THE UK ECONOMY.

Young, Garry

Garry Young [*]

Section I. Recent developments and summary of the forecast

The government's plans for public sector spending set out in its recent spending review caused relatively little surprise as they mainly confirmed what had already been announced in Budget 2000. This was that overall spending, Total Managed Expenditure (TME), would rise by 4 per cent per annum in real terms over the four years to 2003-4. More detail did emerge on how this overall increase would be allocated among the individual government departments. Falling debt interest payments and the effects of lower unemployment on welfare payments and tax receipts will allow departmental spending to rise by an average of 6 per cent per annum in real terms over the same period. A substantial part of this increase is earmarked for capital projects, with the capital budget more than doubling over the four-year period. This means that departmental current spending will rise at the slower rate of about 3 per cent per annum in real terms.

The announcement of these plans has raised a number of concerns about the effect of large increases in departmental spending on the public finances and the economy more widely. Our assessment of the implications for the public finances is contained in the Fiscal Report beginning on page 32. In brief, there appears to be ample scope to finance these spending increases within the existing tax structure and our central forecast is for the overall budget to be in broad balance in the medium term.

Of more concern is the effect on the economy. As the government has itself emphasised, fiscal policy appears to have been tightened sharply in recent years. In Budget 2000, the government took credit for a cumulative fiscal tightening of 4.2 per cent of GDP since 1996-7, measured by the fall in cyclically-adjusted net borrowing by the public sector as a percentage of GDP. In the Fiscal Report, we argue that this overstates the tightening because some of the reduction in government demand has been offset directly by lower private saving due to the changes in public spending and taxation. Nevertheless, there is little doubt that fiscal policy is now being loosened when the economy is closer to full capacity than it was when policy was tightened. This must pose a threat to the outlook for inflation and interest rates.

There are two possible reasons why sharp increases in interest rates might be unnecessary. First, the growth of private sector spending might fall back to accommodate the increase in public spending and so keep the trend in overall spending in line with the trend in output. Second, productivity growth might pick up and allow the economy to sustain a faster growth rate for a number of years. This could of course be helped by the increase in infrastructure investment included in the spending plans.

In our view, a case can be made for each of these possibilities. Household spending has grown strongly over the past three years and more quickly than the growth of income. This has meant that the household saving ratio has fallen from over 9 per cent of disposable income in 1996 and 1997 to 3.8 per cent in the first quarter of this year. This is the lowest rate of saving since the late 1980s, driven partly by fast growth in asset prices but also because higher taxes have been paid for by lower private saving. Having reached such a low level, it is plausible to expect household saving now to increase somewhat, especially if asset price inflation is slowing.

Moreover, over time there has been a clear inverse relationship between the saving of households and government. While such a relationship comes about partly through changes in inflation and interest rates, there are other reasons to expect that the savings decisions of households and government are connected. These range from Ricardian ideas of government saving being a substitute for household saving to the more straightforward notion that taxes that support government saving are often paid out of household saving rather than consumption. While such relationships cannot necessarily be relied on, this pattern suggests that any reduction in saving by government might help to bring about a rise in saving by households.

Business investment growth outside the manufacturing sector has also been very strong recently, growing by over 10 per cent per annum in each year since 1997. As with consumption growth, this rate of expansion is unsustainable and will drop off once the capital stock has been brought up to its desired level. It is quite possible that this will occur this year, although this is very uncertain at present.

Taken together, there is a distinct possibility of some slowdown in private sector spending to offset an increase in public spending growth. It is also possible that productivity growth will increase. This could reflect so-called 'new economy' considerations, but it can also be argued that productivity growth has fallen behind its trend in recent years as employment has expanded rapidly. This is due partly to unusually slow growth in manufacturing productivity since 1995 when the industry as a whole has been affected by the strength of sterling. By the end of 1998, the level of manufacturing productivity was no higher than it had been in 1995. While it grew by 3.6 per cent last year, the pressures on profitability within the industry make it likely that productivity growth will accelerate once sales and output start to expand.

We have built an increase in productivity growth into our forecast. This is not for 'new economy' reasons but because manufacturing industry in particular is assumed to be making up for lost time. Thus after growing by 1 1/2 per cent per annum in each year between 1997 and 1999, we are expecting overall productivity growth to rise to 2 1/2 per cent this year and 3 per cent in 2001 and 2002 before slowing down gradually over time. In the hard-pressed manufacturing sector, we see fast productivity growth as the only reliable way for firms to raise their profit margins. We are expecting manufacturing productivity growth to rise to 4 per cent this year and 5 per cent in 2001 and 2002. In the accompanying box, we discuss some of the possible consequences for the economy if productivity growth does not expand as quickly.

