Consumer spending was the driving force behind recovery in 1992-93, as lower interest rates reduced the debt service burden on households. But, in the first half of 1994, the recovery became more broadly based and more firmly established, with real GDP rising at an annual rate of 3.9 per cent. Exports and government [TABULAR DATA OMITTED] investment, which had been weak in 1993, strengthened markedly while growth of consumer spending slowed somewhat in response to large tax increases, even though the savings rate fell significantly in the second quarter. Private non-residential investment picked up in the second quarter from a weak first quarter level. The pace of GDP growth slowed in the third quarter to an annual rate of around 3 per cent, but survey evidence and order books indicate that the underlying trend in economic activity remains firm.
The net trade contribution to GDP growth was 1.1 percentage point in the first half of 1994, as both exports and imports continued to respond to the large real depreciation sustained since September 1992. Import growth was relatively subdued, despite steady growth in total domestic demand, while exports boomed, reflecting the recovery of demand in world markets and gains in market share. The resulting decline in the trade deficit was accompanied by a higher invisible trade surplus, reducing the current account deficit to only [pounds]2 billion, or 0.6 per cent of GDP in the first half of 1994, compared with [pounds]6.8 billion a year earlier. The second quarter deficit was the lowest since early 1987.
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Disinflation continued in the first nine months of 1994, as underlying inflation(1) dropped to a new 27-year low of 2 per cent in September. The extent of disinflation in the past two years has been much stronger than had been expected by most forecasters - due to low wage settlements, buoyant productivity gains and intense competition. Wage pressures remain weak, with the 12-month growth of average earnings at 3 3/4 per cent in June through August. Unit wage costs both in manufacturing and in the whole economy fell slightly in the second quarter, as productivity gains continued to outstrip average earnings growth. Despite a pickup in producer input prices, the rise in producer output prices remains modest and there has been a continuing improvement in profitability.
Falling inflation in the first half of 1994 occurred in the face of steadily falling unemployment. By September the unemployment rate was down to 9.1 per cent, from a peak of 10.5 per cent in December 1992. Although unemployment has fallen, there is conflicting [TABULAR DATA OMITTED] evidence on recent changes in employment. Establishment data show that employment fell by 9 000 in the year to June 1994, while the Labour Force Survey shows a rise of 226 000 in the year to Summer 1994. The absence of wage pressure suggests that unemployment remains above its "natural rate" and that falling unemployment imparts less upward pressure on wages than in the past.
The current recovery differs from previous upswings in several respects. In particular, there are signs that structural reforms and deregulation in the 1980s are being reflected in a more flexible, less inflation prone economy. Keen competition has helped to restrain inflation. Productivity performance has been strong, while real wage growth has remained moderate. Also, previous recoveries were marked by strong housing market turnover and rising house prices relative to general prices, with large spillover effects on the economy. By contrast, in this upswing the housing market has remained subdued despite big improvements in housing affordability.(2)
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Policies and other forces acting
Fiscal and monetary policies are both tightening. Substantial fiscal consolidation has already taken place and more is scheduled.(3) The tax and spending measures announced in the two 1993 budgets were expected to reduce the public sector borrowing requirement (PSBR) substantially. In the event, the Treasury's summer 1994 economic forecast lowered the projected PSBR to [pounds]36.1 billion in FY 1994/95 and to [pounds]27.9 billion in FY 1995/96 (5 1/4 and 4 per cent of GDP respectively). The OECD Secretariat projects that the net borrowing of government (excluding privatisation proceeds) will fall from 7 per cent in calendar 1994 to 3 1/4 per cent of GDP in 1996. This implies an estimated 2 3/4 percentage points reduction in the structural deficit to some 2 per cent of GDP and stabilisation of the gross debt to GDP ratio at 54 per cent by 1996.
Following indications that demand was likely to grow well above trend, base rates were raised by 1/2 percentage point to 5 3/4 per cent in September, the first increase in almost five years. The effective exchange rate has appreciated by around 2 1/2 per cent since the September increase in base rates, and the spread between United Kingdom and German bond yields has narrowed by some 30 basis points. Nonetheless, the large increase in long-term interest rates - from 6.2 per cent in January 1994 to 8.7 per cent in early November - suggests that monetary policy credibility has yet to be fully established, although the rise in long rates is a world wide phenomenon. Financial market inflation expectations (measured by the spread between indexed and non-indexed bonds) have risen during the year.
Rising private investment, better employment prospects and further recovery in export markets should support sustained output growth in the next two years. But tighter fiscal policy and further rises in short-term interest rates are expected gradually to slow the growth of demand, as the output gap narrows. GDP growth is projected to remain at 3 1/2 per cent in 1995 as in 1994, and to slow to around 3 per cent in 1996. Employment is projected to pick up gradually, as cyclical productivity gains slow. By end 1996, the unemployment rate could be slightly below 8 per cent. With the output gap closing, inflation could rise modestly to around 3 per cent in 1996, just above the midpoint, but well within, the government's target range of 1 to 4 per cent. The current account deficit is projected to remain below 1 1/2 per cent of GDP in 1995 and 1996.
The risks to the output projection appear evenly balanced and depend on the timing and degree to which stronger investment and employment will offset the contractionary effects of higher taxes and interest rates. Better order books, rising capacity utilisation, strong productivity gains and good corporate cash flow are indicative of a healthy investment climate, and investment intentions are indeed strengthening. However, evidence that firms have been slow to hire and still demand high investment hurdle rates and short payback periods for projects suggests that they do not yet fully believe in a sustained low-inflation environment.
OECD Secretariat estimates are that the output gap in 1994 is some 4 per cent, and that the "natural rate" of unemployment is around 7 to 8 per cent - significantly lower than in the 1980s on account of structural reform. Such estimates are subject to uncertainty, but are consistent with inflation remaining subdued, provided demand growth slows as projected, leaving a small output gap in 1996. Short-term interest rates are assumed to rise from 5 3/4 per cent currently to 7 1/2 per cent in 1996, to levels somewhat below projected long rates, and well below peak rates seen in previous cycles. Controlling inflation may be possible with lower interest rates than in the past, as monetary and fiscal policies have been tightened much earlier in the cycle. The risks attached to the OECD Secretariat's central inflation projections are symmetrical. However, the consequences of upward and downward deviations are not. Given the asymmetrical costs of lowering inflation, the authorities will need to remain vigilant against the possibility of a pickup in inflation.
1. Underlying inflation is measured by the twelve month change in RPIX, the Retail Price Index excluding mortgage interest payments.
2. The ratio of house prices to average earnings has fallen from over 4.5 in 1989 to 3.3 in 1994, and is close to its lowest value in the past twenty years. This may reflect the continuing effects of "negative equity" (householders' debts exceeding the value of their property), as well as greater job insecurity, tighter mortgage lending conditions and a steady erosion of the tax advantages to mortgage borrowing. Negative equity may have affected 1.1 million households in the third quarter of 1994 (with a combined value of [pounds]5.6 billion), compared with 1.8 million households in the first quarter of 1993.
3. These projections were prepared before the 29 November 1994 budget.