Chapter II. The world economy.

Barrell, R.J. ; Gurney, Andrew ; Dulake, Stephen 等

CHAPTER II. THE WORLD ECONOMY

Longer-term prospects and the implications of

developments in Eastern Europe

The most important factor affecting our view of long-term prospects is the potential effect of developments in Eastern Europe. Since our last forecast, which was completed three months ago on 9th November 1989 the political map of Europe has changed. The Czechs, Rumanians and Bulgarians appear to have joined the Poles and the Hungarians in the drive for democracy and more open markets. The collapse of the East German regime, and the gathering pace of the drive for unification with the FDR has been even more remarkable. Almost any possible outcome will change the prospects for growth and economic developments in the whole of the non-Communist world. We would argue that these effects will not just be confined to Continental Europe.

Model-based economic forecasts always contain some elements of judgement, but they are generally based on the structure of the model, which is in turn based on a perceived structure of the world. The momentous events in Eastern Europe are likely to change the structure of the world economy in at least two ways. Firstly, the pattern of trading blocks is likely to change. Exports and imports from the East are likely to rise very markedly. As we commented in the November issue of the Review, the Baltic states could very easily emulate the smaller countries on the Pacific rim, and Czechoslovakia and Hungary could easily become major players in European trade in the next ten years. Secondly, a reunited Germany would be an extremely difficult structural change for us to handle. Our model is econometrically based, and we like to have up to 25 years of data available when we are crafting each of our country models. We will not have this for a united Germany. We could expect that a united Germany would produce a very different baseline forecast than that which we are presenting here. Our tools are not well suited to the task of analysing such structural changes. Our main forecast does not allow for German reunification, in part because we feel it will be some years before the process of economic integration is likely to be completed but it does attempt to take on board the implications of other changes in Eastern Europe for the rest of the world. We feel that this should give a good picture of potential developments at least in the short to medium term.

We have allowed three effects to feed through to our main case forecast. The influx of economic migrants into West Germany is already having effects on the economic development of Europe, and we have attempted to allow for this. Our assumptions and their implications are set out in box 8. The Eastern Bloc economies have been running a current account surplus for most of the 1980s. We do not expect this to continue. We have recently recast our database for the Centrally Planned Economies (CPEs) and have consequentially produced a new set of equations for this bloc on our model. We expect these new equations to break down very soon as the underlying structure changes, but they do allow us a basis from which to work. We anticipate that the CPEs will move into deficit in the 1990s. This is the mirror image of saying that we are anticipating a major change in the existing pattern of capital flows, with an increase in flows to Eastern Europe.

There are also likely to be major effects on the US economy as it diverts resources from military expenditure toward more consumer goods production. These effects are discussed below. The effects of government expenditures cuts in Europe are likely to be less marked. Prospects for the world economy in the 1990s look good. In the 1970s and 1980s growth was relatively cyclical, partly because of monetary and fiscal policy shocks in various countries such as the US, but also because of the effects of commodity price shocks. The risks in our forecast, at least over the longer term, all appear to be on the positive side. The opening of Eastern Europe and the associated decline in US government deficit that will follow from lower spending are both likely to be positive factors affecting world growth over the next ten years. In the shorter term, there may be some risks to be faced, and there is a possibility that either inflation may accelerate or the world economy may slow down.

Shorter-term prospects

The late 1980s saw a notable increase in the rate of growth in all the major economies. Output growth in the major four economies reached 4 1/2 per cent in 1988, much higher than the average of 2 3/4 per cent experienced in the mid-1980s. Although there had been some degree of spare capacity in the world economy prior to 1988, the precipitate growth that year, followed by a projected growth rate of 3 1/2 per cent in 1989, led to an increase in the rate of inflation in each of the major four economies. Chart 1 plots recent inflationary developments in this group. Table 1 outlines our forecast for these economies, as well as presenting a number of other summary variables. [Tabular Data Omitted]

