corporate investment have begun to improve a little, with a rise of 0.4 per cent in business fixed investment in the fourth quarter of 1994. Whilst business surveys continue to indicate a small planned reduction of 1 per cent in investment expenditure in 1995, it is possible that the volume of investment may still rise given the present declines in the prices of many capital goods.

In 1994 as a whole net import growth reduced GDP growth by 0.5 per cent, with particularly strong growth in manufacturing imports. The combination of the recent appreciation in the yen and the expected rise in domestic demand over 1995-96, may result in growth of net imports reducing GDP growth by a little over 1.5 per cent this year and a further 1 per cent in 1996. On a dollar basis the current account surplus is projected to decline to $120 billion this year (2.2 per cent of GDP) and $109 billion in 1996 (1.8 per cent of GDP). The medium-term decline is considerably faster than shown in our previous forecasts, with the surplus averaging only 1 per cent of GDP.

In part, the recent changes in the pattern of trade and the slow recovery in domestic corporate investment reflect changes in the pattern of industrial organisation, with many manufacturing corporations increasingly expanding overseas production, particularly elsewhere in East Asia, with the intention of serving both local markets and re-exporting back to Japan. It is likely many Japanese companies will continue to raise the level of output produced overseas, with foreign costs falling in domestic currency terms as the real exchange rate appreciates. The February Tankan Survey indicated that manufacturing corporations planned to raise capital investment overseas by 3.4 per cent in the 1995 fiscal year, but reduce domestic capital expenditure by 1.7 per cent. The share of output produced overseas rose sharply in some sectors; for example foreign output accounted for 29 1/2 per cent of production by Japanese car makers in 1994, compared to 18.7 per cent in 1990. However, across manufacturing as a whole, foreign production accounts for a considerably lower proportion of output than in other countries such as the UK and the US, suggesting that the observed restructuring in recent years can be expected to continue.

Section III. Prospects for Europe

With most of the data from national accounts now available, we estimate that real GDP in the European Union grew by a little over 2 1/2 per cent in 1994, representing a strong recovery from the drop in output of 1/2 per cent in 1993. Inflationary pressures remained subdued, with consumer price inflation across the whole of the EU falling from just over 4 per cent in 1993 to around 3 1/2 per cent last year. However unemployment rose significantly in most continental economies, with Eurostat estimates suggesting that aggregate unemployment in the EU rose from 10.9 per cent in 1993 to 11.3 per cent in 1994.

Financial markets have been affected by significant political uncertainty in some countries, particularly Italy and Spain, but also more recently in France, bringing upward pressure on interest rates and some depreciation of exchange rates against the D-mark in these countries. Although German short-term interest rates fell from 5.2 per cent at the end of 1994 to around 4 1/2 per cent in early May, rates climbed in many other European countries. The differential between French and German short rates rose from 50 to 350 basis points over this period and the gap between German and Italian short rates rose from 290 to 640 basis points. However, the long-term interest differential between France and Germany did not change significantly. We continue to assume that some form of Economic and Monetary Union takes place in Europe in 1999, with membership consisting of an inner core of Germany, France, the Benelux countries, Austria, and possibly Denmark and Ireland. Other countries, such as Italy and Spain, have faced rising long-term interest rates since the start of the year. These rises in interest rates will cause government debt interest payments to rise and increase the fiscal adjustment needed to meet the Maastricht public finance criteria. We discuss the prospects for Economic and Monetary Union below, and in Box C.

Throughout 1994 there was a steady rise in economic confidence in Europe. According to the European Commission's Economic Sentiment Indicator(1), general economic confidence rose to a four year high. The improvement in confidence was concentrated in the manufacturing sector, with much smaller rises in confidence in the construction and retail sectors. Consumer confidence, which fell to very low levels in 1993, increased significantly in 1994, although this has yet to be fully reflected in expenditure. In the early months of 1995, most European confidence indicators showed a tendency to level off, which may indicate a stabilisation in the prospective growth rate. We forecast that EU growth will be around 3 per cent this year and in 1996, with EU inflation remaining at around 31/2 per cent in both years. Unemployment rates will begin to fall in 1995, albeit very slowly, with employment growth accelerating in 1996.

The formation of a monetary union in Europe may have significant implications for the future conduct of monetary policy, as we discuss in Box D where we explore the differing impact of German unification under EMU and the ERM.

