The UK economy.

Kneller, Richard ; Young, Garry

Section I. Recent developments and summary of the forecast

It is now just over two years since the new framework for monetary policy was announced and operational responsibility for the setting of interest rates was devolved to the independent Monetary Policy Committee (MPC) at the Bank of England. A key component of the new arrangements is their accountability. One of the ways in which this is meant to be achieved is by the 'open letter' system, whereby the Governor is to write to the Chancellor whenever inflation is one percentage point higher or lower than the target. It is remarkable that no open letters have yet had to be written.

Inflation over the past two years has been more subdued than at any time since the beginning of the 1960s. On the broadest measure of prices, the GDP deflator at basic prices, annual inflation in the first quarter was 1.9 per cent. This was the ninth consecutive quarter that it was less than 2.5 per cent. Other measures of inflation tell a similar story, the government's target measure of inflation (RPIX) was down to 2.2 per cent in June, with headline RPI inflation down to 1.3 per cent. The internationally comparable harmonised index of consumer prices (HICP) was growing at 1.4 per cent in June, only slightly higher than the EU and Monetary Union area averages (1.1 and 1.0 per cent respectively in May).

The outlook for inflation over the remainder of the year is similarly benign. This has raised concerns that the inflation target might actually be undershot and partly accounts for the decision of the MPC to cut interest rates to 5 per cent in June. Very few people would have believed two years ago that the first open letter from the Governor to the Chancellor would be to explain why inflation had fallen below 1 1/2 per cent, but in the second half of this year there is a probability of about 40 per cent of this happening.

Looking further ahead however, there is now a clear prospect of an upturn in inflationary pressure by the middle of next year. This is because some of the factors that have contributed to recent good performance are unlikely to be sustained as the economic recovery gathers pace.

The main concern is that the labour market did not slacken as growth in the economy stalled. This has meant that unemployment has fallen to a level which may well be below the level that the economy can sustain in the long run. Estimates of the sustainable rate are very uncertain and it may be the case that labour market reforms over a number of years have reduced it to such a level that there is room for further labour market tightening before wage pressure re-emerges. The recent experience of non-inflationary growth in the US points to this possibility.

Wage pressure has been very subdued recently. Excluding bonuses, average earnings grew by 3.3 per cent in the whole economy in the year to May. This is almost two percentage points lower than had been the case a year earlier. This decline partly reflects the fall over the same period in the headline RPI, which forms the base for many wage negotiations. But it is also due to worries in the second half of last year that unemployment was about to rise sharply. Now that these fears have passed, there is a clear risk that wage demands will be increased as the labour market tightens further.

The inflationary implications of wage growth depend on the extent to which it can be financed out of productivity growth. Productivity has stalled over the past year in line with the general weakness in the economy. In the first quarter, it was only 0.5 per cent higher than a year earlier. With such low productivity growth, unit labour costs were 4.5 per cent higher in the first quarter than they had been a year earlier.

Continued growth in labour costs at this rate would pose an obvious threat to the inflation outlook. However, productivity is likely to pick up over the coming year in line with economic growth as companies make more use of their workers. This will reduce inflationary pressure at any given rate of wage growth, but with a tightening labour market could also prompt wage acceleration.

One of the other key factors influencing price developments has been the willingness of companies to accept lower profit margins in a more competitive market. This has been particularly true of the traded sector of the economy where external competitive pressures have been intensified by the strength of the pound. It is notable that unit labour costs have been more tightly controlled in manufacturing where wage growth in the year to May was no faster than growth in productivity. The productivity growth in the year to May of 3.6 per cent came about because of widespread cuts in employment.

When measured in the same currency, costs in the UK are now very high relative to those in the rest of Europe. Unit labour costs in the UK relative to those in other European countries are now 25 per cent higher than was the case on average over the 1984-96 period. A slightly different way of seeing this is to look at the relationship between foreign prices and domestic costs when expressed in the same currency, as in chart 1.

With foreign prices relatively low in relation to domestic costs, firms competing internationally face a dilemma concerning their pricing policy. Either they price to the market, so sustaining their market share but on a very reduced margin, or they price to their costs, maintaining their profitability but on a reduced market share. Neither option is particularly attractive and companies will tend to use a mixture of strategies.

There is some evidence that UK companies have been using different strategies in different markets. In particular, the price of manufactured exports has fallen by around 12 per cent in sterling terms from its peak at the end of 1995. But domestic prices have been relatively steady over the same period. As chart 2 shows, this has meant that UK manufacturers have become more uncompetitive in the domestic market (where their relative price competitiveness has worsened by over 20 per cent since the end of 1995) than in the export market (where their relative price competitiveness has worsened by just over 10 per cent over the same period).

The consequence of this is that margins on domestic and export business have diverged.

Chart 3 shows the very different pattern of margins. While the domestic profit margin has fallen a little since the middle of last year, profitability remains high. This is because the weakness in producer prices at home is sustained by a similar weakness in costs. Until recently, unit labour costs in sterling terms have been subdued, while import prices and the price of inputs have fallen. But the export margin has collapsed to its lowest level since at least the mid-1970s.

The different approach to pricing at home and abroad would appear to be consistent with other information suggesting that the weakness in demand for manufactured goods at the beginning of the year had been predominantly in the domestic market. In the machine tools industry, home turnover in the three months to February was over 20 per cent lower than in the same period a year earlier. By contrast, export turnover was up by 12 per cent. A similar pattern applies to the engineering sector. Home turnover in the three months to February was 1.8 per cent higher than a year earlier, but export turnover was up by 7.6 per cent.