The surge in inflation produced a sharp monetary response from the authorities. Interest rates in the US rose by 2 percentage points between the first quarter of 1988 and their peak in the second quarter of 1989. German rates rose more slowly, but the rise has been larger than that in the US, and more sustained. By early 1990 rates were 8 1/2 per cent, some 5 percentage points higher than two years previously Japanese interest rates have risen by 2 1/2 percentage points over the same period. Chart 2 plots interest rates in 1988 and 1989. The tightening of monetary conditions in the major three economies appears to have had some influence on inflationary expectations as gauged by the spread between short and long rates. If short rates exceed long rates, as they do in all major economies except Japan, then we might conclude that the markets expect inflation to fall. Chart 3 plots recent long rates and our forecast of them into the 1990s. US long rates rose during 1988, but from the third quarter they began to fall despite rising short rates, suggesting that market participants were anticipating that inflation would fall in the long run. German and Japanese long rates have, on the other hand, been rising since the beginning of 1988. However, the spread between long and short rates in Germany has declined markedly as the authorities' sharp monetary response has persuaded the markets that the inflation peak will occur soon, and will not be particularly high. Japanese long rates have risen by almost as much as short rates over the last two years, and they have risen especially markedly in the last two months. We have been anticipating for some time now that Japanese inflation would rise from its recent low levels, and this view is now becoming more widely accepted.

We expect that inflation will have peaked by the middle of 1990 in each of the major economies except Japan. The inflation profile set out in table 1 shows a progressive decline in the average rate of inflation in the major four to below 2 per cent per annum by the end of the decade. The recent appreciation of the deutschemark is likely to slow growth and reduce inflation in 1990 whilst the recent depreciation of the yen is expected to produce the opposite result. In the longer term demand growth in both Germany and Japan is expected to be strong, in the former case partly as a consequence of the influx of immigrants from the East, and in the latter because of the effects of the increasing liberalisation of the Japanese economy. Growth in France and in the rest of continental Europe is forecast to follow that of Germany, reflecting the increasing integration of both their economies and their economic policy making.

The short-term prospects for the US are much more uncertain. Initial estimates for the fourth quarter are that output growth was as low as 1/2 per cent at an annual rate, with all elements of private sector domestic demand showing little growth, and with consumption probably falling from the third quarter. There is indeed a risk that the US may be about to face a downturn, but we do not judge this to be very likely. (However, prospects for the Canadian economy in the short term are not so strong, with growth slowing markedly. Given the degree of integration between these economies there is bound to be some short-term effect on the US.) The dollar has weakened in the last few months, partly because interest rates have been falling, especially relative to the rest of the world. Both factors will support output growth in 1990. The Federal Reserve could be expected to respond to a renewal of inflationary pressures; but recent developments, and especially those on commodity markets, indicate that these pressures are unlikely to emerge.

Most commodity prices rose sharply in dollar terms during 1988 and into 1989 as growth accelerated. However, there were a number of special factors behind these developments that have now been reversed. Metals stocks were very low after a long period of falling metals prices, and the surge in demand produced severe shortages. Commodity prices also rose because the effects of the US drought in 1988 supported food prices into 1989. Table 2 sets out our forecast of commodity prices in the medium term. Year-on-year we are expecting metals prices to fall sharply in 1990, but as chart 4 shows, most of that fall has already happened. High prices for metals in 1988 have resulted in an increased level of available capacity and with the slowdown in demand we anticipate that copper stocks worldwide are likely to rise by 200,000 tonnes in 1990, and the increase will probably be larger in aluminum stocks. These stock build-ups are unlikely to depress prices further, as stocks are currently very low, and prices are probably not yet high enough to sustain current output levels. In the longer term we expect metals prices will resume their long-term real decline as the effects of changing technology outstrip rising demand for metal-based products. [Tabular Data Omitted]

Prospects for free market food prices are slightly better, but the implications of these developments for inflation are small, as non-free market food prices set by the EC and US government are likely to continue to decline in real terms. Declining food stocks, especially in Europe as a result of tighter EC support schemes, along with increasing demand from Eastern Europe, will put some upward pressure on grain and meat prices. Free market prices for foods from developed countries have fallen since their drought-induced high level at the end of 1988. The collapse of both the cocoa and coffee price agreements has reduced prices for less developed country food exports. They are likely to remain weak due to the breakdown of pricing cartels caused by entry into the market on a large scale by non-cartel members - Malaysia in the case of cocoa and Mexico in the case of coffee. Sugar and other less developed country commodity prices are likely to rise as developed world beet and grain surpluses decline.