The expected pick-up in productivity growth, together with some slowdown in the growth of private spending, means that the economy can accommodate increased public spending without provoking a large rise in interest rates. However, we do not believe that interest rates have peaked at 6 per cent. There is little evidence of spare resources in the economy at present and while there is also little inflationary pressure, the risks to inflation appear to be on the upside. We would expect the Monetary Policy Committee (MPC) to raise interest rates to 6 1/4 per cent at the end of the summer, and to raise them again to 6 1/2 per cent by the beginning of next year. We are predicting that rates then stay at this level for three years, before gradually converging on European levels of around 5 per cent at the beginning of 2005 when the UK is assumed to adopt the euro.

The forecast is based around a rate of entry to the euro at [epsilon]1.55 at the beginning of 2005. This is only slightly below the rate of [epsilon]1.59 that is assumed for the average of the current quarter in the forecast. This projected entry rate is based on market exchange rates and yield curves as of 17 July. If it is assumed that arbitrage equalises the expected rate of return that investors can obtain on bonds denominated in different currencies then it is possible to infer future market interest and exchange rate expectations from current market prices. With short-term interest rates in the UK higher than those in the rest of Europe, the market appears to be expecting sterling to decline to about [epsilon]1.57 in 2002 and remain at that level for three or four years. But with long-term rates of interest in the UK at 4.6 per cent and those in Germany at 5.5 per cent, the market also appears to be expecting short-term interest rates in the UK to fall below those in the Euro Area in the long term. If t his is correct then investors must also be expecting sterling to rise in the long term to offset the lower interest rate obtainable on UK stock. In fact, we doubt that long-term interest rates in the UK are currently a true reflection of market expectations. It is likely that they are distorted by an excess demand for government stock caused by a combination of falling debt and regulations imposed on financial institutions which require them to hold this stock. As a consequence, we have used market prices only as a guide to the rate at which sterling might enter the euro rather than a hard and fast measure of market expectations.

Thus we are not expecting any substantial change in the exchange rate in the medium term, although this remains a strong possibility. The actual and forecast exchange rate is now about 3 per cent lower in effective terms than in our last forecast and 5 per cent lower against the dollar. Perhaps more importantly, the exchange rate has fallen significantly from the temporarily very high levels reached three months ago when it rose above [epsilon]1.70. This caused much consternation among manufacturing firms who felt that the rate was a threat to their continued presence in the UK. Anecdotal information suggests that they would settle for a rate of [epsilon]1.55 and are now basing their longer-term decisions on the exchange rate remaining at around this sort of level, while hoping that it will fall further.

Summary of forecast

The slight fall in the effective exchange rate and more substantial fall in the rate against the dollar, together with a stronger outlook for world demand have changed the outlook a little since our last forecast. In particular the prospects for growth in 2001 now look better and, while this is expected to add to inflationary pressure, other new information suggests the economy's ability to generate non-inflationary growth may have improved. For example, revisions to the national accounts have raised the measured level of output while reducing estimates of some prices. In addition average earnings growth has dropped back more quickly than many expected.

The official preliminary estimate of GDP growth in the second quarter has been put at 0.9 per cent. This suggests that the relatively weak first quarter represented a pause after fast growth in the second half of last year rather than a reduction in the underlying rate of growth. We are expecting growth to continue at a slightly faster rate over the remainder of the year to give a rate of just over 3 per cent for the year as a whole.

Domestic demand is set to expand by just under 4 per cent this year, similar to the rate seen in 1999. This will be offset by a smaller negative contribution from net trade with import growth of 8 per cent outstripping export growth of around 7 per cent.

Given the level of sterling, it is likely that the service sectors will continue to grow more quickly than manufacturing in 2000, although we do not expect that the contraction in manufacturing output in the first quarter will be repeated this year. Manufacturing is expected to grow by about 1 1/2 per cent in the year as a whole. Growth in public sector output is expected to pick up to over 3 per cent as increased public spending feeds through.

Faster economic growth cannot reduce unemployment much more without generating excessive inflationary pressure. Instead, with little slack in the labour market, much of the expected growth in output has to be met by increases in productivity. Productivity growth is expected to be particularly strong in manufacturing where it reached 3.5 per cent in 1999 in difficult trading conditions. We expect to see productivity growth in manufacturing of about 4 per cent this year, in line with its average over the 1980s and first half of the 1990s. This will contribute to an increase in productivity growth in the whole economy of around 2 1/2 per cent, the fastest growth rate since 1994.

The combination of increasing aggregate demand and a relatively tight labour market is expected to put some upward pressure on wages. We are expecting earnings growth of around 5 per cent this year. With price inflation expected to remain subdued, this represents an increase in real wages of around 3 per cent.

