COMMENTARY.

Barrell, Ray ; Pain, Nigel ; Weale, Martin 等

Growth prospects

Economic activity has clearly slowed markedly throughout the world economy in recent months. This appears to be having an increasing effect on the short-term prospects for growth in the UK. Our global economic forecasts suggest that the annual rate of increase in world GDP will slow to 2.6 per cent this year from 4.8 per cent in 2000. Much of this is accounted for by simultaneous downturns in the three major economies, the United States, Japan and Germany, for the first time since the mid-1970s. Whilst demand by the household and public sectors in the UK remains buoyant, it is becoming increasingly clear that a significant part of the UK economy is being adversely affected by developments elsewhere. GDP is estimated to have risen by only 0.3 per cent in the second quarter, taking the annual rate of growth down to below trend levels at about 2 per cent.

Since February there has been a succession of poor figures for manufacturing output, with the latest showing output falling by 1 per cent per month. This is probably because of falling export demand and is particularly affecting the capital goods industries. We regard it as being a consequence of the world economic environment, which has weakened markedly in the last couple of months, rather than specifically arising from the present level of the exchange rate. Indeed in five of the seven largest economies in the world both imports and exports fell in the first quarter of 2001; they rose only in Italy and, despite the exchange rate, in the United Kingdom. This weakness, which has continued into April and May, is associated with a contraction in the information technology-related demand for capital goods.

Profit margins of UK exporters are already very low, and there is little that they can now do to maintain sales. Thus, although the level of the exchange rate is not a cause of the current weakness, a lower exchange rate would be a help to exporters.

This weakness in export demand is reinforced by slow growth of domestic business capital formation. Since we also expect the economic situation to remain weak in Germany and Japan and to revive only gradually in the United States, we now anticipate that the rate of growth in the UK will drop to 2.1 per cent this year, a figure slightly below the lower end of the Treasury's forecast range (2 1/4-2 3/4 per cent) which they have recently reaffirmed. We see a modest revival next year helped by a more stable world environment taking the growth rate to 2.6 per cent but have to warn that, given the state of the world economy, there is a substantial downside risk to this projection; so far this year expectations have turned out to be unduly optimistic. In particular share prices in major markets remain unusually high by historic standards. A further decline towards normal levels would have a depressing effect on the world economy.

Monetary policy and economic imbalance

From the Bank of England's perspective, the imbalances in the economy, continuing growth of consumer spending but weakness in the business investment and export sectors and imports therefore rising faster than exports, cause considerable problems in setting monetary policy. With a single instrument, the interest rate, the Bank cannot hope to manipulate both overall demand and the external position.

Markets are now expecting interest rates to rise again (page 9). Our analysis is that, given the unexpected worsening of the economic outlook there has been in the last three months, a further precautionary cut in interest rates would be desirable. If, as we expect, the figures for manufacturing output remain weak and the data also continue to indicate that consumption growth is modest, then this cut will probably take place in August or September. Should our forecast prove to be correct, with growth picking up next year, then the cut will probably be reversed in the Spring and hindsight might say that it was unnecessary. But any forecaster has to make a judgement about when a period of slow growth is going to end. The interest rate cut will be a precaution against the international economy proving more sluggish than we expect. Conversely, it will not add greatly to the inflationary risks.

There are two other justifications which can be made for the reduction. First of all, in the past few weeks long-term interest rates have been rising and this may have had the effect of tightening monetary conditions even though short-term rates have not changed. Since we take the view that there is no case for an overall tightening of monetary conditions, there is a case for a cut in short-term rates to offset the rise in long rates. Secondly, the United States Federal Reserve felt a need to cut the Federal Funds rate again at the end of June. If nothing else, this can be taken as an indication that the Federal Reserve does not believe a sharp recovery in US demand is about to start.

Inflation and the labour market

The inflation rate excluding mortgage interest payments has risen above 2 per cent per annum again, helped by a recovery in oil prices and the effects of the foot and mouth epidemic and adverse weather conditions. There is no longer any expectation that it will fall below the lower limit of the inflation target band (1 1/2 per cent per annum) later this year. We expect it to remain close to its target this year and next year. There is some evidence in the average earnings data that wage growth has accelerated but this measure has an inherent degree of volatility and we would want it to persist for some months before concluding that labour market tightness was finally leading to wage inflation. The slackening of demand growth which we project leads to unemployment turning up, and we expect this rise in unemployment to ensure that wage growth remains constrained despite the inflationary consequences of the increase in the minimum wage later this year.

A black hole in government spending plans?