For some time in January and February the North Sea Brent oil price has hovered around $20 per barrel, and oil prices in the US have also been firm. These price increases should be seen as temporary, resulting from very cold

weather in North America combined with some supply disruptions in the Mexican Gulf. Dubai spot prices have not been so firm, reflecting high levels of OPEC output. According to the International Energy Agency, output of oil in the last quarter of 1989 was at a record level, and this should put downward pressure on oil prices. There may be some upward pressure on prices as a result of reductions in supply from Eastern Europe and Russia as supply difficulties in Siberia and Baku along with increasing demand cuts the surplus available for export. We judge that the combination of rising OPEC supplies and falling supply from elsewhere will leave oil prices approximately stable through 1990 at around $19.00 per barrel before rising in real terms thereafter in line with the real rate of interest in the world economy.

World trade growth appears to have been slowing from its precipitate rate of growth of around 10 per cent per annum in 1988. Manufactured goods trade growth for the major OECD economies slowed from over 10 per cent in 1988 to a projected 8 1/2 per cent in 1989 and we anticipate that it will slow further to under 6 per cent in 1990. Total world trade growth, as measured by the weighted average of all world exports and imports, is also expected to slow from 9 3/4 per cent in 1988 to 7 1/4 per cent in 1989 and 5 1/4 per cent in 1990. This slowdown reflects not only the reduction in the growth of OECD industrial production from 6 per cent in 1988 to a projected 3 1/2 per cent in 1990, and a slowdown in major 7 output growth from 4 1/2 per cent in 1988 to 3 per cent in 1990, but also a sharp reduction in the level of imports by China, and more normal levels of trade growth between the US and Canada. The former had been affected by Peking's headlong rush for economic liberalisation, and it has been curtailed by recent political upheavals. The latter was partly the effect of the new US/Canadian free trade agreement, but it has also been the consequence of strong growth in the US.

Exchange rates and interest rates

The shorter-term prospects for the world economy are likely to be dominated by continuing exchange-rate uncertainty. In the last three months the deutschemark has appreciated by 3 3/4 per cent, whilst the yen has declined by 5 3/4 per cent. The former development has aided the process of adjustment to more sustainable capital flows, whilst the latter has not. The strength of the deutschemark has been supported by the market's beliefs about the effects of developments in Eastern Europe on the German economy. Structural changes to the system of exchange rates of the magnitude we are currently observing cannot be modelled by standard macro-modelling or econometric techniques. The decline in the yen has been a little more difficult to understand. The prospects of a loss of power by the Liberal Democrats in the February election in Japan may have been a cause for some weakness in the exchange rate, but we do not feel that this can be the entire cause of such a large decline. Some commentators suggest the behaviour of Japanese overseas portfolio managers has changed recently. Purchases of US government securities by Japanese houses had often been covered in the forward market to reduce exchange risk. Increased confidence in the US economy has led to a reduction in the level of forward cover, and hence a paradoxical weakening of the yen. However, we do not feel that this is the whole story. Between 1985 and 1988 the Japanese current account surplus averaged 3 1/4 per cent of GDP, but portfolio and direct investment outflows exceeded this in magnitude (Box 7 below analyses the structure of the Japanese capital account, and Box 6 describes the associated process of the removal of controls on outward portfolio investment flows). The strong appreciation of the yen over the period 1986 to 1988 along with the relocation of some productive capacity to the rest of the Pacific rim has weakened the ability of Japanese industry to export, and the liberalisation of the economy has raised imports. As a result the current account surplus in 1989 has fallen to under 2 per cent of GDP. As the exchange rate is determined by both the capital and current accounts this decline in the surplus has led to strong downward pressure on the yen as the current account has not left sufficient space for the desired pattern of capital outflows without recourse to increased short-term borrowing. Given conditions in the world economy and in Japan these can only be accommodated by a lower exchange rate and a higher current account surplus than those seen in 1989.

The decline in the yen has been accompanied by a marked policy response from the Bank of Japan. The Gensaki rate has risen by 1 1/2 points since the third quarter of 1989. We believe that the Bank of Japan will maintain this much tighter monetary stance throughout 1990 and 1991, reducing the rate of growth in the economy.

Table 3 contains our interest-rate forecasts for Japan and for the other major economies. We expect the US interest rate to fall throughout 1990, following some loosening of the monetary stance. However, in the medium term we see little scope for very large reductions in US rates. The prospects for interest-rate reductions in continental Europe are much better. The combination of a projected combined balance of payments surplus and a low and declining rate of inflation should leave sufficient room for cuts in interest rates.