Household incomes, which fell in the first quarter because of higher tax payments, are forecast to grow by 3 per cent in 2000, driven mainly by the growth in labour incomes. With household consumption forecast to grow at a similar rate, the saving ratio is projected to remain quite low at around 4 1/2 per cent in 2000, down from 5 per cent in 1999.

The various influences on household spending, including financial and housing wealth, interest rates and unemployment, are all supportive of a relatively low saving ratio, but it is unlikely that they will change in such a way as to encourage it to fall significantly in 2001. We are expecting the growth in household consumption to slow from 3 1/2 per cent in 2000 to 3 per cent in 2001 as the growth in household non-property income slows.

Although household consumption growth is slowing, the growth in domestic demand is forecast to remain at around 3 1/2 per cent per annum over the coming three years. This is partly driven by increased public spending. Government consumption is expected to grow by 41/2 per cent in 2001, and government investment is set to rise by almost 20 per cent. With the negative contribution from net trade waning, the overall growth rate is forecast to rise to 3 1/2 per cent in 2001.

On the basis of this central forecast, we calculate that there is only a slim chance of output declining in 2001. Indeed, we estimate that the chances of growth being below 2 per cent are only about 20 per cent. Most of the risks are for growth being very strong with a probability of it exceeding 4 per cent being put at about 40 per cent.

We expect that the sectoral pattern of output growth in 2001 will be similar to this year with manufacturing remaining fairly weak. Continued pressure on profit margins is expected to lead to further productivity growth in manufacturing of about 5 per cent in 2001. Job losses in this sector will be more than made up for by employment gains in the rest of the economy. With productivity growth rising to around 3 per cent per annum, aggregate employment is projected to rise at around the same rate as the workforce and this will reduce unemployment only modestly from current levels to about 5 1/2 per cent on the ILO definition by the end of next year.

Against this background, inflationary pressures are expected to begin to build up. We are expecting RPIX inflation to remain at around 2 1/2 per cent until the end of 2001, with an expectation that it will fall below 2 per cent in the short term. The probability of inflation being above target at the end of 2001 is put at 48 per cent, with a 28 per cent chance that it is above 3 1/2 per cent. However, by the beginning of 2002 there is a clear danger that it will rise above the target. There is a one-in-three chance that it will exceed 3 1/2 per cent in two years' time.

Section II The forecast in detail

The components of expenditure (Table 2)

After slowing at the turn of the year, GDP growth rose to 0.9 per cent in the second quarter. This estimate was published after our forecast was completed. We had estimated growth of 0.8 per cent. Using this estimate, GDP in the year to the second quarter was 2.8 per cent higher than it had been a year earlier. This was driven by continuing strong growth in domestic demand of 3.6 per cent, with net trade making a negative contribution of -0.8 per cent.

There are no clear signs of any easing in private domestic demand growth and with public spending set to expand quickly at the same time as a synchronised upturn in the world economy, the prospects for aggregate demand are worryingly strong.

Household spending has been the main factor driving domestic demand. But with the saving ratio now at a low level, this is forecast to slow slightly over the coming two years to a rate of around 3 per cent per annum. Businesses outside the manufacturing sector have spent heavily on investment goods recently. This is believed partly to reflect the installation of infrastructure associated with mobile telephones and other forms of information technology. We are expecting this also to slow down after recent rapid growth. However, fixed investment by the public sector is planned to grow strongly. While there is a good deal of uncertainty about its timing, it is likely that this will boost overall fixed investment in the coming years. We are expecting growth in total investment of more than 5 per cent in 2001 and 2002 after an increase of 3 1/2 per cent this year.

Government consumption has been less expansionary than departmental budgets allowed and in the first quarter it returned to a level marginally lower than it had been a year earlier. The under-spend partly reflects the new spending control regime which allows departments to carry over their allocations from one year to the next, when in the past there would have been an incentive to use them up before the year-end. The relatively low outturn for the first quarter means that the growth rate in the year as a whole is likely to be around 2 per cent. But growth is set to accelerate next year to around 4 1/2 per cent.

The overall growth rate of domestic demand is set to remain at around 3 1/2 per cent per annum over the coming two or three years as slowing growth in household consumption is offset by accelerating government spending.

While net trade has continued to make a negative contribution to GDP growth, this has waned considerably since the beginning of 1999 when it was reducing the annual growth rate by about 2 percentage points. We expect that its negative contribution will have disappeared completely by the end of next year. There are three main reasons for this. First, the effect of a high exchange rate is to reduce the level of net exports and is unlikely to have a permanent effect on the growth rate. Second, the synchronised upturn in the world economy is increasing the size of UK export markets. Third, the shift in the composition of domestic demand growth from private to government consumption is likely to reduce import penetration. Overall we expect export growth to pick up to about 7 per cent per annum from 3.3 per cent last year. Import growth is expected to rise to over 8 per cent this year, before falling back to around 7 per cent per annum in 2001 and 2002.

