The UK economy.

Kneller, Richard ; Young, Garry

Section I. Recent developments and summary of the forecast

Over the past three months, the good news about the economy has outweighed the bad and the chance of a very steep recession has receded. The widespread gloom that was evident in the autumn has partly lifted. This is most apparent in equity prices, which are now at record levels. But survey evidence is also beginning to suggest that firms and households are more confident than they were, especially with regard to their own situation.

This change in sentiment is due primarily to a significant easing in monetary policy, both at home and abroad. UK interest rates have fallen from 7 1/2 per cent in September to 6 per cent in January. The financial markets are clear that further cuts are in prospect.

The easing of monetary and fiscal policy contributes to our view that the economic slowdown in the UK is most likely to be mild. The traded sector, especially manufacturing, will suffer from the effects of weak global demand and a still overvalued exchange rate. Household spending, especially on consumer durables, is also likely to be restrained partly by a lack of confidence. Private sector trading conditions, generally, will be much harsher and profits will be lower than for a number of years. There is also likely to be a small rise in unemployment. But overall the economy is expected to continue to grow and the relatively optimistic position we had taken in October appears vindicated.

Monetary conditions (Table 1)

The reduction in interest rates over the past three months was warranted by the slowdown in demand for UK goods and services that became apparent in the second half of 1998. The cuts in rates came more quickly than we had anticipated as the MPC conceded that it had earlier misread the extent of inflationary pressure in the economy. With longer-term interest rates now below 5 per cent for terms of more than five years, it is clear that the markets are expecting further significant interest rate reductions.

The actual level of interest rates will be determined in the short term by the extent of inflationary pressure. The rate of RPIX inflation in December at 2.6 per cent was marginally higher than had been expected, but this is unlikely to be a harbinger of surprise inflationary pressure. Instead it appears to reflect the impact of bad weather on food prices and the profit-seeking activities of retailers around Christmas. Looking ahead, there is little scope for any significant increase in inflation. Domestic inflation has been quiescent for some time now, despite fairly rapid economic growth, and it would be perverse if it should rise now that growth is clearly slowing. This benign outlook could be threatened by a substantial fall in the exchange rate, but policy cannot be set with such a risk in mind.

The lack of any inflationary pressure suggests that there is room for deeper interest rate cuts in the coming year or more. Eventually, interest rate policy will be determined by British attitudes to joining the euro. We have assumed in this forecast that the euro will be adopted as the British currency from the beginning of 2003, but that the exchange rate will be fixed at euro 1.36 (equivalent to DM2.65) from the beginning of 2001. Interest rates in the Euro Area are expected to be 3.4 per cent at the beginning of 2003, so UK interest rates will need by then to have converged to that level.

We have taken the view that the MPC will cut interest rates in a gradualist manner until they converge with euro-rates at the beginning of 2002. This implies that base rates fall to 5 per cent at the beginning of 2000 and 4 per cent at the beginning of 2001. It is possible that a more activist approach to interest rate policy is adopted and rates fall more quickly. But the precise speed at which rates are cut is less important than the expectation that they will be cut. The evident willingness of the MPC to reduce rates in the face of deflationary pressure was probably as important as the cuts in rates themselves in dissipating some of the gloom surrounding the economy in the autumn.

[TABULAR DATA FOR TABLE 1 OMITTED]

With UK interest rates expected to converge with those in the Euro Area by 2002, a further depreciation of the pound is anticipated. In effective terms, the pound is already more than 5 per cent lower than it was in the first half of 1998, and is forecast to fall by another 3 or 4 per cent before the exchange rate is fixed against the euro. Such a depreciation is welcome but, in our view, British firms and workers will continue to be at a competitive disadvantage at this rate. The sterling-dollar exchange rate is not forecast to change very much over the next three years.

Equity prices have continued to be very volatile in recent months. The world-wide reduction in interest rates has given the markets more confidence and led to a full recovery from the price falls of the late summer. Our forecast is based on robust growth from now onwards, but there is a considerable risk that a more sustained fall in share prices will take place at some stage in the near future. The article by Sushil Wadhwani, on p. 86 of this Review, discusses the possible extent of the over-valuation of equities. One of the risks of this forecast is that world-wide equity prices collapse, leading to a sudden slowdown in the US economy.

Falling interest rates will lead to further reductions in the cost of variable rate mortgages and the returns to a wide range of savings products. This will have a redistributory effect, transferring resources from lenders to borrowers.

The availability and cost of credit seems not to have been adversely affected by the losses made by some banks in loans outside the UK. Similarly the various monetary and credit indicators are continuing to grow at a robust rate, providing no indication of a worsening of credit and monetary conditions.

Fiscal policy (see Fiscal Report)

Fiscal policy is expected to be eased over the coming three years as spending is increased in line with the recommendations of the government's Comprehensive Spending Review. This adds to demand in the economy, especially for the output of the public sector, and will lead to a shift in resources from the private to the public sector. Without the fiscal loosening, interest rates could have been reduced further allowing the UK to join the euro area at a more competitive exchange rate.