Table : Table 3. Short-term interest rates

 Per cent
 GDP
 weighted
 US Japan Germany France average
1986 6.5 5.0 4.6 7.8 6.0
1987 6.9 3.9 4.0 8.2 5.8
1988 7.7 4.0 4.3 6.2
1989 I 9.6 4.2 6.2 9.0 7.6
 II 9.6 4.3 6.8 8.8 7.7
 III 9.0 4.8 7.1 9.2 7.7
 IV 8.9 5.6 8.1 10.2 8.2
1990 I 8.5 6.2 8.4 10.8 8.4
 II 8.4 6.2 8.3 10.6 8.3
 III 8.3 6.1 8.2 10.2 8.1
 IV 8.2 6.0 8.0 9.8 7.9
1990 8.3 6.1 8.2 10.4 8.2
1991 7.9 5.5 7.4 9.0 7.5
1992 7.5 7.4 6.4 7.9 6.7
1993-5 ave. 6.8 3.7 4.6 6.1 5.5
1996-9 ave. 6.5 3.5 4.0 5.5 5.1

Our exchange-rate forecasts, which are given in table 4, are strongly linked to our interest-rate projections. We believe that market operators are rational and forward looking, and that as a result, exchange rates will change in line with interest-rate differentials with some allowance for risk premia. It is difficult to judge at what level we should set these premia. Even if expectations in the past had always been correct, the existence of capital controls will have distorted the pattern of returns available in the world economy. The last issue of this Review discussed the removal of capital controls in Europe, and this chapter contains a discussion of Japanese exchange controls. We have judged that the removal of capital controls in Italy, along with the increased credibility of the Bank of Italy's policy stance, will in future reduce the risk premium on the lire from its ex-post historical level of 4 per cent to 2 per cent. This is the highest of our risk premia. We have assumed that the risk premium on the French franc vis a vis the deutschemark is 0.5 per cent and that on the US dollar against the yen and deutschemark is also 0.5 per cent. In our forecast we use recent levels of the exchange rate as our starting point and set future rates in line with risk adjusted interest differentials. Chart 5 plots recent and prospective exchange-rate developments. The most notable feature is the decline of the dollar by over 5 per cent between the third quarter of 1989 and the present. This is much more the result of the strength of the currencies in the EMS, and especially the deutschemark, and despite the weakness of the yen rather than any specific events related to the US However, the fall in the dollar and the rise in the deutschemark are both conducive to the process of adjustment of current account imbalances in the world economy.

Table : Table 4. Exchange-rate forecasts for the major

 four
 Percentage change in effective rate
 US Japan Germany France
1986 -20.3 25.5 11.5 5.1
1987 -12.7 7.8 8.4 2.0
1988 -5.5 11.3 -0.6 -1.9
1989 4.8 -4.2 -2.0 -2.2
1990 -3.0 -8.7 6.6 5.0
1991 0.7 2.4 0.6 -1.0
1992 0.0 2.4 0.6 -0.6
 yen DM franc franc
 per dollar per DM

Nominal cross rates, year average

1986 168.5 2.17 6.93 3.19
1987 144.6 1.80 6.01 3.34
1988 128.2 1.76 5.96 3.39
1989 137.8 1.88 6.38 3.39
1990 145.0 1.70 5.81 3.41
1991 142.5 1.71 5.90 3.46
1992 139.5 1.70 5.95 3.49

Real cross rates, year average, 1980 = 1.0(a)

1986 0.86 1.32 1.34 1.02
1987 0.77 1.13 1.18 1.04
1988 0.71 1.14 1.18 1.04
1989 0.79 1.23 1.28 1.04
1990 0.84 1.14 1.18 1.03
1991 0.85 1.17 1.20 1.03
1992 0.84 1.17 1.21 1.03
1993 - 95 0.81 1.15 1.21 1.05
1996 - 99 0.74 1.06 1.15 1.09

All data sources are given in the May 1987 Review, no. 120. (a) Nominal rate times ratio of consumers' expenditure deflators.