Household sector (Table 3)

The financial position of the household sector as a whole continues to be very strong and this is providing firm support for consumption. Spending in the first quarter was 4 per cent higher than a year earlier, with purchases of consumer durables other than vehicles up by 16 per cent, clothing and footwear up by 6.5 per cent and spending on transport and communications up by 5.5 per cent. In each of these cases, there was a fall in prices over the same period emphasising the competitiveness of the market for consumer goods. The weakness of household spending on vehicles, which was broadly flat over the year, reflects a general view that car prices are due to fall significantly in the near future.

In value terms, spending on services outstripped that on goods, but this was due to faster growth in prices than in the volume of services brought.

The combination of intensely competitive product markets and a tightening labour market is helping households to benefit from strong growth in real incomes. Total pay is currently growing at a little over 6 per cent per annum, but gross disposable income is expanding more slowly at 5 per cent per annum, partly reflecting the impact of higher tax payments and lower benefit receipts as the movement from welfare to work continues.

With consumer prices growing by around 2 per cent per annum, this is equivalent to an annual increase in real household disposable income of around 3 per cent.

Household income is likely to continue to grow strongly as increasing aggregate demand causes the labour market to tighten further. This is not necessarily unsustainable as there would appear to be room for productivity improvements that would allow household income to grow at an above trend rate for a few years. We expect that real household disposable income will grow by 3 per cent this year, rising to 3 1/2 per cent in 2001 and 2002.

Over the past three years household spending has grown more strongly than income as increased tax payments appear to have been paid our of saving rather than consumption. This has had the effect of reducing the saving ratio from over 9 per cent of household resources in 1997 to 3.8 per cent in the first quarter of this year. Despite this, household wealth has grown strongly, driven by capital gains on equity and housing. In real terms, household net wealth has risen by about 40 per cent since the end of 1995. This also provides a strong background to household spending. Of course, the gains to asset price inflation are not evenly distributed and the high level of house prices in London and some other parts of the country will do little to boost the spending of those who have recently financed their purchases by borrowing. Nevertheless, with nominal interest rates continuing at a low level by recent historical standards, the amount of income that has to be given up to finance house purchase is still relatively low.

While very uncertain, the balance of probabilities suggests that asset price inflation will be relatively subdued in the short term. Many commentators believe that equity markets are overvalued and there are now signs that the housing market is slowing. The perception that the market is slowing is often sufficient to bring it about and we expect house price growth to slow slightly through the year. Our forecast that house prices will be about 10 per cent higher at the end of this year compared with a year earlier is broadly in line with the expectations of other forecasters.

We expect there to be a modest slowdown in household consumption growth this year to around 3 1/2 per cent, with a further fall in the growth rate to 3 per cent in 2001. This will bring spending growth broadly into line with income growth and the saving ratio will remain at around S per cent of household resources.

The relatively low level of saving seen recently has meant that households in aggregate have been borrowing from other sectors over the past two years. Given the very strong balance sheet of the sector as a whole, we do not see this as a problem.

Fixed investment and stockbuilding (Tables 4 and 5)

Fixed investment growth in the non-manufacturing business sector has been very strong over the past three years, growing by 50 per cent since 1996. This reflects a number of factors, including low business taxes, low real interest rates, robust growth in demand, substantial falls in equipment prices and the effect of a strong stock market in reducing the cost of capital. In addition to this, there have been a number of areas where business growth has required the installation of substantial new capital. This includes mobile phone and cable networks. Unfortunately, there is hardly any published evidence that allows us to measure their contribution to overall investment growth. This makes it difficult to predict likely future levels of investment in this sector. On the one hand, it might be thought that once large private infrastructure projects have been installed, capital spending can be reduced substantially. This would suggest that the level of investment might be about to fall. On the other hand, the recen t pace of technological change in information and communications technology suggests that further growth is likely. Our forecast builds in modest growth of 2 per cent in this sector this year, with growth of just over 4 per cent in 2001 and 2002. But the link between investment growth and technological change, which is very difficult to predict, makes this one of the more uncertain areas of the overall forecast.