Summary of the forecast

This forecast shows a mild downturn in the UK economy as a slowdown in the growth of private sector spending adds to the effects of a weakening external position. Growth is forecast to fall from 2 1/2 per cent in 1998 to 1 per cent in 1999, before returning to a faster rate of about 2 1/2 per cent in 2000 and 2001. Central to this relatively buoyant picture is a substantial easing of fiscal and monetary policy. In effect policy has adjusted to stabilise the real economy in response to evidence of slowing demand. Without the easing of policy that has already happened and that which is in prospect, the likelihood of a more serious downturn would be substantially greater.

Although spending by the domestic private sector is expected to be weak in 1999, the underlying financial position of households and firms appears to be very strong. One of the main factors likely to restrain spending is uncertainty about the outlook for demand and jobs. There is now a strong upside risk to the forecast that the effect of low nominal interest rates will be to contribute to faster private sector spending than we currently anticipate. This could be augmented by a surge in consumer spending associated with the year 2000 celebrations.

The composition of output will continue to be biased against the manufacturing sector which is expected to contract by 1 1/2 per cent in 1999. The service sector, which has expanded quickly in recent years, is expected to have a growth rate of between 1 and 2 per cent. The fastest growing sector will be the public sector.

The relatively mild slowdown is not expected to lead to a large rise in unemployment by way of substantial job losses, although some sectors of the economy will do worse than others in this respect. Employment has risen strongly in recent years as growth has been job rich, but productivity poor. Against this background, it would be surprising to see a rise in productivity of the scale needed to deliver a substantial loss of jobs. Consequently we are expecting ILO unemployment to rise only modestly to about 1.88 million by the end of 1999, a rise of less than 100,000 from the level at the end of 1998.

Part of the explanation for the rise in employment over recent years has been the lack of any significant wage pressure. The introduction of the National Minimum Wage in April will add about 1 per cent to the level of wages, but with the economy slowing and overtime falling, the growth of average earnings is expected to moderate slightly to about 4 1/4 per cent. Unit labour costs are expected to grow by about 3 per cent over the course of the year. With demand weak, profit margins can again be expected to contract. As a consequence inflation is expected to remain on target. We expect RPIX inflation to decline almost to 2 per cent by the end of this year and remain low in 2000.

There are substantial risks to the forecast. These appear to be more symmetrical now than in our last forecast, when the downside risk was more apparent. We estimate the probability of a recession, with output no higher at the end of 1999 than at the end of 1998, to be around 30 per cent. The probability of a steeper slowdown with average output growth below zero in the year as a whole is estimated to be around 20 per cent. On the upside, we estimate the probability that growth exceeds 2 per cent to be about 20 per cent.

With regard to inflation, we see the chance of inflation being below 2 1/2 per cent at the end of the year to be around 60 per cent, with a 25 per cent chance that it is below 1 1/2 per cent. Looking two years ahead, we estimate a 55 per cent chance that inflation is below 2 1/2 per cent.

Section II. The forecast in detail

The components of expenditure (Table 2)

The slowdown in UK growth through 1998 can be attributed to the effects of a worsening in net trade. The rate of growth of domestic demand over the year is similar, at about 3 1/2 per cent, to that of 1997. But the growth of exports of goods and services slowed from 8.7 per cent in 1997 to an estimated 2 1/2 per cent in 1998. Import growth also weakened, from 9.5 per cent in 1997 to around 7 per cent in 1998, but not to the same extent.

Within domestic demand, growth in fixed investment picked up slightly from 6.6 per cent to around 7 1/2 per [TABULAR DATA FOR TABLE 2 OMITTED] cent. Inventories also rose slightly. Household consumption grew more slowly, at around 2 1/2 per cent, than in windfall-affected 1997. But this appears to have been compensated for by an increase in the growth of government consumption to 2 per cent.

We estimate that in the last quarter of 1998, output grew only slightly. Exports are estimated to have fallen, in line with recent trade statistics, while imports are likely to have risen slightly. Fixed investment is estimated to have fallen back from the high levels seen in the third quarter. Despite concerns about the weakness of consumer spending, retail sales statistics have indicated continued growth in household consumption in the fourth quarter and we have assumed a rise of 1/2 per cent over the third quarter. Given the disappointment expressed by retailers over the level of consumer demand we have also assumed a further period of inventory accumulation.

Unlike in 1998, the main contributor to the slowdown in growth this year is expected to be a reduction in domestic demand growth. Private sector investment is expected to stagnate, with government investment being the main driving force behind growth of 1 1/2 per cent in fixed investment as a whole. Household consumption is forecast to grow slowly over the year reaching a level only 1 per cent higher at the end of the year than at the end of 1998. Government consumption is expected to be a major source of growth, rising by over 3 per cent in 1999. We expect inventory accumulation to make a negative contribution to growth of about 1/2 per cent, as companies attempt to prevent their stock levels building up excessively. Exports are expected to remain weak, growing by about 3 per cent over the year as a whole. But a decline in import growth as the economy slows will reduce the negative contribution to GDP growth of net trade.

Growth is then expected to pick up steadily to a rate of about 2 1/2 per cent in 2000 and 2001. This is accounted for by an improving contribution from net trade as export competitiveness improves and by further rapid growth in government consumption. The improved economic environment is expected to lead to a resumption of reasonable consumption growth of about 2 per cent per annum and an acceleration in the growth of fixed investment to about 2 1/2 per cent per annum.