In the medium term the Government plans for public spending to rise faster than national income, with the budget surplus being turned into an overall deficit, but with the deficit smaller than the planned level of public net investment. The spending plans are essentially consistent with the golden rule - that current spending should be paid for by tax receipts. Looking further into the future, it is plain that, if the proportion of national income collected in tax is not to rise, then government spending cannot rise any faster than national income; the rates of increase planned over the next two or three years are in that sense unsustainable. But the difficulty arises in projecting for just how long government spending can grow at its current rate, before the rate of growth has to be reduced to that of national income. The Government's projections are based on a prudent and cautious' assumption that the economy will grow at a trend rate of 2 1/4 per cent per annum. Most outsiders tend to think that the trend rate of growth of the economy is slightly faster, at just over 2 1/2 per cent per annum and, if this is true, i) total managed government spending can grow at current rates for longer than the government assumes before its growth rate has to be reduced to that of national income and ii), even when that happens, the growth rate can be slightly faster than the Chancellor's projected rate for the economy as a whole.

The Government projections show that, even if output eventually settles 1 percentage point lower than its mainstream projection, then current plans are still affordable and we continue to forecast that real total managed expenditure can grow by an average of 3.8 per cent per annum for the life of this parliament and still ensure that tax revenues are at least adequate to finance current expenditure. Our own analysis (National Institute Economic Review, April 2001, p.14) suggested that the budgetary impact of slow growth in demand depends on its source. Weak export growth and capital formation have much less of an impact on tax revenues than does weak consumption growth, because consumption spending is taxed directly while exports and capital formation are not. Thus, while the household sector remains relatively unaffected by the slowdown, tax revenue is likely to remain buoyant.

Britain and the euro

The exchange rate is now not very far below the level of [euro]1.75 reached in the Spring of 2000. Then a series of statements by Ministers that they were unhappy with the level of sterling had an effect, and we suspect that it would be prudent to repeat this. We and others suggested then that the Government should make a statement indicating what it thought an appropriate rate for Britain to join the euro might be; there is also a case for this now. However, so far Government statements seem to have been designed more to support the exchange rate than to encourage any adjustment and there have been some confusing signals on the question of euro membership but with a general consensus established that it is not an immediate goal.

The Government has reiterated that its decision will be based on the five tests:

i) Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?

ii) If problems emerge is there sufficient flexibility to deal with them?

iii) Would joining EMU create better conditions for firms making long-term decisions to invest in Britain?

iv) What impact would entry into EMU have on the competitive position of the UK's financial services industry, particularly the City's wholesale markets?

v) In summary, will joining EMU promote higher growth, stability and a lasting increase in jobs?

The National Institute's position on the matter is that the UK's economic cycle is now reasonably synchronised with that of the Euro Area. Membership would also lead to lower and more stable interest rates which should help long-term decision-making. Our work has suggested that output would be more volatile if Britain joins the Euro Area given the existing fiscal framework. This indicates that a more active fiscal policy would be desirable to reduce the impact of this; in any case output volatility is likely to be offset by greater price stability. Judgement about whether the euro offers the necessary flexibility thus depends on how these two are traded off. We do not expect euro membership to have much of a long-run impact on jobs (although entry at an appropriate exchange rate is important); employment levels are usually regarded as determined by labour market conditions and not by monetary arrangements. But the fall in unemployment since the question was drafted in 1997 makes the point about jobs much less relevant than it was then; it would be more appropriate to look to see that euro membership was not expected to have an adverse effect on jobs, and we see no reason why, at an appropriate exchange rate, it should.

The question about the City raises the intriguing possibility that the Government will conclude that euro membership is plainly in the national interest, in that it offers higher growth and stability, but reject it on the grounds that the City might lose out. Our view is that an analysis of the impact on the City should be limited to an assessment of the consequences for the development of national income. The financial and business sector provides less than 20 per cent of national income and we have no reason to believe that there are external benefits associated with the sector which gives it more importance than this.

There are, however, now two other issues concerning euro membership which, in practice, might be as important as the five tests. The first is the so-called sixth test, concerning the transparency of the decision-making process and political accountability of the European Central Bank. For Britain to insist on changes to either as a condition for membership would, in practice, simply be a means of staying out of the currency union. To ask for the decision-making process to change in order to accommodate Britain would seem tactless to the existing members, while to make the ECB politically accountable, for example by having the inflation target set by EU governments, would go to the heart of the notion of central bank independence as required by the German constitution and would not be negotiable.