While similar factors are affecting the manufacturing sector, the main influence on investment growth here has been the generally depressed level of activity. This has meant that product demand could be met through existing capacity. Investment fell by 14 per cent in 1999, albeit from a high level, but picked up in the first quarter to a level 3.2 per cent higher than a year earlier. This mainly reflected capital spending 13.5 per cent higher than a year earlier in the chemicals and engineering industries. The fact that these industries have been the fastest growing parts of manufacturing reinforces the view that capital spending is related to the strength of product demand. The outlook for investment growth here is looking more positive now that sterling has fallen from the levels reached in April. We expect that it will be broadly flat in 2000 and 2001, before picking up further in 2002.

Private sector housing investment is perhaps weaker than one might expect given the strength of the housing market in general. We are expecting growth of above 4 per cent, both this year and in 2001. Investment in commercial property has not been strong in recent years, reflecting the excess capacity built up in the late 1980s. However, rents are now growing more quickly and prices are also picking up. This has led to signs that some new development, at least in London, is for speculative purposes. This is perhaps evidence of renewed confidence in the commercial property sector.

Public sector housing investment is expected to grow sharply this year, rising by over 20 per cent, but from a low level. The main non-housing component of general government investment is also expected to rise sharply over the coming years in line with the government's plans. However, there is a good deal of uncertainty about when the expenditure will actually be made. Public sector investment was up by 3.6 per cent in 1999 and is expected to grow by 64 per cent between 1999 and 2002.

The overall outlook for fixed investment spending is good, albeit with a number of uncertainties relating to companies' need for new capital rather than the availability and cost of finance. Our central expectation is for growth of 3 1/2 per cent this year, followed by growth of 5 per cent in 2001 and 2002.

As with the household sector, the company sector balance sheet appears to be strong overall. However, just as investment spending has been disparate across different industries, so some firms, particularly those exporting to the Continent, have a worse balance sheet than the average. Nevertheless, there is no strong evidence of a significant number of companies in financial difficulty. The strength of the overall balance sheet also indicates that the company sector net borrowing of around 2 per cent of GDP is unlikely to be problematic or to impose a brake on capital spending.

Balance of payments (Tables 6 and 7)

The traded sector of the economy has suffered the effects of a high exchange rate against the other European economies since the end of 1996. This has resulted in both a loss of market share in export markets and a sharp reduction in the profitability of exports. The volume of exports grew by an average of 3 percentage points less than world trade in 1998 and 1999. This loss of share would have been much more pronounced if exporters had not reduced their prices substantially. The average price of manufactured exports is now 14 per cent lower than in 1995, but export price competitiveness is still 3 per cent worse than at that time, reflecting the effects of the strong pound and low world inflation.

It now appears that the outlook for exporters is much more promising with world demand growing quickly and the exchange rate having fallen back somewhat from its highs in early May. While there is relatively little room for manoeuvre, firms are likely to take advantage of the improving situation to boost their margins, especially in export markets.

Looking forward, we do not expect to see any substantial improvement in export price competitiveness. Export prices are expected to go up slowly from now onwards as firms attempt to improve their margins and by the end of the year manufactured export prices are expected to be 3 per cent higher than at the end of 1999. A further rise of 4 1/2 per cent is in prospect for next year.

Against this background, the volume of manufactured exports is expected to grow by about 10 per cent in both this year and next. This is more or less in line with the growth of world trade which is forecast to grow by 10 per cent this year and 7 1/2 per cent in 2001.

Manufactured import prices are forecast to grow by 1 per cent this year and 3 per cent in 2001. This would mark an end to the period of falling import prices enjoyed since 1996. Nevertheless the volume of manufactured imports should continue to expand strongly with growth expected to be 9 per cent in 2000 and 8 per cent in 2001.

The trade balance is forecast to reach a record deficit of [pound]23 1/2 billion in 2000. We expect this to decline over the next few years as the world economy remains strong and domestic exporters seek to improve their profitability. This improvement is also reflected in the overall goods deficit which is expected to fall from [pound]29 billion this year to [pound]26 billion in 2002. With the services, transfers and income balance forecast to return a surplus of around [pound]15 billion, the overall current balance deficit is forecast to decline from [pound]15 billion this year to [pound]12 billion in 2002. This is relatively small at just over 1 per cent of GDP.

The financial account of the balance of payments has seen some very large flows recently. These largely reflect international mergers and acquisitions. In the first quarter, direct investment abroad was [pound]125.3 billion. This mainly reflects the acquisition of Mannesmann AG by Vodafone AirTouch Plc for [pound]133 billion. This was financed by the issue of Vodafone AirTouch shares to Mannesmann shareholders and, as such, is recorded as inward portfolio investment. Such flows swamp the current account deficit.