Household sector (Table 3)

There has been a distinct slowdown in the growth of household spending over the past year that has contributed to the general state of pessimism about the UK's economic prospects. Many retailers, especially those hoping to sell 'big ticket' items, were clearly disappointed by the weakness of demand around the Christmas period. But it can be argued that this was an inevitable consequence of the boost to spending that came from various windfall payments to households in 1997. At the end of 1997, household spending generally was 4.3 per cent higher than a year earlier and spending on durable goods was 13.2 per cent higher. This probably encouraged expectations of further strong growth in 1998, but it was unlikely that households who bought new durables in 1997, probably out of their windfall receipts, would feel the need to buy similar goods again in 1998. This appears to have been the case and by the end of 1998, spending on durables looks likely to have been around 1 per cent lower than a year earlier with overall household spending up by less than 2 per cent. The annual growth rate of retail sales, which cover about 40 per cent of household spending, slowed to 1.4 per cent in the last three months of the year, down from 5.6 per cent a year earlier.

It would therefore appear that consumer demand has recently been 'disappointing' because expectations were too high in the first place. Despite the perception of weaker consumer demand, it is likely that spending has continued to be quite strong in an underlying sense once account is taken of the unusual boost to spending in 1997. This is consistent with a range of indicators which suggest that the household sector remains in a very healthy position. The usual factors that might be thought to affect consumer sentiment include real income and wealth, the level of real and nominal interest rates as well as perceptions of job security.

Despite the recent volatility of the stock market, the overall level of household net wealth (including housing) is around historically high levels. Indebtedness is not only small in relation to the stock of assets held by households, but low nominal interest rates mean that the proportion of income needed to service debt is also very low. Fears of unemployment are likely to have a dampening effect on spending, but they would be quickly dispelled if we are correct in believing that the economic slowdown will be shortlived.

Real household disposable income growth appears to have been quite weak in 1998 at around 1 per cent over the year as a whole. But this partly reflects erratically high tax payments in the first quarter of the year as a [TABULAR DATA FOR TABLE 3 OMITTED] consequence of self assessment. In the last quarter of the year, real income is expected to have been just over 2 per cent higher than a year earlier. There was very strong growth of some components of pre-tax income in 1998. In particular, compensation (wages and salaries plus employers' contributions) grew by 5 per cent in real terms. But this was largely offset by weakness in other components of income. Net property income fell by almost 4 per cent as a consequence of higher mortgage rates and a fall in dividend receipts. Further, social contributions paid rose by more than social benefits received as unemployment fell.

Our alternative measure of real income, which excludes property income and some income not paid directly to households, grew by an estimated 1.7 per cent in 1998. This shows higher growth than the official income series, but is also distorted by erratic tax payments. We expect this to grow by over 3 per cent in 1999, driven largely by continued firm growth in real compensation. But this will also benefit from less growth in tax payments on non-property income and from faster growth in social benefits received than social contributions paid. Real household disposable income is expected to grow by 2 1/2 per cent. The slightly slower growth rate in the official income series reflects an increase in taxes on property income as tax relief on profit-related pay is phased out.

Whichever measure is used, real household income growth is expected to be relatively strong in 1999 despite the slowdown in national income. This reflects a further fall in the share of profits in the economy and continued weakness in import prices.

Looking further ahead, the growth in real household disposable income is expected to come into line with that of national income. In 2000 and 2001, we expect growth of around 2 1/2 per cent. Within this total, property income is expected to grow strongly as mortgage rates are cut and dividend receipts recover from the temporarily low levels of 1998 and early 1999. But against this, transfers to general government are expected to rise. As a consequence, non-property income is expected to grow at a much slower rate than national income.

Against this background, household spending has considerable room for further expansion. However, we expect some further slowdown in the growth of spending this year in response to worries about the state of the economy generally. This is likely to be particularly noticeable in spending on durable goods. Overall, we expect consumption growth of around 1 1/4 per cent. This is consistent with a rising saving ratio. The household saving ratio averaged a little over 9 per cent in 1996 and 1997, but is likely to have fallen to 7 1/2 per cent of disposable income in 1998. This is expected to rise back to around 8 1/2 per cent in 1999.

Beyond next year, spending is set to grow at an underlying rate of around 2 per cent. This is somewhat less than the growth in real household disposable income, so that the saving ratio will continue to rise to around 10 per cent by the end of 2001. The slower growth in spending than income is partly accounted for by relatively slow growth in non-property income; in effect, fast growth in property income, much of it paid to pensions funds rather than households, is expected to have a relatively small effect on spending.

The forecast decline in household spending growth is likely to reduce growth in the demand for housing. This is expected to slow the rate of house price inflation from about 12 per cent in 1998 to about 5 per cent in 1999 and 1 per cent in 2000 and 2001.

Fixed investment and stockbuilding (Tables 4 and 5)

The outlook for fixed investment is particularly uncertain at present and is being determined by two contrary influences. On the one hand, the cost of capital is low, especially in nominal terms, and company balance sheets are strong. This would tend to support an increase in capital spending. But on the other hand, confidence is low and the prospects for demand, especially in the traded sector, appear to be poor. Given the dire scenarios for the UK and world economies that some commentators have been describing, it would be unsurprising if companies postponed some capital projects until the outlook became a little clearer.