Prospects for Economic and Monetary Union (EMU)

In the November 1994 Review, we assessed the prospects for Economic and Monetary Union from our forecasts for the seven largest EU member states. The Maastricht treaty requires economic convergence between countries before a monetary union is formed. Progress towards convergence can be assessed on a number of criteria. The key conditions relate to inflation, government deficits and debt to GDP ratios, interest-rate differentials and currency stability. Further details are given in Box C, and the note by John Arrowsmith in this Review. Our forecasts in November suggested that none of the seven countries would meet all the criteria by 1996. However we predicted that Germany, France and the UK might meet all the criteria by the end of the century, and that the Netherlands and Belgium could qualify if they were deemed to have made sufficient progress towards reducing their debt stocks. Spain was expected to have too high a level of inflation to qualify, while Italy failed to meet any of the convergence criteria.

We now review these findings in the light of developments over the past six months. Our results are summarised in Box C and Charts C1 and C2. We have become more optimistic about the fiscal position in France and Italy, reflecting faster growth in both countries and additional budgetary measures taken in Italy. However we have revised downwards our forecasts for Spanish growth and hence our projections for the Spanish fiscal position have become less optimistic. As we discuss in our analysis of the Italian economy below we are more pessimistic about the outlook for inflation in Italy, principally due to the continuing devaluation of the lira.

We do not anticipate that any country will meet all the convergence criteria by 1996, although the interpretation of a number of the criteria remains ambiguous. In particular, it appears possible that the maintenance of a stable exchange rate outside the ERM could satisfy the currency stability requirement. (This is particularly true of the accession agreements of Austria, Sweden and Finland.) At present the UK and Germany appear most likely to meet all the criteria by 1996/7, although this is dependent on the degree of stability of the sterling exchange rate in the coming year. It is important to note that the German debt to GDP figures are for the ratio of total debt to West German GDP. If East German GDP is included, the debt ratio would only be 49.1 per cent in 1994, rather than the 53.7 per cent shown in Box C. The total debt stock has recently risen rapidly due to the inclusion in government debt of the outstanding liabilities of the east German privatisation agency Treuhandanstalt.

The French government deficit, forecast to be around 3 1/2 per cent in 1996 could be overlooked if it was felt to have declined substantially and was deemed to be sufficiently close to the reference value. Similar reasoning could also enable the Netherlands to qualify if its debt to GDP ratio was not thought to be too excessive at around 74 1/2 per cent. By 1999 Germany and France would clearly meet all criteria. The Netherlands would almost certainly be accepted as it would have made significant progress towards reducing its debt to GDP ratio towards 60 per cent. Belgium would represent an interesting test case. It would meet all criteria apart from having a debt stock of over twice the level of the reference value at 138 per cent of GDP. However it would have already made some progress in reducing its debt stock from 150 per cent of GDP in 1994 and would have virtually eliminated the government deficit. On this basis it is not inconceivable that Belgium could be accepted into a monetary union(2).

The prospects of Italy and Spain joining any monetary union appear to have worsened since last November. It is possible that Spain could meet both the criteria for public finances by 1999. However its forecast inflation rate is presently 1 1/2 per cent in excess of the target and its long-term interest rates could be around 3 per cent too high. Despite the improvements to its fiscal position, Italy is not expected to meet any of the criteria by 1999 and its inflation rate is forecast to be over 3 per cent above the target. The inflation criteria is arguably the most important and unless Italy and Spain take actions to reduce perspective inflation pressures lower inflation than we are forecasting, they would not be suitable candidates.

Germany

The German economy has experienced a rapid recovery from recession. Real GDP growth in west Germany is now estimated to have been 2 1/2 per cent in 1994, compared with a drop in output of 1 3/4 per cent in 1993. The recovery was entirely driven by domestic demand as net exports were little changed. The most significant component of domestic demand was stockbuilding - stocks held by (West) German firms rose by 1 1/2 per cent of GDP. There was also some modest growth in the other components of domestic demand. Consumption rose by 3/4 per cent, investment by 1 1/2 per cent and government expenditure by 1 per cent. National accounts data are not yet available for the first quarter of 1995 but most indications suggest that the economy is continuing to expand. The volume of new orders for basic and producer goods in west Germany was up 8 1/4 per cent in the year to January while new order volumes rose 4 1/2 per cent for capital goods. However consumer goods registered a slight fall in new orders of 1/2 per cent.

In response to the economic recovery unemployment as fallen, albeit slowly. From a peak of 9 1/4 per cent in August, the jobless total in west Germany fell to just over 9 per cent in March. Unemployment has also fallen in the new Lander. The jobless total in eastern Germany was just over 15 per cent in March, down from over 17 1/2 per cent a year ago. The German government has announced retraining and job creation schemes, costing DM 3 billion, [TABULAR DATA FOR TABLE 12 OMITTED] in an attempt to create 180,000 jobs before the end of the century.