There is of course a limit to how far companies can sacrifice profits in order to maintain sales. The latest evidence suggests that the recent improvement in manufacturing is being driven predominantly by growth in domestic demand. In the machine tools industry, home turnover in the three months to May is 0.8 per cent higher than in the three months to February. By contrast, export turnover is down by over 12 per cent. A similar pattern applies to the engineering sector. Home turnover in the three months to May is 1.0 per cent higher than in the three months to February, but export turnover is down by 1.7 per cent.

If this improvement in domestic conditions is sustained, then manufacturing firms are likely to attempt to improve their domestic margins. As a consequence, this source of disinflationary pressure is expected to wane as the economy picks up.

Monetary conditions (Table 1)

Thus it is possible to view the very low rates of domestically generated inflationary pressure seen currently as unlikely to survive an improvement in the general economic situation. If sterling were also to fall sharply from current levels, then the risk of an increase in inflationary pressure would be strong.

Indeed, inflationary pressure is likely to build up without a fall in the exchange rate. If it remains at around current levels, then the exchange rate will no longer be acting to reduce inflationary pressure at any given level of overall demand. With low international inflation, a fairly constant exchange rate will have a neutral effect on domestic prices. A rise in domestically generated inflationary pressure will then feed through into inflation itself.

Recent movements in the exchange rate have seen the pound appreciate against the euro, but depreciate against the dollar. Other things being equal, this movement of currencies would tend to increase inflationary pressure as many world prices are denominated in dollars. In fact, the dollar prices of oil and basic materials are now stronger than at the time of our last forecast, thereby adding to inflationary pressure.

Our short-term forecast builds in a very modest exchange rate depreciation with the sterling rate against the euro falling from ??1.53 in the current quarter to ??1.50 by the end of next year. The rate against the dollar is expected to rise slightly over the same period. However, longer-term exchange rate expectations are assumed to be based on entry into EMU at the beginning of 2003 at a rate of ??1.33, broadly consistent with our estimates of a competitive rate. The assumption that the pound will fall to a competitive level sometime beyond 2000 does nevertheless have an effect on our short-term inflation forecast since inflation is partly determined by what it is expected to be. This is shown in chart 4, which compares the paths of inflation on different assumptions about the rate of entry in 2003.

As in our April forecast, we have assumed that the general expectation that the exchange rate will be fixed at ??1.33 is incorrect. Instead, we have assumed that from the beginning of 2001 expectations of the entry rate are gradually revised upwards from ??1.33 to ??1.44, equivalent to DM2.825. This is the rate implied by four-year interest rates on sterling and euro denominated risk-free bonds. UK interest rates are then set equal to those in the rest of the euro area once the sterling exchange rate is fixed against the euro from the first quarter of 2003.

The revision to exchange rate expectations does not affect the short-term forecast, but it does affect the behaviour of the economy in the early part of the next decade. To see this, Chart 5 shows the changing pattern of interest rates and exchange rates as people learn that sterling will join EMU at a high rate.

This shows a trade-off between higher interest rates and a higher exchange rate which prevents the overvalued exchange doing too much damage to the real economy.

[TABULAR DATA FOR TABLE 1 OMITTED]

In the short term, we have assumed that interest rates remain at 5 per cent until the end of next year. At present, there is a clear tension between the very good short-term outlook for inflation and the risk that it will pick up in the next year. With sterling so strong, the MPC is unlikely to raise interest rates until there are clear signs of an increase in inflationary pressure. This is unlikely to become apparent until next year, if at all. However, the MPC will also be mindful of the mistakes of the 1980s when interest rates were not raised by enough to head off excessively strong growth in domestic demand. The then Chancellor, Nigel Lawson, has said that monetary policy was too loose in 1986 at a time when inflation was also relatively low:

"On the basis of the information that was available to me at the time, it would have been thought highly eccentric to have pursued a tighter policy than I did. Inflation, however measured, was down to 3 1/2 per cent in 1986 - reflecting of course the impact of lower oil prices. (Indeed the headline rate went below 2 1/2 per cent in July 1986.) Producer price inflation was already at its lowest level for decades. House prices did ... start to take off; but this followed several years in which there had been virtually no increase in real terms at all. Moreover at this stage the housing boom seemed confined to central London, and around the turn of 1986-87 the Bank advised me that it was probably petering out." (Nigel Lawson, 1992, The View From No. 11, Bantam Press, p. 645.)

With hindsight, the early indicators of inflationary pressure slightly after that time were rapidly rising asset prices, especially house prices, and a substantial worsening of the current account of the balance of payments which dissipated some of the excess growth in domestic demand. While house prices have been growing strongly and the current account is heading for a large deficit, neither of these indicators are yet suggesting an inflationary threat comparable to that of the late 1980s. Nevertheless, they and other indicators will be watched closely for an inflationary signal.

Perhaps one of the most important lessons of that period is the need to discourage excessive optimism about economic prospects. There is therefore a need for the MPC to be prepared to move interest rates preemptively to avoid this.

It is also clear that the costs of adopting a monetary policy stance that is too tight are falling. While the MPC would rightly be castigated for undershooting the inflation target if the economy were in recession, it would be more difficult to be critical when the economy is growing well and unemployment is falling.