Our overall view is that business investment will [TABULAR DATA FOR TABLE 4 OMITTED] [TABULAR DATA FOR TABLE 5 OMITTED] stagnate in 1999. This follows a number of years of strong growth. Since 1994, business investment has grown at an average annual rate of 9 per cent, with faster growth in non-manufacturing. To some extent this has been necessary to maintain the capital stock in the face of rapid obsolescence of newer types of capital. But it is likely, given the overall economic climate, that there will be a pause in capital spending.

We expect non-manufacturing business investment to rise by just over 2 per cent in 1999 and to maintain a similar rate of growth in 2000 and 2001. Manufacturing investment is expected to be much weaker than this, with a fall of around 5 per cent expected for 1999. This is consistent with the poor outlook for demand in the manufacturing sector that has been reflected in a number of business surveys. Business investment as a whole is forecast to rise by a little under 1 per cent in 1999 and about 2 per cent in 2000 and 2001.

The financial position of companies is expected to remain relatively strong, especially for non-financial companies who are expected to benefit from the low level of nominal interest rates. In aggregate, these companies moved into financial deficit in 1997 after four years of paying back debt. Their financial deficit reached [pounds]8.9 billion in 1997 and is expected to have been around [pounds]15 billion in 1998. This is expected to decline to about [pounds]5 billion in 1999 as interest rates fall and investment is subdued. This outcome depends partly on the level of dividend payments. These fell from over [pounds]17 billion in the first quarter to about [pounds]12 1/2 billion in the third quarter. This could be due to the worsening of the financial deficit, but the overall balance sheet of companies is very strong. It is more likely that the fall in dividends is a response to the announcement that Advance Corporation Tax (ACT) is to be abolished from April this year. Our forecast is for dividends to rise sharply from recent low levels and that by the year 2000 they will be 16 per cent higher than a year earlier.

Private sector housing investment is expected to be relatively static in 1999, in line with housing starts in 1998. Public sector housing investment is expected to pick up quite sharply, rising by almost 10 per cent in 1999, albeit from a low level. This is accounted for by the local authority capital receipts initiative. Other general government investment is expected to rise in line with the government's plans. We expect a rise of 4 per cent in 1999 and over 6 per cent in 2000 and 2001.

Inventory accumulation is estimated to have reached almost [pounds]4 billion in 1998, although these figures are susceptible to large revisions. Our interpretation is that some of this has been involuntary and that companies will resist building up their stock levels in 1999. We are forecasting no stockbuilding in 1999 and a slight fall in 2000.

Balance of payments (Tables 6 and 7)

The last couple of years have seen very difficult trading conditions for UK export firms. There is unlikely to be any respite in the short term. The much discussed problems in the world economy have meant that world trade growth, which reached almost 10 per cent in 1997, has stalled and is forecast only to grow at just over 4 per cent for the whole of 1999. This has led to an increase in competition in both overseas markets and at home. In addition the over-valuation of sterling during the same period has meant a deterioration of price competitiveness and profit margins. Recently sterling has weakened on the foreign exchanges, helping to explain the recent pick-up in optimism in survey data, but it remains overvalued by an estimated 10 per cent. The effective exchange rate averaged 103.9 in 1998, against 86.3 in 1996, the year in which the exchange suddenly appreciated. It is forecast to slide to 98 in 1999.

The decline in export volumes expected from such a major deterioration in price competitiveness failed to materialise in 1997, but is evident in the data in 1998. Exports of manufactured goods grew by over 9 per cent in 1997 and 1996 but have grown year-on-year by only 3.5 per cent and 1.7 per cent in the first two quarters of 1998 and not at all in the third quarter. These modest increases in exports of manufactured goods compare relatively badly with the exports of services. Exports of services grew by over 10 per cent in the first two quarters [TABULAR DATA FOR TABLE 6 OMITTED] of 1998 and still grew at a very healthy 6.8 per cent in the third quarter despite the slowdown in world trade growth. The strong export growth of manufactured goods in 1997 appears to be due to a market expectation that the appreciation of the pound was temporary and to the ability of these export firms to maintain price competitiveness by squeezing profit margins. This can be considered only a temporary solution and is why manufacturing export growth slowed in 1998. The figures for the manufacturing sector also compare badly with those for world trade, suggesting that UK manufacturing exporters are losing market share.

Given an expected fall in the value of sterling and the pick-up in world trade from current levels, export growth is forecast to recover towards the end of this year. Manufacturing exports are forecast to grow by 5 per cent in the last quarter of 1999 and by 6 per cent in 2000, while service exports are forecast to grow by between 4 to 5 per cent over the same period. On these figures exporters should broadly maintain their share of world markets.

Reductions in import prices resulting from the appreciating exchange rate have meant that the terms of trade have risen to levels last seen in the early 1990s. UK [TABULAR DATA FOR TABLE 7 OMITTED] exporters have attempted to maintain competitiveness through cuts in export prices, although not by as much as the change in the exchange rate. As noted elsewhere the manufacturing sector has been more successful than the services sector in achieving these reductions in export prices but this has meant that these firms have felt the pressures of the Bank of England's interest rate policy more acutely. The terms of trade are forecast to fall in 1999 as sterling begins to depreciate on the foreign exchange markets. Both export and import prices are forecast to stop falling and to begin to rise again by the middle of this year.