There is increasing concern in Germany about cost competitiveness. This stems from recent pay settlements and the rising value of the D-mark. Hourly pay growth has continued to be very modest - with the rate of increase in hourly wage rates at 2 1/4 per cent in the year to January, slightly above the average for 1994 of 2 per cent but well down on the 4 1/2 per cent recorded in 1993. However it is the rate of increase in pay settlements which has been causing concern. Following strikes early in the year, the engineering union, IG Metall, and the employers agreed a settlement around 4 per cent which covers 3 3/4 million workers. The employers had wanted to postpone the introduction of a 35-hour week from October 1995 but this was successfully resisted by the union. The combination of these two factors could be enough to push the growth in hourly wage rates in engineering towards 10 per cent by the end of 1995. Settlements in other key industries have been also around 4 per cent.

The effective value of the German currency has risen by about 5 per cent since the start of the year. The Bundesbank recently eased monetary policy with a cut in the discount rate to 4 per cent and the repurchase rate to 4.5 per cent. The reason given for the shift was the slow growth in M3 rather than turbulence on the currency markets. However the Bundesbank had come under pressure from German exporters concerned about cost competitiveness following the rise in the D-mark. The rise in the value of the currency would also have allowed the bank to take a more sanguine view of the inflationary outlook.

Fiscal policy tightened significantly in 1995. The 7 1/2 per cent solidarity tax was re-introduced from the start of the year and tight control of public expenditure. However there is concern that fiscal consolidation could come unstuck in 1996. The Constitutional Court has ruled that no income tax should be levied on incomes at or below subsistence level. Estimates of the revenue cost of this ruling vary, but it will be significant, costing at least DM16 billion per annum (1/2 per cent of GDP). Extra spending will also result from a decision to increase state allowances for dependant children. However these losses may be offset by measures to tax benefit payments. In medium-term there are also plans to cut government expenditure by reducing social benefits - particularly assistance to the long-term jobless.

Our forecasts for West German GPD is given in Table 12. We expect growth to accelerate to around 3 per cent in both 1995 and 1996. We predict that faster growth will come from both domestic demand and net exports. The most significant component of domestic demand growth will be investment, particularly by the business sector. Capacity utilisation levels have risen significantly and most surveys point to faster investment growth. We expect government and private consumption to both grow by 1 per cent in 1995. Private consumption is likely to be held back by the increases in taxation, notably the 7 1/2 per cent solidarity tax. However since the tax increases were pre-announced, it is likely that German consumers will have already taken them into account. We therefore expect consumption growth to rise slightly more quickly than real disposable income. Government consumption will be restricted by fiscal consolidation. Net exports are expected make a significant contribution to growth. However, we are less optimistic about growth in net exports in 1996 following the rise in the D-mark. As detailed in Table 13, pan-German export volume [TABULAR DATA FOR TABLE 13 OMITTED] growth is expected to be 9 per cent in 1995 but fall significantly to around 5 1/2-6 per cent in 1996 as the full effects of the appreciation take hold. Import volume growth is expected to be close to 7 per cent in this year and to accelerate to 8 1/2-9 per cent in 1996.

In 1996 we predict that growth will be entirely driven by domestic demand. Consumption growth, which will have been very slow for five years, is expected to accelerate to around 2 1/2-3 per cent. Investment growth is also expected to remain high, but government consumption will continue to grow slowly. The continuing economic [TABULAR DATA FOR TABLE 14 OMITTED] recovery will lead to some decrease in the level of unemployment. We expect that the unemployment rate will fall to around 9 per cent in 1995 and to 8 1/2-9 per cent in 1996. We do not foresee the very rapid rise in average earnings feared by some German industrialists. Average earnings growth is expected to pick up somewhat but to remain fairly modest at around 2 1/2 per cent in 1995 and 3 1/2 per cent in 1996. We think that West German consumer price inflation will remain stable at around 2 per cent in both years.

France

Mr Jacques Chirac's presidential term begins as the French economy continues to make a strong recovery. In 1994 real GDP is estimated to have grown by around 2 1/2 per cent following a fall in output of around 1 per cent the previous year. The recovery in France was entirely driven by growth in domestic demand, which rose by around 3 per cent last year. Domestic demand growth was made up of a modest expansion of all components but there was particularly rapid growth in stockbuilding. The change in inventory decisions, which followed large cuts in stock levels during the recession of 1993, contributed around half of the total growth in real GDP in 1994. However the high value of the franc has meant that trade generated growth was limited and in 1994 net exports fell by 1/4 per cent.