Thus interest rates are not expected to be changed so long as the strength of sterling continues. However, an interest rate rise will become increasingly likely if the economy develops as we expect. The longer-term outlook for interest rates is dictated partly by the approach to monetary union. With Euro-area interest rates continuing at a much lower level than in the UK, convergence will require some fall in UK rates before EMU entry in 2003. We have assumed some rise in rates to 6 per cent by the end of 2001 before falling back to just under 5 per cent in 2003.

Share prices have recovered substantially from their weakness in the late summer of last year. While there are strong grounds for believing them to be overvalued, we have forecast that they will continue to rise at the same rate as nominal income.

Summary of the forecast

It is now clear that output growth in the UK economy paused at the turn of the year with measured growth of 0.1 per cent in the final quarter of 1998 and no growth in the first quarter. Our latest estimates, based on a range of information, suggest that growth resumed in the second quarter at a rate of slightly less than 1/2 per cent. It would therefore appear that any threat of recession is now in the past.

Prospects for the remainder of this year and into 2000 are generally good. Apart from stockbuilding, all of the components of domestic demand are expected to grow steadily. The household sector is expected to benefit from strong income growth, with real wages rising by about 3 per cent this year. With interest rates remaining low, the threat of unemployment disappearing and further strong growth in asset prices, there is an excellent background for household spending. In addition, the government is committed to large increases in its own spending on both goods and services and capital. The background to private sector investment is also fairly good, although we do not expect the manufacturing sector to be raising its capital spending.

With the exchange rate continuing at a very high, uncompetitive level, some of the expansion in domestic demand is expected to spill over into an increased current account deficit. We expect import growth of about 5 per cent this year, with exports approximately flat. This adverse movement in net trade is expected to reduce the growth rate this year by about 1 1/2 percentage points. Export growth is expected to pick up a little next year, but net trade is still expected to make a negative contribution to the growth rate of about 1/4 per cent. The goods deficit in the balance of payments is forecast to rise from [pounds]20 billion in 1998 to [pounds]34 billion next year.

The growth rate is expected to be around 1 1/4 per cent in 1999, rising to about 2 1/2 per cent in 2000. Given the composition of demand, the weakness in manufacturing industry is expected to continue. We expect its output to fall by around 1 per cent this year, before growth picks up 1/2 per cent in 2000. Public sector output is expected to grow by 2 to 3 per cent in 1999 and the following two years as public spending increases. The output of the private sector service industries is also expected to pick up quickly after relatively slow growth of 2-3 per cent this year.

In recent years, output growth has been achieved by expanding employment rather than by productivity gains. This has been achievable because of spare capacity in the labour market. However, it is doubtful that there is much more unused capacity to absorb. Consequently we expect further growth in the demand for labour to bid up average earnings. This will have two effects. First, it will encourage firms to economise on labour and improve productivity. Second, it will add to inflationary pressure.

Average earnings are now forecast to grow by about 4 3/4 per cent in this year and next, but with the growth rate picking up to 6 per cent by the end of 2000. Productivity growth in the whole economy is forecast to rise from 1/2 per cent this year to 2 per cent in 2000 and 2001.

Employment growth is set to continue at a relatively low rate, so that unemployment stabilises at around current levels of around 1.8 million on the ILO definition.

As earnings growth picks up and the effects of a higher exchange rate on inflation begins to wane, we expect to see some increase from the low rates of inflation seen this year. RPIX inflation is forecast to rise from 1.8 per cent at the end of this year to 3.1 per cent at the end of next year. The path for the headline RPI is expected to be more volatile. At the end of this year, it is forecast to be growing at an annual rate of 0.7 per cent, benefitting from the effects of low interest rates. By the end of next year it is forecast to be growing by 3.7 per cent, reflecting the effect of the abolition of tax relief on mortgage interest payments.

There are substantial risks to this, as to any forecast. We estimate the probability of a recession, with output no higher at the end of 1999 than in the first quarter, to be around 16 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 7 per cent. On the upside, we estimate the probability that growth exceeds 2 per cent to be about 16 per cent.

With regard to inflation, we see the chance of it being below 2 1/2 per cent at the end of the year to be almost 80 per cent, with a 40 per cent chance that it is below 1 1/2 per cent. Looking almost two years ahead, we estimate a 37 per cent chance that inflation is below 2 1/2 per cent at the end of 2000.

Section II. The forecast in detail

The components of expenditure (Table 2)

The background for renewed growth in demand continues to be favourable with all of the main domestic sectors well placed to increase spending. Households are in a strong financial position and are likely to experience good growth in income. Additionally, the expected pickup in domestic demand should encourage further growth in capital spending by companies. Government consumption is also expected to rise strongly in line with announced plans. The main factors restraining growth are likely to be a negative influence from destocking and the continued depressing effects of an [TABULAR DATA FOR TABLE 2 OMITTED] overvalued exchange rate and slow world trade growth.

We estimate that in the second quarter of 1999, output grew by about 0.4 per cent. Within this total, household consumption is also forecast to have grown at 0.4 per cent, with slightly higher growth of 0.5 per cent in government consumption. Fixed investment is forecast to have risen by 2 per cent on a weak first quarter with inventories falling by [pounds]0.1 billion. Together, these contribute to a 0.6 per cent growth in domestic demand. This is expected to have been offset by a further negative contribution from net trade with exports rising by less than imports.