Imports of both manufactured goods and services grew by over 10 per cent in 1996 and 1997 and by over 7 per cent in 1998. However, recent figures have suggested that this rate of growth has now begun to decline. The figures for year-on-year growth for the third quarter of 1998 were 4.5 per cent in service imports and 8 per cent for goods. As the UK economy slows further and sterling depreciates the growth of imports is expected to continue to fall through 1999 to just over 3 per cent (compared with 6.8 per cent in 1998) and 4 per cent in 2000.

The turmoil in international financial markets had some benefits for the UK balance of payments in the third quarter of 1998. The losses by foreign owned banks and other financial institutions reduced profits remitted abroad and meant that these were marked as credits on the services balance such that the current account was some [pounds]2.5 billion in the black. The services balance which had fallen to just over [pounds]3 billion in the first two quarters of 1998 jumped to [pounds]7.7 billion in the third quarter on the back of these losses by foreign financial institutions. The forecast is for a surplus of around [pounds]18 billion per annum in 1999 and 2000. The trade balance, in contrast, continues to fall further into the red. The trade deficit on goods is forecast to increase from -[pounds]11.9 billion in 1997 to close to -[pounds]20 billion in 1998. A faster rate of growth of exports over imports is expected to reduce the rate of increase of the trade deficit beyond this date. The current balance, which recorded a [pounds]7 billion surplus in 1997 is now expected to be close to balance in 1998 (a deficit of [pounds]1.7 billion), but the deterioration of the trade balance means that the overall deficit is expected to continue to increase after this date.

Output and employment (Tables 8 and 9)

The slowdown in growth has not been shared equally among the different industrial sectors. Manufacturing output has been depressed throughout 1998 and fell quite sharply in the last few months of the year. Construction output was noticeably weak in the second and third quarters, partly reflecting lower infrastructure output. But output has been especially strong in the business services, transport and telecommunications parts of the service industries. Public sector output has also been relatively robust, growing at about the same rate as the economy as a whole.

As the economy slows down, there is little reason to suppose that the industrial composition of output will change dramatically except that public sector output will grow more quickly than that of the private sector. This reflects the announced increase in government spending. In 1999, we expect manufacturing output to fall by about 1 1/2 per cent, construction output to fall by 2 per cent and private sector services output to grow by between 1 and 2 per cent. Public sector output is expected to grow by around 3 1/2 per cent.

As growth picks up again in 2000 and 2001, we expect to see a more even pattern of growth in the private sector. Manufacturing is likely to perform better as the exchange rate depreciates somewhat and competitiveness is improved. Public sector output is likely to continue to be strong.

The slowdown in activity in 1999 is expected to be associated with a fall in productivity growth. This is [TABULAR DATA FOR TABLE 8 OMITTED] common in the downturn of a business cycle as capacity utilisation falls and firms hold on to labour that they could manage without, to avoid the costs of sacking workers and having to hire similar staff shortly after. There is also likely to be some fall in hours worked per worker.

The extent of the fall in productivity growth will reflect the costs of hiring and firing workers, expectations about how long the slowdown is likely to last as well as the extent to which companies can afford to hold on to surplus staff. There is a general view that the labour market is now more flexible than it used to be, particularly in view of the number of workers who work part [TABULAR DATA FOR TABLE 9 OMITTED] time or are on temporary contracts. This would encourage companies to lay off surplus staff, thus reducing the extent of any fall off in productivity. However, the general financial health of the company sector and the likelihood that the slowdown will be short-lived work in the opposite direction. Our overall view is that productivity growth will fall somewhat in 1999. The extent of the fall is relatively small with a decline in the growth rate from 1.3 per cent in 1997 and 1998 to about i per cent in 1999. Manufacturing productivity is expected to be stagnant in 1999.

As growth picks up again in 2000 and 2001, productivity is also likely to increase as underutilised workers become more productive. This is expected to be particularly apparent in manufacturing which tends to have higher productivity than most other industrial sectors.

Overall productivity growth is expected to rise to about 1 3/4 per cent in 2000 and 2001. This would be the fastest growth rate seen since 1994. Productivity growth has been low over the recovery from the recession of the early 1990s as those without jobs have been absorbed into work. Relatively low earnings growth over this period has enabled those without work to find it, but this has been achieved partly at the expense of productivity. The capital-labour ratio has shown relatively slow growth over most of this period. But this is liable to change if the current slowdown is relatively mild and there is no appreciable slackening of the labour market. Then real earnings growth would pick up, encouraging firms to increase capital investment thus raising labour productivity.

Employment is expected to be stagnant in 1999 as output growth of 1 per cent is accounted for by productivity growth of 1 per cent. There is expected to be a small fall in employment in manufacturing, but this is likely to be made up for by an increase in employment in the public and private service sectors.

Unemployment is expected to rise very modestly over the course of 1999 and by the end of the year is expected to reach 1.4 million on the claimant count and 1.88 million on the ILO definition. Further modest increases are expected for 2000 and 2001.