Unemployment has recently begun to fall slightly. In February the rate was 12 1/4 per cent after averaging 12 1/2 per cent in 1994. The high level of unemployment has contributed to the modest growth in pay settlements. In the final three months of 1994 hourly wage rates in manufacturing grew by just over 2 per cent. Whole economy average earnings growth was probably around 2 1/2 per cent in 1994. The low level of pay increases combined with the high value of the franc has kept French inflation low. Consumer prices rose by 1.8 per cent in February, very slightly up on the 1994 average inflation rate of 1.7 per cent.

There have been suggestions that President Chirac is not fully committed to the franc fort policy. This was subsequently denied by President Chirac, and the consensus of opinion seems to be that the strong franc policy will [TABULAR DATA FOR TABLE 15 OMITTED] be maintained. The first few months of the Chirac presidency will the most interesting. If he does have doubts about the value of the currency then the temptation will be to act quickly and devalue now, rather than wait and be forced by events in some future crisis. This political uncertainty and the general turmoil on the currency markets in February and March led the Banque de France to tighten monetary policy. Short-term interest rates jumped in early March when the Banque withdrew its 5-10 day repurchase facility - effectively removing the ceiling from short-term interest rates. Rates have declined since in response to the Bundesbank's interest-rate cut but have remained relatively high by recent standards. However the rise in French interest rates was concentrated in short term rates, with long rates moderating a little. Despite the tightening in French monetary policy, the value of the Franc declined against the D-mark from 3.43 francs in the final quarter of 1994 to around 3.55 at the end of April. However the decline against the D-mark was not mirrored in changes in the effective exchange rate as the franc appreciated against some currencies notably the pound, lira and peseta.

The future direction of fiscal policy is not yet clear. It is perhaps not surprising that neither Mr Chirac nor Mr Jospin spelt out exactly what fiscal measures they would take to ensure that France meets the Maastricht public finance criteria for deficits and debt. Some limited revenue raising measures have already been taken for this year - notably rises in corporation taxes, some local taxes. some energy taxes and cigarettes duties. There was also an aim for no growth in total real expenditure. We have assumed in our projections that measures will be [TABULAR DATA FOR TABLE 16 OMITTED] taken, on both the revenue and expenditure side, to meet the Maastricht fiscal criteria by 1997.

Our forecasts for GDP are in Table 15 and for trade are in Table 16. We expect that GDP growth will average around 3 per cent in both 1995 and 1996 and will be entirely driven by domestic demand. The fastest growing component of domestic demand is predicted to be investment with growth of around 7 per cent in both 1995 and 1996. Business investment is expected to grow particularly strongly in response to the improving economic conditions and relatively low long-term interest rates. We expect a modest tightening of fiscal policy to meet the Maastricht public finance criteria. This should keep the growth of real personal disposable incomes to below 2 per cent. For this reason consumption growth will be held back to around 2 per cent in 1995 and between 2-2 1/2 per cent the following year. Government consumption growth is also expected to be fairly modest for the same reason, at a little under 2 per cent. Unemployment is forecast to fall from 12 1/2 per cent in 1994 to around 12 per cent in 1995 and between 11 1/2-12 per cent in 1996. Average earnings growth is expected to remain modest - at around 3 per cent in both years. Consumer price inflation is also expected to remain stable at around 2 per cent in both 1995 and 1996.

Net exports are not forecast to offer any contribution to growth because of the high value of the franc. Strong growth of around 9 1/2-10 per cent is expected for both export and import volumes this year, falling to around 6 per cent and 7 per cent respectively next year. The current account surplus is projected to be little changed in 1995 but to fall slightly in 1996 to around 1/2 per cent of GDP.

Italy

Italian GDP growth averaged around 2 1/4 per cent in 1994 following a drop in output of 3/4 per cent the previous year. Last year's growth was broadly based with significant contributions coming from most components of domestic demand and from net exports. Total domestic demand grew by almost 2 per cent, made up of consumption growth of 2 per cent and stockbuilding which contributed 1/2 per cent. As part of Italy's attempt to control its public finances, government consumption grew very slowly at around 1/4 per cent to GDP growth. Total investment was also fairly flat, registering little overall growth in 1994. Net exports continued to make a significant contribution to growth. Unemployment continued to rise in Italy and is estimated to have averaged 12 1/4 per cent in 1994. Earnings growth and inflation fell to historically very low levels (3 per cent of GDP) both averaging around 4 1/2 per cent respectively last year.