In the year as a whole we now expect to see robust growth of a little under 3 per cent in domestic demand. This is driven by strong growth of 2 3/4 per cent in household consumption, 3 1/4 per cent in government consumption and 5 1/2 per cent in fixed investment, as strong growth in the non-manufacturing and public sectors offsets a sharp fall in manufacturing investment. Stockbuilding is expected to be close to zero, thereby making a negative contribution to growth of about 1/2 per cent. Exports of goods and services are expected to remain very weak, falling slightly on the year. The effect of this on growth is partly offset by a decline in imports growth to 5 1/4 per cent as the economy slows.

Growth is then expected to pick up steadily to a rate of about 2 1/2 per cent in 2000 and 2001. This is largely accounted for by a better contribution from net trade as export competitiveness improves and by continued growth in government consumption. Consumption growth is expected to stabilise at about 2 1/2 per cent per annum. The growth in fixed investment is expected to decline to about 3 1/2 per cent per annum by 2001.

Household sector (Table 3)

The outlook for the household sector is excellent as the economy continues to expand with high rates of employment and strong growth in real earnings. This, together with very buoyant asset prices and low interest rates, is likely to lead to further improvements in consumer confidence and spending.

In 1998, household disposable income growth was adversely affected by increases in some taxes and higher mortgage rates. Without these depressing effects, real household disposable income growth in 1999 is likely to be more closely related to the growth in real earnings. We are expecting that in 1999 average earnings will grow by around 4 3/4 per cent in nominal terms and by 2 3/4 per cent in real terms. With employment continuing to grow slightly this will raise the real disposable income of households by about 3 1/4 per cent. Excluding property incomes (dividends and interest payments), real disposable incomes are expected to grow by around 4 1/2 per cent.

Looking further ahead, the prospects for household income growth remain good. We expect earnings growth to rise to around 5 1/4 per cent in 2000 as the labour market begins to firm and productivity picks up as the economy grows more quickly. Real household disposable income is expected to grow at about 4 1/2 per cent.

Alongside an improving outlook for household incomes, wealth is also providing strong support for consumer spending. At the end of 1998, households had net financial wealth of about [pounds]2000 billion (enough to finance current levels of consumption for about 4 years) and housing wealth of [pounds]1500 billion. While the stock market appears significantly over-valued, there are no strong grounds for forecasting a correction in the short term.

The housing market has been grabbing a large share of the headlines in recent months because of large increases in house prices. This has led to worries that we could see a return to the 'property boom' of the 1980s. As chart 7 shows, real house prices are indeed rising fast. Using ONS data house prices increased in the first quarter of 1999 at an annual rate of 8 per cent, similar to the 9 per cent recorded in the previous two quarters. Recently published data from the Halifax suggest that this rate of growth has increased in the second quarter of 1999.

One of the factors influencing the demand for housing is the cost of home ownership. The user cost of housing is a function of, amongst other things, mortgage interest rates. Since their peak in 1990 real mortgage interest rates have been falling steadily, albeit with the occasional temporary rise.

The willingness of mortgage lenders to lend to first-time buyers, both in terms of loan-valuation ratios and income multiples, has also increased recently. Indeed it has been commonplace to hear of mortgages offered at greater than the value of the property and based on income multiples well above those traditionally used. As [TABULAR DATA FOR TABLE 3 OMITTED] can be seen from chart 8 there was a large increase in the loan-value ratio after 1994 to around 90 per cent. However since the end of 1997 this ratio has fallen back and currently stands at around 80 per cent. This probably reflects the influence of income as a binding constraint on the amount that may be borrowed.

Other contributory factors to the current growth in house prices are expectations of their future growth and the fact that they remain historically low in relation to both household incomes and consumption. Chart 9 expresses this second point quite clearly; at the beginning of the year real house prices were at their lowest level since the start of the data series in 1964 in relation to both real disposable income and consumption. This chart also indicates that there is a long way to go before equivalent levels to the two previous house price booms are reached.

The recent surge in house prices has been strongest in the London area. There is obviously a risk that this will spill over into the rest of the country. As is shown in chart 10, the London housing market has typically been more buoyant than the rest of the UK and, in the property boom of the late 1980s, led the rest of the country.

Although house prices are currently increasing quickly compared with previous episodes of fast house price inflation in the UK, such as those in 1971-2 and 1987-9, current increases in real house prices are still relatively modest. In 1971-2 real house price inflation reached 40 per cent whereas in 1987-9 it reached over 25 per cent. This may suggest that we are beginning to see the first signs of another boom-bust cycle in the UK housing market, but there are some reasons to believe that this will not be the case. Perhaps most important of these is the fact that interest rates will be raised if there are any signs that prices are rising too quickly. In addition to this the removal of mortgage interest tax relief from next year will further push up the user cost of housing adding further downward pressure on house prices.

Caution on the part of mortgage lenders, house buyers and the Bank of England may further temper this recent strength of the housing market in the short term. Buyers of property are likely to display caution because of the effect of the problem of negative equity that followed from the large falls in house prices in the early 1990s.

Finally there are some reasons to believe that any trickle-out effect from the London housing market to the rest of the UK may be small. House prices in London are displaying strong growth because of the strength of the London economy and also the renewed popularity of London as a place to live. Both have meant stronger demand pressures that are less likely to be repeated in the rest of the UK. Faster GDP growth in London is partly a result of the fact that the sectors in which London specialises (i.e. financial services, tourism) have faired relatively better than industrial sectors in which it does not (i.e. manufacturing). Our forecast for GDP growth in London is around 2 per cent, significantly higher than the 1 1/4 per cent growth forecast for the UK as a whole.