The small response of unemployment to the forecast economic slowdown mainly reflects the shallowness of the downturn that we are predicting. But it can also be attributed partly to the effect of the New Deal for young unemployed people. In previous economic downturns, there has not been such a comprehensive scheme in place to give help and advice to people who have lost their jobs as well as the offer of job subsidies to firms who take them on. This is expected to limit the extent to which unemployment is allowed to build up.

It is also important to recall that unemployment has been falling on the ILO definition at a rate of about 250,000 a year for the last five years as it has adjusted from the high levels of the last recession. Few people would claim to know the precise level at which unemployment can be sustained, with many estimates being around 7 per cent of the workforce. But against its recent downward trend, the forecast rise in unemployment represents a substantial change relative to the level it might have attained in the absence of a economic slowdown.

Earnings and prices (Tables 3 and 10)

We use the average earnings series implicit in the National Accounts as an indicator of earnings growth. This suggests that the growth of average earnings is now beginning to slow down. Although still strong, the third quarter average of 4.3 per cent is felt by most commentators to be consistent with the Bank of England's inflation target of 2.5 per cent growth in RPIX. This figure is below the peak in the second quarter of 1998 of 5.2 per cent.

Average earnings growth is expected to fall this year from 4.75 per cent in 1998 to close to 4.0 per cent in 1999. A number of factors explain this. Firstly there is the completion of bonus payments and profit related pay adjustments, which are backward looking in nature. As the economy slows and profit margins fall these are likely to exert less upward pressure on wages. Secondly, the expected slowdown in demand along with the [TABULAR DATA FOR TABLE 10 OMITTED] expected rises in unemployment suggests an unwinding of the pressures on wages from shortages from skilled labour. Survey evidence also suggests that firms are complaining less about of a shortage of skilled workers. Further, evidence from the Industrial Relations Services (IRS) survey suggests wage negotiators are beginning to switch their focus from pay increases to job security, while firms, on the expectation that profit margins will fall, are reported as being less willing to submit to pressure for higher pay. Finally wage demands are expected to decline as a consequence of falling inflation. Wage settlements for many workers are linked to current RPI inflation, which has fallen since last year, and expectations of future inflation. The expectation is that the RPI will continue to fall, partly as a consequence of falling mortgage interest payments, a view that also appears in the latest survey data.

Average earnings growth this year will be affected by government initiatives such as the national minimum wage (NMW). The NMW is expected to add around 1 percentage point to average earnings growth by the middle of this year. The impact on the labour market of the NMW remains unclear as does the effect of other government initiatives, such as the working time directive introduced in October 1998. Given this, although market conditions suggest the upward pressure on wages will be weak, there remain some transient upside risks to the forecast for average earnings.

Growth in whole economy unit labour costs remained strong at 4.0 per cent for the third quarter of 1998 which appears to be a consequence of slow productivity growth. This is slower however than the 4.1 and 4.5 per cent seen in the first and second quarters respectively. Unit labour costs are forecast to grow between 2.5 to 3.0 per cent this year, before falling to around 1.0 per cent in 2000.

Elsewhere in the economy inflationary pressures remain weak. The GDP deflator, the most comprehensive measure of cost pressures, grew by 1.1 per cent in the year to the third quarter of 1998 (down from 2.0 per cent in the second quarter). This is very low compared with recent UK history and represents the lowest figure for four-quarter growth since 1994. It is below the average figure expected for 1998 (this figure includes the forecast for the fourth quarter) of around 1.8 per cent. This compares with our forecast for 2000 of about 2.0 per cent and about 1.75 per cent in 2001.

Producer input prices fell again in the third quarter of 1998, by 0.1 per cent, although this is a smaller fall than in the previous two quarters of 3.9 per cent and 2.5 per cent respectively. Despite the increase in wage costs discussed above, other costs, such as import prices, fuel and raw materials, have fallen in price. These, combined with difficult trading conditions have meant that producer output price growth has also remained low. Producer output prices were weak through 1998. The forecast is that prices from both these series will continue to fall until around the middle of this year before beginning to rise thereafter. Input prices are expected to grow significantly in 2000 at above 5 per cent per annum.

The imports deflator fell again in the third quarter of 1998 and the index now stands at 89.0 (1995 = 100). These price falls, which have been going on throughout 1997 and 1998, have been faster for goods and oil than services. The index for the price of manufactured goods stands at 85.8 in the third quarter of 1998 (the last available data point) while the index of service imports stands at 94.2 (both 1995 = 100). These falls have not however been as fast as the rise of sterling and are believed to reflect profit creaming by foreign firms. As a consequence import prices are not expected to rise by as much when sterling begins to weaken on the foreign exchange markets.

The index for import prices is expected to stop falling around the middle of the year, before its growth rate rises to around 3 per cent per annum by the end of the year and into 2001. Given that imports account for around 10% of GDP and 20% of final expenditure this can be regarded as adding to inflationary pressure.

Import prices can be viewed as one of the few potential sources of inflationary pressure within the economy over the next few years although this depends on the exchange rate falling. Somewhat ironically they may also become a significant problem if interest rates are cut more aggressively than market expectations causing sterling to weaken faster than we have forecast. This view also appears in the minutes of the January MPC meeting and partly explains the decision to move interest rates downwards in a series of small steps. Interestingly this approach would also suggest, or at least not rule out, further cuts in base rates over the coming months.