The 1995 budget contained around L50 trillion worth of measures to improve public finances, which have continued to be the focus of much concern. The measures, which were evenly split between expenditure cuts and revenue increases, included cuts in pension and health expenditures, cuts in public sector recruitment, the speeding of tax settlements and selective tax amnesties. Although these measures were widely welcomed they were seen as insufficient given the scale of the Italian budget deficit. A 'Supplementary Budget' was subsequently agreed on March 21. This includes a package of measures worth about L20 trillion (1.2 per cent of GDP). The main elements of the package are a rise in some VAT rates, energy taxes and changes to the rate at which deductions from personal income tax are paid. Although the combination of these two budgets represents some significant progress it is widely felt that more measures will be necessary. The financial markets have yet to be convinced that Italian public finances are on a path towards long-term sustainability. Short-term interest rates continued to rise and long rates remained high. Three month rates are currently around 11 per cent compared with 9 per cent in the first quarter and 8 per cent in the final three months of 1994. Ten year rates have been around 13 1/2 per cent for much of this year. [TABULAR DATA FOR TABLE 17 OMITTED] Because a large proportion of Italian public debt is held at the short end a rise in the level of short-term interest rates significantly increases the cost of servicing the public debt. If the Italian government was to put together a credible package to significantly reduce the deficit then it may be able break into a virtuous circle of an improved government deficit leading to a fall in short-term interest rates, leading to reduced government interest payments and hence a further fall in the deficit.

Our forecasts for the Italian economy are in Table 17 and 18. The interesting question is how the Italian economy will react to the latest devaluation. The lira has continued to depreciate against the D-mark and is around 7 1/2 per cent lower than in the last quarter of 1994. The devaluation of 1992 resulted in a large increase in net exports and yet consumer price inflation fell in 1993 and 1994. However the 1992 devaluation took place when there was a significant overvaluation of the lira and the economy was entering a recession. Neither of these now apply to the Italian economy which has been growing strongly for about a year. The inflationary impact of the devaluation will be exacerbated by the increases in indirect taxation as part of the supplementary budget planned for this year and for 1996. We estimate that these rises in indirect taxation will raise the average indirect tax rate significantly in 1995 and in 1996. Wage negotiations for 1995 are now settled so there is limited scope for significantly faster earnings growth this year but we expect that the growth in average earnings will double to 10 per cent in 1996. Consumer price inflation has already increased from 3.8 per cent in January to 4.9 per cent in March and is expected to average over 5 1/2 per cent in 1995. In response to the faster wage growth in 1996 we forecast inflation accelerating to 6 1/2 per cent that year.

The devaluation should also bring faster output growth in the next two years. We forecast that GDP will grow by 3 1/2 per cent in 1995 and 4 per cent in 1996. This growth will be largely driven by domestic demand in 1995 but in 1996 we expect a large contribution from net exports as the full extent of the devaluation feeds through into export and import volumes. The government's moves towards fiscal consolidation are expected to affect both public and private consumption. Government consumption is predicted to fall by around 1/2 per cent this year and to rise by the same amount in 1996. Rises in taxation will reduce real personal disposable incomes by around 1/2 per cent in 1995. However we are still expecting some growth in private consumption this year as consumers reduce their savings. Overall consumers' expenditure growth is expected to remain modest at around 1 1/2 per cent this year and 2-2 1/2 per cent in 1996. The faster economic growth should allow unemployment to fall to a little under 12 per cent in 1995 and 11 per cent in 1996.

As shown in Table 17, we are forecasting a fairly strong trade response from the recent devaluations of the lira. Export volume growth is predicated to be about 7 1/2-8 per cent in each of the next two years while import volumes are projected to grow by 5 1/2 per cent in 1995 and to remain static in 1996. We expect a worsening of the trade balance in 1995, partly due to 'J' curve effects but we are projecting a significant improvement in 1996.

[TABULAR DATA FOR TABLE 18 OMITTED]

Spain

The Spanish economy has made a steady recovery from the recession of 1993. GDP growth averaged around 2 per cent in 1994 - largely driven by the external sector. Net exports contributed 1 1/4 per cent to growth, while domestic demand grew by only 3/4 per cent. Export volumes have increased extremely rapidly and are estimated to have risen by over 20 per cent in 1994. Import volume also grew very quickly at around 15 per cent. Private consumption and investment both recorded modest increases of around 1 per cent, while government spending rose by just 1/4 per cent due to the government's moves towards fiscal consolidation. Unemployment continued to rise in 1994 and averaged 23 3/4 per cent while inflation showed little change on 1993, averaging around 5 per cent.