The net investment position of the UK economy showed a negative balance of [pound]128.7 billion at the end of the first quarter. This is the difference between assets of [pound]2582.3 billion and liabilities of [pound]2711.1 billion. Despite the negative net balance, net income is generally positive (over [pound]8 billion in 1999) reflecting the higher yield on assets than liabilities, much of which are on deposit in the UK banking system. While this situation persists, the overall net position is not any cause for concern.

Output and employment (tables 8 and 9)

The annual growth rate in the first quarter was 2.9 per cent. This reflected strong growth of 3.3 per cent in the service sector and slower growth of 1.5 per cent in production. The construction industry picked up strongly to grow by 4.8 per cent. At a more detailed level, output in the post and telecommunications industry grew by 13.3 per cent. This industry produced 67 per cent more output than it did in 1995. Apart from such obvious exceptions, growth over the past year appears to be much more similar in different industries than had been the case a year or more ago.

It had been feared that such divergent trends would continue this year, with manufacturing looking particularly vulnerable to problems caused by the high exchange rate. However, recent information suggests a better outlook. The exchange rate has declined from its earlier peaks. At the end of April it reached [epsilon]1.71, 7.5 per cent higher than is assumed for the current quarter. In addition, manufacturing output grew in April and May and is expected to show growth of around 0.6 per cent in the second quarter. With demand picking up generally, the prospects for manufacturing are better than they were three months ago. We now expect growth of about 1 1/2 per cent in manufacturing output this year. This is set to rise by around 2 1/2 per cent in 2001 and 2002.

Although the outlook for manufacturing has improved, the industry is unlikely to perform as well as other parts of the economy. Public sector output will expand quite strongly in response to increased spending. Similarly, the service sector is also likely to continue to expand rapidly.

The increase in aggregate output in the forecast is not expected to be matched by increased employment. The number of workforce jobs is expected to increase at a similar rate to last year, by 0.8 per cent, to 28.21 million by the end of the year. While there are differences across sectors this implies that the increases in output discussed above must be generated by improvements in productivity.

Productivity growth has been relatively sluggish since the mid-1990s, such that its level is now only 7 per cent higher than in 1995. This has been much less than might have been expected on past trends. It reflects the absorption into employment of almost one and a half million people over the same period. It also partly reflects the stagnation of manufacturing which is typically the source of much of the UK's productivity growth. Our expectation is that productivity growth will make up some of the lost ground over the next few years. This is likely to be particularly apparent in manufacturing. Here profitability has been hit by the strong pound and this will encourage firms to keep costs down as they grow. We are expecting productivity growth here to pick up to 4 per cent this year and 5 per cent in 2001 and 2002. It is possible that this underestimates the scope for a productivity improvement since this does little to make up for the ground lost since the mid-1990s.

Greater competition for labour in the other sectors of the economy is likely to encourage firms there to economise on the number of workers they employ. We expect overall productivity growth to rise from 1.5 per cent in 1999 to 2 1/2 per cent this year and 3 per cent in 2001 and 2002. This is above the trend growth rate and reflects some catch-up, following below trend growth in the second half of the 1990s.

Employment is expected to grow at about the same pace as the workforce in the next few years. This will stabilise the unemployment rate at around current levels.

Thus ILO unemployment is expected to remain at around 5 1/2 per cent of the workforce. The non-employment rate is also expected to stabilise at about 24 per cent of the population of working age.

Earnings and prices (Tables 3 and 10)

After peaking at 6 per cent in February, the headline rate of growth of average earnings in the whole economy fell to 4.6 per cent per annum in May. On the national accounts measure of wages and salaries per head, pay growth was at 5.2 per cent per annum in the first quarter. Given the distortions in pay around the turn of the year and the effects of the introduction of the National Minimum Wage in April 1999, underlying pay is probably now growing at around 4 1/2 per cent per annum.

Looking ahead, continuing growth in the economy is likely to add to upward pressure on pay. This will be compounded by the effect of slightly increasing RPI inflation which tends to form the basis for many pay deals. We expect a modest rise in the growth of average earnings to just over 5 per cent in 2000 and then to 5 1/2 per cent in 2001 and 6 per cent in 2002.

This rate of growth need not contribute to excessive inflationary pressure if it is accompanied by fast enough growth in productivity which reduces the growth of unit labour costs. Unit labour costs are estimated to have grown by 4 per cent in 1999, reflecting growth of 5 per cent in average earnings and productivity growth of around 1 1/2 per cent (other influences on unit labour costs are employer contributions made to the national insurance scheme and other payments on behalf of employees). It is generally reckoned that the trend growth rate of productivity in the UK is about 2 per cent per annum. However, after the sluggish performance of the late 1990s, we expect it to expand sufficiently to keep the growth of unit labour costs in check at around, or just under 3 per cent per annum. But with import prices now expected to rise, having fallen from 1996, any pressure on inflation from the labour market will not be off-set by cheaper imports.