The emergence of inflationary pressure in Japan lessens the need for large and continuing appreciations of the yen. The appreciation of the real exchange rate experienced over the last few years is likely to be maintained after this year, albeit more by rising prices than an appreciation in the nominal exchange rate. We are projecting that progressively the Japanese current account will fall as a per cent of GNP over the next decade, as will that of Germany. Both are plotted in chart 6. The US current account will also move slowly back toward balance partly as a result of a successful anti-inflationary policy, but more slowly than we have previously believed. However, we do not feel that this will be destabilising, as changes in the world situation over the last three months have major implications for the US economy in the longer term, as we explain below in our section on the US.

Our model and forecast contains a `hard' version of the EMS, and as such involves few, but predictable realignments of central rates. In our forecast exchange-rate changes depend only upon risk adjusted interest differentials, and our projected differentials would only require realignments of central rates every two years or so, normally triggered by the lire. We feel that such a hard EMS is a necessary prelude to the successful construction of a monetary union, and it remains our central forecast. This does not mean that the EMS parity structure is without its risks of major realignments. Developments in Eastern Europe have already strengthened the deutschemark, and the influx of migrants is likely to push down wages and raise profits. Both forces should strengthen the deutschemark considerably, and we feel that by the end of 1990, when the situation with regard to the East is perhaps clearer, an overwhelming case may be presented for an upward revaluation of the deutschemark by 15 to 20 per cent within the Exchange Rate Mechanism. This is not our central forecast, but it must be taken as the major risk facing the European Community.

The United States

The US economy appears to be slowing down more rapidly than we had previously anticipated. First estimates suggest that real GNP grew by 1/2 per cent at an annual rate in the fourth quarter of 1989. Consumption fell, as did business investment. If there had not been some unanticipated increase in stocks then domestic demand would have fallen in the quarter. The unwinding of these excess stocks does not bode well for growth in the early part of 1990.

There are other clear signs of a slowdown in US activity. Employment growth has been slowing, from 3.1 per cent in 1988 to 2 per cent at an annual rate between March and December. Manufacturing employment fell in every month between March and December 1989. Industrial production growth has slowed from 5.7 per cent in 1988 to 3.3 per cent in 1989, although there are as yet no signs of a sustained downturn. There is evidence to suggest that consumer spending is likely to continue to fall in the near future. Retail sales grew by 5 per cent in 1989, the lowest growth since 1982. Housing starts fell in both November and December. The signs on inflation are conflicting. Consumer prices were rising 4.9 per cent at an annual rate in November and December, and they rose by 4.6 per cent in 1989, the largest increase since 1981. However, the GNP deflator rose by 3 1/2 per cent in the last quarter of 1989, a lower rate of increase than had been experienced earlier in the year.

Table 5 contains our forecast for US GNP over the next five years. Despite the very poor performance in the last quarter of 1989, we are projecting that GNP growth will only slow down to 2 per cent in 1990. This slowdown is in part the result of the appreciation of the dollar during 1988 and the first half of 1989. This will have reduced the prospects for exports and raised the potential for imports and our equations suggest that these effects will now be feeding through. The recent and projected decline in the dollar should help reduce these effects. (Box 1 reports a simulation which allows the dollar to fall by 10 per cent.) Domestic demand growth will also fall in 1990. but our projections are now more optimistic than they were threee months ago. Interest rates have fallen more than we had anticipated, and if short-term rates average 8 1/4 per cent in 1990, down from 9 1/4 per cent in 1989, then we expect housing investment to recover and the slowdown in business investment to be moderate. However, stockbuilding is likely to exert a negative influence in the short term. (Box 2 reports a simulation of our model with a 1 per cent cut in US interest rates.) [Tabular Data Omitted]

During the early 1990s we are expecting that US growth will be slightly below capacity at around 2 to 2 1/4 per cent. US inflation as a consequence is likely to fall, with the CED inflation rate falling from 4 1/2 per cent in 1992 to 2 1/2 per cent in the mid-1990s. We forecast that less than capacity growth will cause unemployment to rise, albeit to only 6 1/2 per cent in 1992. The US current balance is expected to deteriorate in the short term from a deficit of 112 billion dollars in 1989, to 138 billion dollars in 1990 as a consequence of the lagged effects on trade volumes of the appreciation of the dollar up to the third quarter of 1989. The sharp slowdown in the Canadian economy that we are forecasting for 1990 will also reduce further the prospects for US exports and the balance of payments. Our exchange-rate assumptions produce a relatively flat path for the US effective rate after the recent decline. This means that in the longer run the US deficit is likely to decline only slowly. We are currently projecting that even by 1999 the deficit is likely to have fallen to only 1 3/4 per cent of GNP. Interest rates and exchange rates on our forecast are set partly to produce a pattern of current accounts in the world economy that we see as sustainable by structural capital flows. We have revised our views of the sustainable US deficit in the light of recent political developments in the world and their consequences for the US public sector finances.