Monetary policy was tightened by the Banco de Espaia at the start of the year when the intervention rate was raised by 0.65 points to 8 per cent. In spite of this the peseta was devalued by 7 per cent in early March. This was the fourth devaluation in 2 1/2 years and it came after [TABULAR DATA FOR TABLE 19 OMITTED] the peseta fell towards its ERM floor. At the same time the Banco de Espana raised the intervention rate by another 1/2 per cent to 8 1/2 percent. Long-term interest rates have also risen, from 8 per cent in the first quarter of 1994 to around 12 per cent now. The Banco de Espana objective is to gradually reduce the inflation rate to 3 per cent over the next three years. Any upward deviation from this path would cause it to tighten monetary policy. The Bank's preferred intermediate target is 8 per cent growth in broad liquid assets held by the public (ALP). Other variables to be used as indicators include the growth of domestic credit and changes in net external assets. Fiscal policy was tightened with a rise in VAT of 1 per cent from the start of 1995. There have also been public spending cuts of Pta150 billion this year (around 1/4 per cent of GDP).

Our forecasts for the Spanish economy are in Tables 19-20. We predict that GDP growth will accelerate to between 2 1/2-3 per cent in 1995 and remain at this level in 1996. Growth in 1995 will be entirely driven by domestic demand, with particularly strong growth in investment [TABULAR DATA FOR TABLE 20 OMITTED] of around 5 per cent. Private investment fell very sharply in the recession of 1993 when it registered a year-on-year fall of over 10 per cent. In recent months signs of capacity constraints have emerged in the Spanish economy. Capacity utilisation rose to 2 1/2 per cent in the final three months of 1994 to reach its highest level for over three years. Capital goods production was also up very sharply in the first two months of 1995. We forecast that firms will attempt to rebuild their inventories which were also cut back significantly in 1993 and 1994. The change in firms stockbuilding in 1995 could contribute as much as 1 per cent to GDP growth this year. Government fiscal consolidation measures should restrict the growth in government consumption to less than 1 per cent this year and around 1 per cent in 1996. The VAT rise in 1995 will also restrict the growth of real personal disposable incomes and hence will restrict consumers' expenditure growth to around 2 per cent in each of the next two years. Net exports are predicted to decline somewhat in 1995. This is partly because we do not expect that the spectacular rate of increase in export volumes in 1994 of over 20 per cent can be sustained in 1995. However it is also because we foresee import volume growth remaining fairly buoyant due to faster GDP growth.

We expect inflation to rise significantly in 1995 to a little over 5 1/2, per cent, partly because the rate of value added tax was increased from the start of the year by 1 per cent and also because emerging capacity constraints. However we predict that the high level of unemployment and modest growth will restrain the growth in average earnings to around 3-3 1/2 per cent in 1995 and 4 per cent in 1996. This should allow inflation to fall back to around 4 1/2 per cent in 1996 when the temporary effect of the rise in indirect taxation falls out and monetary policy is tightened further. Unemployment is expected to fall back somewhat from the extremely high levels experienced in 1994. The jobless rate is projected to fall to around 22 1/2 per cent this year and 20 1/2 per cent in 1996.

NOTES

(1) European Economy; Supplement B, Business and Consumer Survey Results, No 3, March 1995.

(2) There is a precedent for such a liberal interpretation of the fiscal criteria. In 1994 the Commission decided not to initiate the excessive deficit procedure in respect of Ireland, despite its debt ratio of over 90 per cent. However the Commission's interpretation on these matters may well be challenged by those opposed to monetary union.

(3) However, Italian unemployment data has suffered from a number of redefinitions in recent years, making it hard to pinpoint underlying trends.

RELATED ARTICLE: Box A. The Effects of Recent Financial Market Developments on Growth and Inflation

The pattern of exchange rates and interest rates in the major world economies has changed significantly since our last forecast in February. The yen appreciated strongly in March and April and the dollar, sterling and lira all fell. Equity prices rose in those countries whose currencies had depreciated, with the exception of Italy. Long-term interest rates fell in four of the G6 economies, and short-term rates fell in three. Our forecasts for interest rates are derived from the term structure in the forward markets, with the exchange rate path being derived from an uncovered interest parity assumption. Tables A1 and A2 show the differences between the policy assumptions made in our February forecast and those implied by the pattern of interest and exchange rates at the end of April. In addition, Japanese and German equity prices are respectively 19 and 12 per cent lower (in domestic currency terms) than we had previously projected, while equity prices in the US are around 10 per cent higher. We do not assume that each country seeks to revert to its previous target for the monetary base.

We would expect that a realignment of exchange rates would have no real effects in the long-run. In the short-run growth would fall in the revaluing countries and rise in the devaluing countries. The overall effects in the short-run depend on the speed of response of the economies concerned. In the current situation we believe that the devaluers (the US, Italy and the UK) will respond more rapidly to the realignment than the revaluers (Japan, Germany) and hence the overall short-term effects should be positive. In addition, monetary policy has been loosened (almost) everywhere, giving an additional boost to demand, although in the countries which have revalued this may be offset by the lower real value of equities.