This would suggest that the inflation outlook is now very finely balanced. We foresee consumer prices rising by 2 per cent by the end of this year and by 2 1/2 per cent by the end of 2001, broadly in line with costs. A similar pattern is predicted for RPIX, but the headline RPI is expected to rise a little more quickly in response to the rise in interest rates in the second half of 1999.

Other domestic prices are expected to grow more or less at the same rate as consumer prices. The GDP deflator is expected to grow at about 2 1/2 per cent in 2001, but is forecast to rise to 3 per cent in 2002, partly reflecting faster growth in the prices of goods and services consumed by the government.

National and sectoral saving (Table II)

The current account deficit of the economy as a whole is a reflection, subject to a statistical residual, of the financial position of the individual sectors in the economy. Table 11 shows how the imbalances between the saving and investment of the individual sectors is resolved. Ultimately, any investment that cannot be financed by domestic saving needs to be financed abroad.

Household sector saving is expected to be about 3 per cent of GDP this year, but picking up in the years ahead. At present saving is less than investment by households resulting in an unusual financial deficit. This means that the household sector is not a net lender to other sectors as is usually the case. Company sector saving is expected to remain below investment such that the deficit of saving relative to investment is of the order of 2 per cent of GDP. The government sector is now meeting the Golden Rule so that its saving is positive and is forecast to remain in excess of its investment over the next three years.

The current account moved into deficit last year and is expected to remain at a little over 1 per cent of GDP in the coming four or five years. It is fairly clear that the movement into deficit of the current account of the balance of payments is associated with the increased deficit of the private sector. For households, saving fell sharply in 1998 and has remained low since. For companies, the move into deficit can be traced back partly to the strength of the pound which has encouraged spending to be switched away from domestic goods and towards foreign goods, thereby reducing profits and company saving. If this situation were to continue then companies would at some stage need to adjust their saving or investment to prevent their indebtedness rising too quickly. This would feed through either directly, through lower spending on foreign investment goods, or indirectly through the effects of lower dividend payments on household spending on imports, to the current account. The process of adjustment would also affect prices in such a way that competitiveness is eventually restored. Through these channels, a current account deficit is ultimately corrected.

The economy in the medium term (Table 12)

The way in which the economy behaves over the medium term is determined partly by a range of shocks that are inherently unpredictable. But there are other important influences on its development that can be foreseen. These include trends in the size and composition of the population, forthcoming changes in the policy framework as well as adjustments to existing disequilibria. As we have noted, the economy as a whole is close to an equilibrium position at present, but there are a few imbalances that will be adjusted in the medium term. Among these is the current weakness of manufacturing due largely to the overvalued exchange rate.

We continue to assume that sterling's rate against the euro will stabilise in the fairly near future in advance of actually joining EMU. We have assumed that sterling will be fixed at [epsilon]1.55 (equivalent to DM3.04) from the beginning of 2005, a rate broadly consistent with market expectations. Many would regard this rate as being too high and it certainly implies a higher real exchange rate than the UK has been able to sustain historically. But since the end of 1996 the economy does appear to have adjusted to a high exchange rate. At first exports appeared not to be affected by the strong pound, but these then weakened sharply both in 1998 and in the first half of 1999. The contraction in the manufacturing sector was also a consequence of the high pound. But we now see grounds for expecting the growth of exports and manufacturing output to recover without a substantial depreciation of the nominal exchange rate. However, we are not expecting the ground lost over the last few years to be made up.

The increases in public spending announced in Budget 2000, especially with respect to investment, will have an expansionary impact of aggregate demand over the medium term. This will put some upward pressure on domestic inflation and the current account deficit which will however decline over the coming decade as households and firms bring saving and investment into line.

Inflation is forecast to remain low over this period. With the sterling exchange rate fixed, there will nor be room for large persistent differences in inflation across the Euro Area. So long as this is clearly understood, expectations, which are crucially important in the inflationary process, should help anchor inflation itself.

The outlook for interest rates and inflation is consistent with long-term real interest rates of around 2 per cent. This is much lower than has been normal in the UK over the past twenty years, but is consistent with real yields on UK government index-linked debt. Short-term interest rates are expected to rise slightly, reaching 6 1/2 per cent in 2001. They are then projected to fall, converging on euro rates by the beginning of 2005.

Unemployment, on the ILO definition, is forecast to fall to just over S per cent of the working population. This is slightly lower than is the case now, and is a reasonable estimate of the sustainable rate of unemployment. The rate of real wage growth is sensitive to which deflator is used. Using the GDP deflator at basic prices, the real wage is forecast to grow at about 2 1/2 per cent per annum, similar to the rate of growth of productivity.