The scale of political changes in Europe has, we feel, major consequences for the profile of US fiscal deficits and their implications for the economy. Our public sector forecasts are always based on the policy assumption that in the long run the ratio of total government debt to GNP must be stable. For the US this implies a public sector deficit of around 1 per cent of GNP as the total government debt to GNP ratio is around 40 per cent and we believe that trend growth in the US is around 2 1/2 per cent. If the markets share our beliefs, and look as far into the future, then they will not see temporary increases in the deficit as destabilising. Over the last decade the US government has faced a credibility problem over debt. Expenditures have been growing strongly, and taxes have been cut. As a consequence debt has risen. It had been politically difficult to raise taxes, and hard to cut expenditure. Hence small changes in the deficit were seen as having permanent implications. This is no longer the case. In our last forecast we had assumed that real defence spending would fall by 2 per cent a year, and that military transfers overseas would be reduced. The world situation has changed a great deal between 9 November 1989 and 9 February 1990. We are now assuming that there will be much deeper and more sustained cuts in US government spending on defence procurement. We cannot be sure of the timing of cuts, but we have reduced our government expenditure growth from 2 per cent per annum to 1.8 per cent over the whole forecast period. Even this scale of cuts, which will reduce US government absorption of resources from over 20 per cent of GNP in 1987 to around 18 per cent in 1999, may be too small. Box 3 reports a simulation of the effects of 1 per cent of GNP change in US government spending. [Tabular Data Omitted]

This spending assumption has two implications. Firstly it is much easier for the US authorities to reach our target of a 1 per cent of GNP deficit. In the short term this means that there is much less need for the large tax increase package that we were assuming in our last forecast. In fiscal 1991 we are now assuming that taxes will be increased by only $12 billion above current agreed levels, spread evenly between excise taxes and corporation taxes. This will leave the out-turn for the Federal deficit around $30 billion higher than the Balanced Budget Act targets. Higher than average target outturns do not, however, trigger automatic cuts in expenditure or increase in taxes. These can only be the result of the Office of Management and Budget projections of the deficit that are in turn dependent upon their own rather optimistic forecasts for the US economy. However, given the longer-term prospects, we no longer consider that this budget overrun will be seen as a political problem. We expect that growth in 1990 to 1992 will benefit from a less tight fiscal stance. The second implication of the decline in the defence budget is that the pattern of expenditure in the economy will change markedly, resulting in a higher level of consumers' expenditure as a per cent of GNP. This increased expenditure will lead to a higher level of imports, but also a higher level of capital inflows. Consumer goods industries will find their profits increasing relative to defence industries, and the penetration of overseas ownership (both direct and portfolio) of consumer goods firms is much higher than that for defence firms. Thus higher profitability will induce supporting capital flow. The increased deficit and capital inflows will not be without their cost. We expect that US real interest rates will stay high through most of the 1990s in order to induce the required capital inflows. [Tabular Data Omitted]

Japan

The recent sharp rise in Japanese interest rates has been a strong response to emerging inflationary pressures. Consumer prices were rising by 2 1/4 per cent at an annual rate in the last quarter of 1989 after having been virtually unchanged between 1985 and the first quarter of 1989. This inflation performance was largely the consequence of the delayed effects of an appreciating yen, but given the low level of import penetration in Japan (only about 15 per cent), the slackness in the labour market at the beginning of the period was probably at least as important in keeping inflation down. Over the last 18 months, and especially over the last three months, the yen has been depreciating and labour market conditions have tightened a great deal.

In December 1989 the unemployment rate fell to 2.1 per cent, its lowest level since 1981, and the job offers to applicants ratio was 1.32, a level at which it settled in June 1989. This is the highest this index has reached since the early 1970s. For the last year overtime worked has been at higher levels than for at least 16 years. We estimate that total compensation is likely to have grown by 8 1/4 per cent in 1989, with a growth in all economy earnings per head of around 6 1/2 per cent. This is considerably higher than 3 to 3 1/4 earnings growth per head seen in 1987 and 1988.