The strength of sterling has meant that UK exporters have been forced to reduce their prices by cutting costs and squeezing profits in order to maintain competitiveness. According to the latest available data the index of export prices stands at 92.3 in the third quarter of 1998 (1995 = 100) against 92.7 in the second quarter. Reductions in export prices by this means can only be regarded as a short-term solution.

The majority of falls in the aggregate export price index have been achieved by falls in the price of UK goods along with the fall in the oil price rather than the services sector. Prices of manufactured goods are now 20 per cent lower than the base year of 1995, while prices in the service sector are over 2 per cent higher. This difference can explained in part by the strong growth in average earnings (which have been even higher in the service sector) which account for a large part of costs in the service sector. Manufacturing export prices are forecast to continue to fall through 1999 whereas the export price of services are expected to grow by around 4-5 per cent per annum in the middle of this year before the growth rate settles at around 2-2.5 per cent per annum beyond this. The overall export price index is expected to continue to fall up until the middle of the year before reaching about 1 per cent growth by the end.

Inflation has remained within 2.5 to 3 per cent for the last few years despite the strength of the UK economy; the forecast is for RPIX inflation to fall below target as the economy slows.

The RPIX measure of inflation can usefully be compared to its sister series the RPI and the RPIY. The RPI has been above the RPIX measure since early 1997 and currently stands at 2.8 per cent for December (down from 3.0 per cent in November). This difference can be explained by the mortgage interest payments component not included in RPIX which rose as the MPC raised base rates. The mortgage interest component of the RPI rose by 28 per cent in the second quarter of 1998 and 20 per cent in the third quarter. As a consequence of base rates now being lowered the RPI measure of inflation is beginning to fall and is expected to fall below RPIX inflation by the first quarter of 1999 and remain below for the period thereafter.

RPIY inflation excludes from it both changes in mortgage interest payments and indirect taxation. Changes in indirect taxation have meant that the RPIY inflation has remained below the RPIX measure over recent years and stands at 2.0 per cent per annum for December. This figure is up slightly on the October and November figure of 1.8 per cent per annum. This measure provides strong evidence that despite the growth of consumer expenditure and earnings over the last couple of years retailers have felt unable to raise prices. RPIY inflation is forecast to remain around or below 2 per cent per annum through 1999 and into 2000.

The Office for National Statistics has recently started publishing the Harmonised Index of Consumer Prices (HICP), a measure of retail price inflation which is consistent across European countries. The HICP is broadly comparable with other inflation series but has slightly different coverage and excludes housing costs. It also uses a different method of weighting the prices of different goods. The last HICP data is for October 1998 when the inflation rate was 1.3 per cent. This is down by 0.2 percentage points from September. Our forecast suggests that this measure of inflation will rise slightly in 1999 reaching 1.9 per cent by the end of the year. The target range set by the European Central Bank is 1.5 to 2 per cent per annum.

National and sectoral saving (Table 11)

Table 11 shows our forecasts of national and sectoral saving. This puts together parts of the forecast that have already been discussed. This shows that in 1998 saving and investment in the UK were almost exactly balanced with domestic investment financed by domestic saving.

Over the next two years, national investment is expected to rise relative to saving. This is the equivalent of [TABULAR DATA FOR TABLE 11 OMITTED] an increase in the deficit on the current account of the balance of payments, which is expected to worsen to 1 per cent of GDP by 2001. In this way the overseas sector provides the necessary savings to finance the domestic shortfall. A current account deficit of this size is not a problem, although it will mean that the net financial position of the UK will worsen further. In the third quarter of 1998, the UK was estimated to have a negative net overseas assets position of [pounds]60 billion. This is expected to widen to about [pounds]100 billion by the end of 2001.

Within the domestic economy, the household sector is in its customary position of saving more than it invests and lending the surplus to other sectors. Investment by the company sector is expected to continue at about 12 1/2 per cent of GDP, larger than it is able to fund from retained profits alone. As a consequence the company sector is expected to draw in funds from other sectors to finance its investment plans. Its deficit is expected to reach 3 per cent of GDP by 2001.

The government sector is in approximate balance at present. While saving is expected to remain positive (thus meeting the Golden Rule on one possible definition), it is not expected to be sufficient to finance rising investment (so that the government continues to run a deficit). Thus it too is likely to need to borrow from other sectors to finance its need for capital.

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 the development of the economy 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. It can be argued that the development of the British economy over the 1990s has been largely shaped by the need to adjust to the recession of the early part of the decade. The main problem for the economy over the past two years or more has been its grossly over-valued exchange rate. The adjustment to this will have a continuing effect on the economy over the coming years. But in other ways the economy is well balanced with inflation low and unemployment probably close to its sustainable rate.

Foremost among the policy influences is whether the UK decides to adopt the euro. We have assumed that this will take place at the beginning of 2003, but that sterling will be fixed at euro 1.36 (equivalent to DM 2.65) from the beginning of 2001. This allows a two-year trial period of exchange rate stability before rates are irrevocably fixed. UK interest rates are assumed to have converged on euro rates by the beginning of 2002. On the basis of current market rates, this would mean that UK interest rates fall to around 3 1/2 per cent in the early years of the next decade, before rising to 4 1/2 per cent by the end of the next decade.