The government has identified slow productivity growth as one of the important problems of the UK economy and it is possible that policy action over the coming years will be successful in raising it. However, we have made no special allowance for this. Our forecast of productivity growth is consistent with long-term trends in the economy, although we are forecasting some above trend growth in the early part of the decade as productivity makes up some of the ground lost in the second half of the 1990s.

Forecast errors and probability distribution (Tables 13 and 14)

Table 13 provides a set of summary information as regards the accuracy of forecasts that have been published in the July Review. The latest complete National Accounts information available when these forecasts are constructed is for the first quarter of the current year.

A rule of thumb is that a 70 per cent confidence interval for a variable of interest can be obtained by adding a range of one absolute average error around our central forecast. Thus we can be 70 per cent sure that GDP growth in 2000 will be between 2.4 and 3.8 per cent. The size of the average errors indicates that some variables are easier to forecast than others. For example, the errors in forecasting consumers' expenditure are smaller than those in forecasting fixed investment. It is also the case that the error in forecasting GDP growth is smaller than that made in forecasting its components. This arises because of offsetting movements among the components.

The probability distributions around the growth and inflation forecasts have been calculated assuming that the distributions are normal and are shown in Table 14. The standard errors have been calculated from the historical forecast errors underlying Table 13. These estimates of the probability distribution around our central forecasts provide a quantitative assessment of the limits of our forecasts.

Our estimates suggest that there is now a 76 per cent chance that growth this year will turn out to be in the range of 2 to 4 per cent, with only a 10 per cent chance of growth below 2 per cent. For next year, growth prospects are much more uncertain. However, it is now thought very unlikely that it will be below 1 per cent. There is a 51 per cent chance that it will be between 1 and 4 per cent and a 40 per cent chance that it will be above that.

For inflation, there is a 60 per cent chance that it will end the year between 1.5 and 2.5 per cent. The risks are clearly larger looking ahead. In two years' time, there is an evens chance that inflation will be above 2 1/2 per cent. However, the imprecision of the forecast is shown by the fact that there is a 30 per cent chance that it will be below 1 1/2 per cent. The chance that it will be more than 1 per cent away from target in either direction is put at 60 per cent. The fact that it has stayed within this fairly narrow bound over the past two years is an indication of either the skill of the MPC or their good fortune.

(*.) The forecast was compiled using the latest version of the National Institute Domestic Econometric Model. I am grateful to Ray Barrell, Richard Kneller, Nigel Pain, Rebecca Riley and Martin Weale for comment and discussion.

Box I. Productivity to the rescue?

Our central forecast sees the growth rate increasing to accommodate higher public sector spending without generating any substantial inflationary pressure. The key reason that this is feasible is because we believe that there is room for a spurt in productivity growth to match the spurt in spending. This box considers the outlook for the economy if this judgement is wrong.

Without an acceleration in productivity growth, firms would be able to meet demand only by increasing employment and this would tighten the labour market further, contributing to an increase in wage pressure. In the short run, an increase in wages would reduce the profit share. But it would also add to inflation, unless action were taken to damp down demand by raising interest rates.

To quantify these effects we have re-run the forecast, assuming that productivity grows at an average rate of 2.1 per cent per annum over the five years to 2004. rather than the 2.6 per cent per annum growth predicted in the central forecast. We have not changed the interest rate and exchange rate projections underlying the forecast in order to focus on the impact on inflationary pressure. In the short run, output would grow as in the main forecast, but with employment rather than productivity rising. But in the longer term it would decelerate to reflect lower productivity growth. ILO unemployment would be reduced temporarily by 1/2 a percentage point relative to the main forecast and RPIX inflation would rise to 3.7 per cent in 2001, almost 1 1/2 percentage points above the main case. This shows how far inflation can change even within the MPC's forecast horizon.

Increased inflationary pressure at home would worsen competitiveness, thus reducing exports and increasing imports. This would worsen the current account deficit, but also draw in resources to meet fast-growing demand. However, the public finances would be improved further in this situation. This is because public spending is fixed in cash terms, while the extra inflationary pressure is likely to raise tax receipts.

The table below outlines some of the main results. It shows an upside risk to inflation that might materialise without a pick-up in productivity growth. An early signal of this would come from an acceleration in earnings growth above the rate of 5.4 per cent per annum predicted for 2001 in our forecast.

However, this is just one of the many risks to which the forecast is exposed. It is possible that productivity growth stays low, but wage pressure does not pick up because the sustainable rate of unemployment is lower than we currently believe. A good guide to the overall uncertainty surrounding our forecast is shown in tables 13 and 14 of this chapter.