One consequence of high house prices is that first-time buyers are facing a binding constraint on the amount they are able to borrow. This can be seen in the recent decline in their loan to value ratio which comes about because the amount that first-time buyers can borrow is linked to their earnings, which have been growing less quickly than the value of the property they wish to buy. To some extent, this will act as a restraint on house prices which cannot rise significantly unless new money enters the market.

Our forecast is for end-year house price inflation of 7 1/2 per cent. We expect a similar rate of growth in 2000 and 2001.

The rate of growth of household consumption fell in 1998, largely as a consequence of the unwinding of the effects of the windfalls received in 1997. Household consumption in the fourth quarter of 1998 was only 1.7 per cent higher than a year earlier, the lowest year-on-year growth rate since 1985. Within this total, there has been a noticeable change in the composition of household spending. Over the same period, spending on durable goods is down by 0.7 per cent, spending on non-durable goods is down by 0.8 per cent, whereas spending on services is up by 4.6 per cent. There is now some evidence that spending on durables is beginning to pick up again, although the timing of spending on vehicles, the main component, has been affected by the introduction of the new bi-annual registration system. This partly explains the strong growth of household spending in the first quarter.

It is estimated that consumers' expenditure grew by almost 1 1/2 per cent in the first quarter alone. Since then, retail sales grew by a little under 1 per cent in the second quarter.

Against such a strong background, household spending has considerable room for further expansion. Overall, we expect consumption growth of around 2 3/4 per cent this year. This is likely to pick up through the year and into 2000 where we expect to see growth of around 2 1/2 per cent.

The household saving ratio is estimated to have fallen to 4 1/2 per cent in the first quarter. This reflects continued weakness in dividend income in advance of the abolition of Advance Corporation Tax in the second quarter. Once this distortion is past, the saving ratio is expected to rise back to around 9 1/2 per cent in 2000. With relatively subdued investment by the household sector, the rising saving ratio is expected to lead to renewed acquisition of financial assets. This is likely to be associated with relatively modest growth in mortgage and consumer credit, since households in aggregate are able to meet their spending plans out of their own resources. Fixed investment and stockbuilding (Tables 4 and 5) Fixed investment took a long time to recover from the recession at the start of this decade, but has grown strongly since the beginning of 1994. In the year to the first quarter of 1999, aggregate fixed investment grew by almost 5 per cent. Much of this was accounted for by growth in non-manufacturing business investment which rose by almost 17 per cent. Investment in manufacturing dropped by almost 10 per cent over the same period.

We expect slightly more moderate growth in investment in 1999. This mainly reflects the slowdown in the economy and continued uncertainty about the outlook for demand. Furthermore, despite relatively strong balance sheets, the financial position of companies has weakened slightly following strong capital spending. Non-financial companies moved into financial deficit in 1997 after four years of paying back debt. Their financial deficit reached [pounds]8.5 billion in 1997 and almost [pounds]21 billion in 1998. This is expected to decline to about [pounds]4 billion in 1999. We do not however expect investment to stagnate. Recent business surveys suggest renewed business optimism. The British Chambers of Commerce survey shows an increase in the number of firms who have revised their investment plans upwards in the first quarter of this year, both in manufacturing and services. Against this, the April CBI Industrial Trends survey reports continued weakness in investment intentions in the manufacturing sector. Overall we forecast growth in fixed investment of around 5 1/2 per cent this year, slowing to a little over 3 per cent by 2001.

Growth in business investment is expected to continue at different rates in the traded and non-traded sectors. This reflects the different outlook for demand. We expect non-manufacturing business investment to rise by around 12 per cent in 1999, declining to roughly 4 per cent in 2000 and 2001. Manufacturing investment is expected to be much weaker than this, with a fall of around 7 1/2 per cent expected for 1999. Thereafter manufacturing investment is expected to remain roughly stagnant.

Private sector housing investment is expected to drop by roughly 4 per cent this year, in line with housing starts in 1998. However, low mortgage rates are likely to increase housing demand and we expect renewed growth in private sector housing investment of up to 7 per cent in 2000. Public sector housing investment is expected to pick up quite sharply, rising by around 16 per cent in 2000. Other general government investment is expected to rise broadly in line with the government's plans. We expect this to rise by 6 1/2 per cent in 1999 and over 10 per cent in 2000.

[TABULAR DATA FOR TABLE 4 OMITTED]

[TABULAR DATA FOR TABLE 5 OMITTED]

Inventory accumulation was a little over [pounds]3 1/2 billion in 1998. With the slowdown in demand in the last quarter of 1998 we expect some of this has been involuntary. We forecast little change in stocks over the course of 1999. With slower growth in the traded sector, we expect manufacturing inventories to be run down by about [pounds]1.5 billion in 1999. This is expected to be offset by stockbuilding of a similar size in distribution and elsewhere.

Balance of payments (Tables 6 and 7)

The balance of trade has been a restraining influence on [TABULAR DATA FOR TABLE 6 OMITTED] GDP growth since the large appreciation of sterling at the end of 1996 - a feature that looks set to continue over the short term. The volume of imports grew by over 8 per cent last year, down slightly on the 9.4 per cent recorded in the year earlier but still much stronger than the growth of exports in both years (8.6 per cent in 1997 and 3.1 per cent in 1998).