Table A3 summarises the impact of these financial developments on growth, taking our previous forecasts in February as the base projection. In the short-term the impact on growth is greatest in Italy and the US, reflecting the size of the devaluation in the former, and the impact of lower long-term interest rates and higher equity prices in the latter. In the medium-term, growth also picks up in Germany and Japan, reflecting the initial rise in world trade and the relative speed with which lower interest rates stimulate demand in these economies.

The effects of a realignment on real exchange rates will eventually disappear on our econometric model and we think in the world, as they will return to where they would otherwise have been. In revaluing countries prices will rise less rapidly than they would otherwise have done, while in devaluing countries prices will rise more rapidly for a period. The effects of the realignment on our previous forecasts of inflation rates can be seen in Table A4. The three countries with the highest growth effects, the US, UK and Italy, are also the ones where inflationary pressures are most pronounced.

[TABULAR DATA FOR TABLE A.1. OMITTED]
Table A.2 Real Effective Exchange rates


 (percentage points difference from February base)


 1995 1996 1997 1998-2002


US -5.3 -5.8 -5.3 -4.3
Japan +12.5 +14.7 +14.3 +13.2
Germany +2.7 +3.2 +3.1 +2.4
France -0.1 -1.1 - 1.2 -0.7
UK -3.5 -4.3 -4.2 -2.9
Italy -8.7 -9.8 -10.0 -9.8
Table A.3. Real GDP Growth Rates


 (percentage points difference from February base)


 1995 1996 1997 1998-2002


US +0.4 +0.7 +0.2 -0.1
Japan -0.5 -0.1 +0.4 +0.2
Germany -0.2 +0.2 +0.4 +0.1
France 0.0 +0.3 +0.3 0.0
UK +0.2 +0.5 +0.4 -0.1
Italy +0.8 +1.2 +0.3 -0.1
World trade +0.1 +0.6 +0.5 +0.2
Major 7 GDP +0.1 +0.5 +0.3 -0.1
Table A.4. Inflation Rates


 (percentage points difference from February base)


 1995 1996 1997 1998-2002


US +0.2 +0.9 +1.0 +0.7
Japan -0.2 -0.8 -0.8 -0.6
Germany -0.1 -0.4 -0.3 0.0
France -0.1 +0.1 +0.3 +0.3
UK +0.3 +0.6 +1.0 +1.2
Italy +1.3 +1.8 +1.3 +1.3
Major 7 CED +0.1 +0.4 +0.5 +0.5


RELATED ARTICLE: Box B. Realignments and Monetary Policy

In this box we report some illustrative simulations designed to show the various ways in which relative price adjustment can occur in the aftermath of an exchange-rate realignment. When a country devalues by, say, 10 per cent, then it is to be expected that its relative price level will eventually be 10 per cent higher than it would have otherwise been. Inflation itself may not rise, but it will be higher than had been previously anticipated for some period. The absolute change in the domestic price level will depend upon the monetary policy adopted both at home and abroad after the realignment. A depreciation of the dollar implies an appreciation of other currencies, with upward pressure on US prices, and downward pressure on prices elsewhere. If other countries successfully maintain their existing monetary base targets, then they will offset the downward pressure on their prices from the exchange rate change. If, however, the foreign countries accommodate some of the fall in prices, then the US has to inflate less to bring about an equivalent adjustment in the real exchange rate. We have undertaken several simulations in order to bring out the effects of monetary policy in the aftermath of an exchange rate realignment. In all cases adjustment is slow, in part because the US is a relatively closed economy, with imports around 15 per cent of GDP.

Chart B1 plots the effects of a devaluation of the US and Canadian dollars on the US real effective exchange rate, under two different scenarios.

In the 'benign' case the US accommodates the price increase, while everybody else targets their money bases (and hence price levels). In the alternative scenario, labelled 'fix', we assume that all interest rates are fixed at base. In both cases the real exchange rate reverts towards its base level, albeit slowly.

Chart B2 plots the effects of the devaluation on US and German prices if interest rates are left fixed. The D-mark/dollar rate has changed by 10 per cent, and hence relative prices eventually change by 10 per cent, with the adjustment being shared.

Chart B3 plots German prices with fixed interest rates (fix) and German monetary targeting (benign). German (and all non-North American) prices eventually return to base and hence all adjustment in the US real effective rate takes place through US price changes.

RELATED ARTICLE: Box C. The Maastricht Convergence Criteria

Inflation

Each country must have a sustainable price performance which means that its consumer price inflation rate must not exceed that of at most the three best performing states (in terms of price stability) by more than 1.5 per cent in the last year.