Inflation is forecast to be very low over this period. This is based on a view that the European Central Bank (ECB) will be as successful in controlling inflation as the Bundesbank has been in recent years. With the sterling [TABULAR DATA FOR TABLE 12 OMITTED] exchange rate fixed, there will not be room for large 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.

It is likely that sterling will enter the euro area at an exchange rate which is overvalued by about 5 per cent. This will also contribute some downward pressure on inflation. The effective exchange rate is expected to appreciate throughout most of the decade as the euro rises against the dollar.

The outlook for interest rates and inflation is consistent with real interest rates of around 2 to 3 per cent per annum. 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.

Fiscal policy is assumed to be tight on average over the period in line with the current government's targets. But if the UK adopts the single currency, then fiscal policy will need to be used for stabilisation purposes. To have sufficient flexibility for this purpose, it will be necessary for the budget deficit to be small on average. In keeping with this, government consumption is expected to grow by less than GDP. This would allow some increased spending on transfer payments as the proportion of pensioners in the population rises.

Unemployment, on the ILO definition, is forecast to settle at about 6 1/2 per cent of the working population. This is slightly higher 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 1 3/4 per cent per annum, the same as the rate of growth of productivity. Other price indices are expected to grow a little more quickly than this, reflecting small increases in indirect taxes, a slight worsening of the terms of trade and, in the case of the RPI, an increase in mortgage costs once interest rates begin to rise.

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.

On this basis we would expect to see economic growth of around 2 per cent per annum over the next ten years, with lower growth beyond that as the population of working age grows more slowly. Among the expenditure components, household consumption is expected to grow by about 2 per cent per annum. Fixed investment is set to grow by slightly less than this, but net trade is set to make a small positive contribution to growth as competitiveness improves gradually over the period. This reflects an adjustment to a slightly uncompetitive [TABULAR DATA FOR TABLE 13 OMITTED] starting position. The current account is set to remain in deficit by about 1 1/2 per cent of GDP throughout the period.

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 January Review. The latest National Accounts information available when these forecasts are constructed is for the third quarter of the preceding 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 1999 will be between 0 and 2 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 prediction intervals of our forecasts.

Thus, inflation is likely to remain low, most likely between 1 1/2 to 3 1/2 per cent but with a large risk this year of it being below 1 1/2 per cent. Forecasting 2 years ahead is much more uncertain as shown by the probability distribution of the various outcomes. Effectively there is a I in 3 chance of inflation being in the range of 1 1/2 to 3 1/2 per cent with a similar probability of it being below and above this range.

Table 14. Probability distribution of growth and inflation forecasts

Inflation: probability of 12 month RPIX inflation falling in the
following ranges

 1999Q4 2000Q4

less than 1.5 per cent 25 37
1.5 to 2.5 per cent 35 16
2.5 to 3.5 per cent 22 15
more than 3.5 per cent 18 32

 100 100

Growth: probability of annual growth rate falling in the following
ranges

 1999 2000

less than 0 per cent 18 10
0 to 1 per cent 32 11
1 to 2 per cent 32 19
2 to 3 per cent 15 20
3 to 4 per cent 3 19
more than 4 per cent 0 21

 100 100

As regards output there is an 18 per cent chance of average output falling this year and a 30 per cent chance that it will be no higher at the end of the year than at the end of 1998. There is an 18 per cent chance of the growth rate exceeding 2 per cent. As with inflation the forecasts for 2000 are much more uncertain and the risks more diffuse. There is roughly a 40 per cent chance of growth between 1 and 3 per cent, with a 20 per cent chance of it being below 1 per cent and a 40 per cent chance of it being above 3 per cent.

Box A. Long-run monetary policy and exchange rate assumptions

The objective of monetary policy is to achieve underlying inflation, measured by the RPI excluding mortgage interest payments (RPIX) of 2 1/2 per cent at all times. Since monetary policy is believed to act with a lag, interest rate decisions are based on the prospects for inflation up to two years ahead. If recorded inflation turns out to be a percentage point higher or lower than the target, then the Governor of the Bank of England is expected to write an open letter to the Chancellor explaining why this occurred and what is to be done about it. Evidence from the National Institute model suggests that, with the best will in the world, it is only possible to keep inflation within such a narrow range for 50 per cent of the time.

Our assessment of inflationary conditions suggests that the MPC will continue reducing interest rates in 1999, eventually converging on German interest rates in 2002. Our forecast for the exchange rate is generated from the assumption that the UK will join EMU in 2003. Of key importance here is the level of the exchange rate at which EMU entry might take place. Experience in the ERM demonstrated conclusively the importance of choosing the right rate. In our view an appropriate rate for sterling is about 1.30 euro to the pound, or lower. However, we no longer think that sterling will be as low as this by the time the government is otherwise ready to fix the exchange rate. As a consequence, it is expected that sterling will join EMU at a rate of euro 1.36 (equivalent to DM2.65). In order to join EMU at this rate in 2003, it will be necessary for the exchange rate to trade at around this level from early in 2001. As the Maastricht Treaty implied, it would be unwise to consider entering a monetary union without a reasonable prior period of exchange rate stability. This allows the prospective partners to judge whether their economies are sufficiently convergent for there to be a good chance that the union will be a success.