Weakness on the export side of the balance of payments is partly explained by the slowdown in world trade, affecting the demand for UK exports, and this is forecast to continue through this year and into next. By our current estimates world trade is forecast to grow by [TABULAR DATA FOR TABLE 7 OMITTED] between 4 and 5 per cent per annum from 1999 to 2001, as compared to over 10 per cent in 1997. The other contributory factor to the poor showing of exports has been the strength of sterling on the foreign exchanges. As discussed earlier, the high value of the exchange rate forces UK companies in the traded sector to make uncomfortable choices between maintaining profit margins and protecting their market share.

The effect of the high exchange rate in reducing the price of imports puts pressure on UK companies selling at home. The imports deflator fell again in the first quarter of 1999 and the index now stands at 85.4 (1995 = 100). These price falls, which have been going on throughout 1997 and 1998, have been smallest in the service sector. The index for the price of manufactured goods stands at 83.5 in the first quarter of 1999 (the last available data point) while the index of service imports stands at 93.5 (both 1995 = 100). The difference between sectors reflects differences in the ability of firms in different sectors to widen profit margins.

We forecast that the index for import prices will cease falling at the end of this year. Our forecast is that import prices will fall by an average of -2.5 per cent in 1999 but rise by around 2.0 per cent in 2000 and 2001. The largely offsetting forecast movement of sterling against the dollar and the Euro mean that imports prices are unlikely to contribute much to inflationary pressures in the economy over the short term.

Lower import prices combined with the strong consumer demand within the UK has meant that imports into the UK have grown very strongly over the last few years. Imports of both manufactured goods and services grew by over 10 per cent in 1996 and 1997 and by over 8 per cent in 1998. However, as the level of UK GDP growth has slowed so has the growth in the volume of imports. The figures for year-on-year growth for the first quarter of 1999 were 8.6 per cent in service imports and 6.5 per cent for manufacturing. As UK GDP growth stutters and then picks up again this year it is expected so too will the level of imports. Growth in imports is forecast at 5.2 per cent in 1999 (compared with 8.4 per cent in 1998) and 5.6 per cent in 2000.

Export prices have also been reduced as a consequence of the strong exchange rate, but not to the same extent as the prices of imports. This has meant that the terms of trade has risen to levels last seen in the early 1990s. The terms of trade index (1995 = 100) currently stands at 106.2, up on the average for 1998 of 105.3. Our forecast is that the terms of trade will stabilise in 1999 at around 106.6.

The rate of growth in the volume of manufactured goods exported has been falling steadily since 1997 and growth was -0.8 per cent in the first quarter of 1999. This was slightly better than the 1.4 per cent fall in the last quarter of 1998. Service exporters have faired relatively better than their manufacturing counterparts. Export volumes of services grew by 5.7 per cent in the first quarter of 1999, although this is much lower than the 11.5 per cent registered in the first quarter of 1998. The growth of service exports is currently much stronger than that predicted by normal fundamentals, perhaps indicating a favourable change in the demand for UK service exports. Service export volumes are growing faster than world trade, suggesting UK firms are increasing market share.

The level of manufacturing exports is forecast to begin to start growing again late this year, whereas service exports are forecast to display robust growth of around 3 per cent throughout. After the middle of 2000 manufacturing exports are forecast to grow by over 5 per cent, as a result of the pick-up in world trade and gradually improving competitiveness. The difference in the volume of exports between sectors is also reflected in the price series of the two. The price of exported manufactured goods is expected to continue falling up to the start of the new millennium averaging 0.9 per cent per annum in 2000 and 2.0 per cent in 2001. In contrast, the price of service exports is forecast to grow at close to 3 per cent in both 2000 and 2001. The overall export price index is expected to continue to rise at an annual rate of around 1.7 per cent by the beginning of 2000.

The current balance showed a deficit of [pounds]1.2 billion in the first quarter of this year and looks set to worsen throughout 1999 and into 2000 as the economy recovers while the exchange rate remains uncompetitive. The goods balance is forecast to deteriorate further. The deficit in the first quarter stood at [pounds]6.8 billion, up from [pounds]6.3 billion in the fourth quarter of last year, our forecast is that it will further deteriorate to around [pounds]8.0 billion by the end of next year. The services balance appears to have peaked last year at [pounds]7.8 billion in the second quarter. Since then it has been declining somewhat and currently stands at [pounds]5.6 billion. The surplus is expected to continue this downward trend through 1999 and into 2000, with a forecast surplus in 2000 of [pounds]20.4 billion, down from [pounds]22.8 billion expected for this year. The overall current deficit is forecast at [pounds]6.5 billion in 1999 and [pounds]13.7 billion in 2000.

The current account balance is now a relatively minor contributor to the overall flows into and out of sterling assets. Table 7 indicates how the current account balance is financed. The so-called basic balance is composed of the current account balance plus net direct investment and portfolio investment. Recently this has been negative, reaching almost [pounds]90 billion in 1998. The size of the deficit is mainly because direct and portfolio investment abroad has exceeded such investment into the UK. This balance has to be financed either by a repatriation of other investment back to the UK or by other foreign investment in the UK. In practice, this has been achieved by a net increase in foreign deposits in the UK banking system. Overall, the international investment position is such that the UK has [pounds]58 billion more foreign liabilities than it has assets. Even though we expect the current deficit to rise over the next two years, it is likely to remain a relatively small proportion of national income and will not have a substantial effect on the net foreign asset position.

Output and employment (tables 8 and 9)

The pattern of output growth has continued to be uneven across the industrial sectors, reflecting divergences in the pattern of demand. In the first quarter, output was flat, having shown very weak growth in the fourth quarter of last year. The main sectors of decline have been in production, although business services and finance fell back by 0.3 per cent in the first quarter, albeit after strong growth at the end of last year. The main growth industries have been distribution, transport and communications and the public sector.