Fiscal Situation

The government deficit to GDP ratio should not exceed 3 per cent and the government debt to GDP ratio should not exceed 60 per cent unless the excess is either exceptional and temporary, or unless the ratio is declining toward the target level at a satisfactory pace.

Interest rates

Long-term interest rates must not exceed those of at most the three best performing countries (in terms of price stability) by more than 2 per cent in the last year.

ERM

Maintained normal fluctuation margins allowed for by the ERM for at least two years. No bilateral devaluation of a country's central rate (on its own initiative) over the same period.

[TABULAR DATA OMITTED]

RELATED ARTICLE: Box D. Monetary Policy Under EMU and the ERM

Our forecast suggests it will be possible for a number of European countries to form a monetary union around the turn of the century. Monetary policy would then be run by a European central bank which would take account of European developments. When the ERM was at its strongest between 1989 and 1992, monetary policy was being run by the Bundesbank, taking into account German developments. Hence the response of the ERM to internal developments could be strongly asymmetric. For instance, an increase in demand in Germany would have been met by a stronger response than an equal increase in demand in France. This would not happen under EMU.

In the February 1991 Review we argued that German unification could be treated as a large fiscal expansion, and that its effects were best analysed using the assumption of rational expectations in the foreign exchange and financial markets. As the Bundesbank was prepared to raise interest rates in response to the expansion of demand of the D-mark exchange rate appreciated. As the UK, France, the Netherlands, Belgium and the other ERM countries were all targeting their D-mark exchange rates their interest rates (and effective exchange rates) all rose. We argued at the time that the Germany expansion was essentially contractionary elsewhere because the monetary tightening more than offset the increases in trade from higher German spending. It is useful to ask whether things would have been different under EMU.

We undertook two simulations on our model in order to contrast the effects of a German fiscal expansion under the ERM and EMU. German government spending was increased by 2 per cent of GDP. In the longer-term taxes are raised to keep the government solvent, but this happens only slowly on the model. Under the ERM monetary policy is set to target the base trajectory for the German money supply, while under EMU it is set to target a European wide aggregate. In both cases the exchange rate 'jumps' in the first period, but the initial appreciation is much less under EMU, because the increase in German demand has much less impact on interest rates when managed with regard to European targets. Chart D1 plots short and long-term interest rates in both cases. The long rate jumps in the first period, cumulating changes in the short rate. The D-mark/dollar exchange-rate changes by 1 1/2 per cent in the first period under ERM rules and then follows the arbitrage path. The EMU appreciation is half this size.

The weaker monetary response may appear to conflict with German objectives but we argue it does not. Chart D2 plots the effects of the expansion on Germany output in the two cases, while Chart D3 plots the effects on the UK. The shock is, at best, initially more expansionary everywhere, as can be seen from the table D. Under the ERM the expansion feeds through to close trading partners such as the Netherlands and Belgium, while the appreciation has the most negative effect on the countries with the least close trade ties to Germany such as the UK and Spain. However, the longer-term effects are the same under both sets of rules. Fiscal effects are transitory, as taxes are raised to keep the deficit on target and hence output returns to its base trajectory. The European central bank is assumed to target its aggregate as successfully as the Bundesbank, and hence the price level returns to base in both cases, as can be seen from Chart D4.

It is possible to claim that German unification would have been better handled under EMU, with less negative output effects in the rest of Europe, and no long-run difference in German inflation. However, this would have required a central bank as committed to its European objectives as the Bundesbank is to its German goals.
Table D. The effects on output in Europe of a German fiscal
expansion.


Per cent difference in GDP from baseline.


 Year 1 Year 2 Year 3


 ERM EMU ERM EMU ERM EMU


Germany 1.48 1.57 0.90 1.06 0.52 0.70
France -0.01 0.02 -0.04 0.03 -0.04 0.05
UK -0.10 -0.01 -0.23 -0.08 -0.28 -0.10
Italy 0.03 0.06 0.00 0.07 -0.05 0.07
Spain -0.06 0.01 -0.16 0.00 -0.18 0.00
Netherlands 0.09 0.19 0.08 0.22 0.06 0.19
Belgium 0.23 0.33 0.09 0.25 0.04 0.18
Rest EC 0.09 0.19 0.00 0.12 -0.14 0.00


Assumptions:


2 per cent of GDP expansion of Germany government spending


Fiscal solvency in place - see May 1992 NIER note by Barrell and
in't Veld


Monetary targeting


Forward-looking exchange rates, long-term interest rates and labour
markets
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Title Annotation:includes related articles
Author:Barrell, Ray; Pain, Nigel; Morgan, Julian
Publication:National Institute Economic Review
Date:May 1, 1995
Words:16913
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