The second question concerns the exchange rate at entry. This is of great practical importance although not mentioned in the five tests because entry at an overvalued rate could lead to membership being bad for growth and employment over the medium term. Here the Government position can only be described as confused. At the time of the election, rumours that there would be an early referendum on the euro led to weakness in sterling and the Treasury made clear that it did not want the exchange rate to decline because it was concerned about the inflationary impact of a depreciation. The best way of avoiding the inflationary impact of a decline in sterling is not by delaying a referendum but by the Treasury saying that it would like early membership and that it thinks today's exchange rate is suitable. Our own view, by contrast, is that membership at a rate of [pounds]1 = [euro]1.50 would currently be appropriate and that the current exchange rate of [pounds]1 = [euro]1.65 implies an overvalued real exchan ge rate and carries deflationary risks. We note that sterling has risen to this level from [euro]1.57 in January without a sharp fall in inflation and presume that it could fall back to around or below this level without giving rise to excessive inflation.

However there is a more subtle point about exchange rates and we regard this as the key to the whole matter. The euro has fallen sharply against the US$ since it was set up in 1999. A part of this decline was simply unwinding an earlier spell of dollar weakness, but today the euro is, at [epsilon] = US$0.86, some 27 per cent below its mean value for the period 1996-8. We see three possible resolutions of this. The first is that the much-forecast recovery of the euro does eventually happen. This will allow sterling to decline against the euro without necessarily falling against the dollar; such an adjustment would be less inflationary than if sterling fell against both currencies. If this happens, there would be no economic reason not to proceed to a referendum. The second possibility is that the fall of the euro relative to the dollar represents a new exchange rate equilibrium. If this is the case there will be no recovery in the euro but, over a two-year period, we would expect the Euro Area to adjust to thi s new equilibrium without significant and sustained inflation. As a part of this process, one might expect to see further depreciation of sterling against the dollar and a modest fall against the euro, but the changes would not be very large and British industry would have to adjust to the new economic realities.

The third possibility is that the decline of the euro represents the early phase of an inflationary process and that inflation picks up sharply in the Euro Area in the next couple of years. We think this is an unlikely explanation of the current situation but if it turns out to be the case, then Britain would probably not want to join the Euro Area and it is quite possible that the monetary union would not survive.

These points, which might, by stretching the first of the five criteria be included in it, provide a good reason for waiting for two years or so to see how the weakness of the euro resolves itself and in order to obtain a better feel for the exchange rate at which Britain might think of joining the monetary union.

However, a forecast has to be produced on some assumption about euro membership. In the recent past we have assumed that sterling would join by the end of the current Parliament. Enthusiasm for this may increase, but at the moment there does not seem to be a great deal. Accordingly, in this forecast we assume that sterling stays out of the Euro Area and that the Government does not align our inflation target with that in the Euro Area. The consequences of this are that long-term inflation is higher in the UK than in the Euro Area and, because real interest rates are likely to be similar in the UK and in the Euro Area, nominal interest rates also remain higher.

The Government could, of course, avoid this outcome by reducing the inflation target. So far they have not done this in the belief that it would lead to higher interest rates and lower growth. If this were the case it would be a powerful reason for raising the inflation target in order to deliver faster growth and lower interest rates. Such outcomes would be likely only if markets did not take the Government's policy targets seriously.

Summary of the forecast
 UK economy
 Probabilities a
 Inflation Real gross
 target Output national Real Manufacturing
 met b falling c income d GDP d output d
2000 - - 3.3 3.0 1.6
2001 60 - 3.0 2.1 -1.1
2002 63 1 1.8 2.6 1.1
 Retail price index f
 Excl. Current
 Unemployment e All items mortgages balance g
2000 1.60 3.1 2.1 -14.2
2001 1.53 1.8 2.3 -8.4
2002 1.61 2.3 2.1 -15.6
 World economy
 Real Consumer World
 PSNB h GDP prices i trade j
2000 -18.4 4.8 1.8 12.6
2001 -11.7 2.6 2.0 4.0
2002 -4.1 3.0 1.4 6.6
(a)In percentage terms.
(b)Inflation excluding mortgages below 2 1/2 per cent per annum
at the end of the year.
(c)A fall in annual output.
(d)Percentage change, year-on-year.
(e)ILO definition, fourth quarter, millions.
(f)Percentage change, fourth quarter on fourth quarter.
(g)Year, [pound] billion.
(h)Public sector net borrowing, fiscal year, [pound] billion.
(i)OECD countries, percentage change, year-on-year.
(j)Volume of total world trade, percentage change, year-on-year