We would expect this broad pattern to continue. The latest figures for manufacturing suggest its output has not fallen since December of last year, but output in the second quarter is likely to be about 1 1/2 per cent down on a year earlier. Such recovery as there has been is quite weak and we continue to believe that a further decline in output is likely. The decline in output over the year is expected to be a little over I per cent.

Output growth outside of manufacturing is unlikely to be rapid. The public sector is expected to show relatively fast growth in line with the forecast growth of public spending. Growth in the service sector is also likely to be between 2 and 3 per cent, much slower than in recent years.

Productivity growth in 1999 is expected to continue at a slow rate. Slowdowns are normally associated with reductions in productivity growth as capacity utilisation falls and firms hold on to labour to avoid firing costs and subsequent retraining costs. The likelihood that the slowdown will be short-lived accentuates the fall in productivity, since firms will be less willing to adjust labour to temporary fluctuations in demand. This is indeed reflected in the fact that the growth slowdown so far has not been associated with a reduction in employment.

Employment continues to rise. According to the Labour Force Survey, in the quarter from March to May this year employment is at 27.36 million, up by 20,000 on the previous quarter. This represents about 74 per cent of the working age population. We are expecting employment to continue to grow as the recovery gains pace. However, we expect growth to be much slower than it has been in recent years at about 1/2 per cent per annum rather than 1 1/2 to 2 per cent as in 1996 to 1998. This partly reflects the fact that much of the slack in the labour market has been used up, although it is not clear how much more slack remains.

ILO unemployment fell by 34,000 in the three months to May, leaving the ILO rate at 6.2 per cent down from 6.3 per cent. The claimant count has continued to fall and is down to 4.4 per cent on the official definition in June. This represents a fall of 80,000 over the past year despite the slowdown in economic activity.

The fall in unemployment is partly attributable to the effects of the New Deal for Young Unemployed People (NDYUP). Claimant unemployment among 18- to 24-year-olds has fallen by around 40,000 over the same period. This is more than accounted for by a sharp decline [TABULAR DATA FOR TABLE 8 OMITTED] of around 50,000 in long-term unemployment among the young.

We expect the ILO rate to remain at around current levels throughout the rest of this year and 2000. The claimant count is similarly expected to remain stable at around 4 1/2 per cent.

Earnings and prices (Tables 3 and 11)

It is now increasingly likely that unemployment has fallen to a level close to its equilibrium level. This means that further increases in the demand for labour will be met by increases in earnings rather than employment. This will cause companies to expand output by raising productivity.

However, earnings growth is very subdued at present once allowance is made for bonuses. In the year to May, average earnings, excluding bonuses, grew by 3.3 per cent in the whole economy and by 3.1 per cent in the private sector. This is consistent with latest information on pay settlements. Income Data Services (IDS) report that the most common settlement is for increases of between 3 and 4 per cent, with just over a quarter of new deals for less than 3 per cent. Similarly, Industrial Relations Services (IRS) report that the dip in settlements to 3 per cent at the beginning of the year has been sustained.

[TABULAR DATA FOR TABLE 9 OMITTED]

Since settlements tend to lead average earnings, this would suggest that there is little prospect of a pick-up in pay pressure before the end of this year. We are forecasting earnings growth at the end of this year of just under 5 per cent, the same as at the end of last year. However, we expect pay pressures to pick up next year as the labour market tightens further. We are forecasting earnings growth of about 6 per cent by the end of 2000.

The Bank of England undershot the government inflation target for RPIX of 2.5 per cent in June (RPIX inflation was 2.2 per cent), reflecting the fact that current inflationary pressures in the economy remain subdued. This is a very slight rise on the figure for May (2.1 per cent) but a continuation of the general downward trend that started back in 1997. Favourable movements in costs and weak demand have meant that RPIY inflation, which excludes the effect of taxation, remained at 1.5 per cent in June from May. RPI inflation, the most [TABULAR DATA FOR TABLE 10 OMITTED] widely used measure of retail price inflation has also continued to fall and currently stands at 1.3 per cent. This is the lowest figure since 1993. Inflation in the Harmonised Index of Consumer Prices (HICP) for June was 1.4 per cent, up slightly on the figure recorded for May of 1.3 per cent. This remains above the average for the EU and monetary union member states of 1.1 and 1.0 per cent respectively.

The Bank of England has been helped in keeping inflation within its target range over the recent past by a combination of factors including the strength of sterling and weakening domestic and international demand. While these factors look set to continue to provide a favourable path for inflation over the short term the challenge to the Bank of England is the control of inflation as these restraining factors unravel over the medium term. We look at each of the separate indices for costs (which includes average earnings), demand and import prices before moving on to discuss our forecasts for the main target indices.

As outlined above, conditions in the labour market are expected to lead to an increase in the rate of wage settlements over the next year or so. According to official figures unit labour costs in the first quarter of 1999 were 4.5 per cent higher than a year earlier. Like previous quarters this appears to be a consequence of slow productivity growth in the economy (output growth slowed but firms did not shed workers). Our forecast for growth of unit labour costs is 4.4 per cent this year, 3.2 per cent in 2000 rising to 3.9 per cent in 2001.

Outside the labour market the price of other producer inputs have continued to fall. Producer input [TABULAR DATA FOR TABLE 11 OMITTED] prices fell by just over 5 per cent on the year in the first quarter of 1999. This rate of decline if anything appears to have increased since the middle of last year largely as a result of falls in the price of raw material imports and oil. The import price of raw materials fell by an average of just over 5.3 per cent in 1998, whereas in the first quarter of 1999 the figure was close to -10.3. The oil price also fell compared with a year earlier in 1999Q1, by 12.7 per cent. This rate appears to have slowed since the very large falls registered last year (the figure for 1998Q4 was -42.5 per cent).

Producer input prices are expected to continue to fall through this year, albeit at a slowing rate, before rising through 2000 to around 7 per cent per annum at the end of that year. This results from both increases in raw material import prices and the price of oil. The oil price index, a historically volatile index, is forecast to reverse much of the recent fall in price through the rest of this year and to rise by around 33 per cent this year.

The strength of demand in the economy is often indicated by the ability of producers to pass on increases in input prices (both in labour and in raw materials) to output prices. The index of producer output prices currently stands at 101.7, at broadly the same level as it has been since 1996. The recent past of this series is explained by strong growth in labour costs being offset by falls in the prices of raw materials. The effect of producer output price on overall inflation in the economy is expected to be benign through this year and not to rise above 1 per cent per annum until the middle of 2000. After this point increases in both demand and the price of inputs mean output price inflation will begin to rise steadily to around 2.5 per cent by 2001.

As noted above the Bank of England has been helped in meeting its inflation target by the strength of sterling on import price inflation. We discuss more about the components of these series elsewhere and so concentrate on the aggregate import price variable here. The imports deflator fell again in the first quarter of 1999 and the index now stands at 85.4 (1995 = 100). The price of imports has been falling steadily through 1997 and 1998, and has been fastest in the goods and oil sector over the service sector. The rate of this decline appears to be slowing over recent quarters and our forecast is that the index for import prices will cease falling around the end of the year. From then import price inflation is set to rise continually through 2000 to around 2.4 per cent.

The conditions for inflation over the short term would therefore appear to be good. Our forecast is that RPIX inflation will remain significantly below target well into next year.

Low inflation over the short term is also reflected in the other inflation series. RPI inflation is forecast to fall to around 0.7 per cent at the end of year while RPIY inflation is forecast to fall to a low of around 1.6 per cent.

There are possible black clouds for inflation over the medium term however. As the economy picks up it is expected that wage pressures will continue to grow in an already tight labour market. This combined with rising input and import prices from a steadying of sterling has led us to revise upwards our forecasts of inflation in 2000 and beyond. We now expect RPIX inflation to increase above the Bank's target level by the middle of [TABULAR DATA FOR TABLE 12 OMITTED] 2000 at around 3.3 per cent. The effect of increased demand in the economy is also reflected in a forecast increase in RPIY inflation, whereas the abolition of tax relief for mortgage interest payments is expected to lead RPI inflation to rise to over 4 per cent in 2001.

National and sectoral saving (Table 12)

Table 12 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. This is expected to change into this year and next as the current account worsens, so that the overseas sector provides some of the finance for domestic investment.

Thus in 1999 and 2000, domestic saving is expected to fall by about 1 per cent of GDP with little change in domestic investment. This is associated with a sharp fall in company sector saving of around 2 1/2 per cent of GDP over the two years. This is offset partially by a rise in household saving. Partly this change comes about as a consequence of an increase in company dividend payments which reduce saving by companies but are unlikely to be spent immediately by households.

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 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 over 3 per cent of GDP by 2001.

The government sector is also in approximate balance at present. While saving is expected to remain positive (thus meeting the Golden Rule on one possible definition), it is expected to decline somewhat.

The economy in the medium term (Table 13)

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. 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 overvalued 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 ??1.44 (equivalent to DM2.825), a higher rate than most people currently anticipate. UK interest rates are assumed to have converged on euro rates by the beginning of 2003. On the basis of current market rates, this would mean that UK interest rates fall [TABULAR DATA FOR TABLE 13 OMITTED] to around 4 3/4 per cent in the early years of the next decade, before rising to 5 1/4 per cent by its end.

Inflation is forecast to remain 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 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.

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. 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, which are currently around 2 per cent.

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 3/4-2 per cent per annum, similar to 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 for productivity growth is consistent with long-term trends in the economy.

On this basis we would expect to see economic growth of between 2 to 2 1/2 per cent per annum over the next ten years, with lower growth beyond that as the population of working age slows down. Among the expenditure components, household and government consumption are expected to grow by a little more than 2 per cent per annum with slightly faster growth in fixed investment.

[TABULAR DATA FOR TABLE 14 OMITTED]

The current account deficit is set to average about 1 1/2 per cent of GDP throughout the period.

Forecast errors and probability distribution (Tables 14 and 15)

Table 14 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 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 0.5 and 1.9 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, shown in table 15, have been calculated assuming that the distributions are normal. The standard errors have been calculated from the historical forecast errors underlying table 14. These estimates of the probability distribution around our central forecasts provide a quantitative assessment of the limits of our forecasts.

Table 15. 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 37 20
1.5 to 2.5 per cent 41 17
2.5 to 3.5 per cent 19 21
more than 3.5 per cent 3 42
 100 100

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

 1999 2000
less than 0 per cent 7 7
0 to 1 per cent 33 12
1 to 2 per cent 44 18
2 to 3 per cent 15 22
3 to 4 per cent 1 19
more than 4 per cent 0 22

 100 100