Output growth in 1989 appears to have been strong although our projected rate of 5 1/4 per cent is below the level experienced in 1988. The decline in competitiveness between 1986 and 1988 had a marked influence even into 1989 with exports of goods growing less rapidly than imports. There was also a large deterioration in the non-factor services balance, reflecting a very rapid growth in overseas tourism and in other services imports. As table 8 shows, we believe that the overseas sector will have made a negative contribution to GNP growth in 1989 However, the slowdown in domestic demand has had a more marked influence, with both consumption growth and especially housing investment growth falling during the year. The reduction in consumption growth is particularly notable given the strength of average earnings, and the combination of effects from the consumption tax and the late Emperor's death along with rising interest rates on personal borrowing has produced a rise in the personal sector's savings ratio to 16.6 per cent in 1989, up from 13.8 per cent in 1988. Housing investment has slowed in response to rising mortgage rates over the last two years and also to the development of capacity constraints in the building industry that have emerged because of the pace of business investment growth. In the third quarter of 1989, however, housing starts, especially for owner occupation, began to pick up, and latest figures indicate that 1989 as a whole will see some small rise in housing investment. Business investment has been growing very rapidly, and survey evidence reveals that investment plans have been continually revised upwards during the year. Higher interest rates from the turn of the year are likely to reduce investment growth from its high levels in 1989.

The effects of high rates of investment growth in 1988 and 1989 are beginning to be felt. Capacity has been expanding, and despite a high rate of growth in output capacity utilisation measures have not been rising in recent months. There is evidence that much investment has been in labour-saving capital which should enhance productivity growth and reduce inflationary pressures. [Tabular Data Omitted]

We are forecasting that domestic demand growth in 1990 will be 1 per cent below that in 1989, largely as a result of higher interest rates. Our econometric model of Japan displays quite large interest-rate effects, although they can feed through slowly, especially in the case of business investment. These high interest rates are expected to be maintained for some time, and they will keep domestic demand growth down to 5 per cent in the medium term, below the average rate of 6 1/2 per cent in 1987 to 1989. This constraint on demand will successfully moderate the inflationary pressures that are beginning to emerge in the economy. We expect unemployment to rise from its current level of 2.1 per cent to 2 1/2 per cent in 1990, and to 2 3/4 per cent in 1991 and 1992 before beginning to fall again. Consumer prices have been rising strongly by Japanese standards in recent months, and the recent fall in the value of the yen will not help this to moderate. Our model displays little effect on Japanese consumer prices from overseas prices in the medium term, reflecting the low level of import penetration in the economy. However, we do expect inflation to peak at around 2 per cent in 1990, and to remain at around 1 1/2 to 1 3/4 per cent in the medium term.

Slowing domestic demand growth in 1990 is in our forecast accompanied by a rise in GNP growth. The effective exchange rate fell by 4 per cent in 1989 when compared to 1988, and at the turn of the year it fell even more sharply. We do expect a small reversal of this fall in 1990, but we are forecasting that the effective rate will have fallen by 8 3/4 per cent in 1990 when compared to 1989. We are expecting a yen/dollar rate of 144 in the last quarter of the year. This sharp fall in the yen has three significant consequences.

Firstly, Japanese GNP includes the constant price domestic currency value of net property income from abroad. The Japanese probably have the world's largest stock of net assets, and more importantly a large stock of gross assets held overseas. A fall in the exchange rate raises the domestic currency value of the overseas assets and their associated income flows by exactly the amount of the change in the exchange rate whilst leaving unchanged the income flows on foreign assets held in Japan. The fall in the yen in recent months will, according to our calculations (and our model) raise Japanese GNP by almost 1/2 per cent in 1990 through this channel alone. It is not clear what impact this rise in measured income should have on demand and output in Japan, and our model gives it very few channels of influence.

Secondly, we believe that some of the major increase in the growth of imports of services observed during the period of the appreciation of the yen will be reversed. Our services trade equations, which were reported in the November 1988 issue of this Review, have large and fast acting competitiveness effects. We have argued in the past that services import growth would be a major factor affecting the reduction of the Japanese current account surplus in the longer term, and although we still believe this to be true, in the short term a turnaround in the services balance will help improve the current account.

Thirdly, the fall in the value of the yen in 1989 has already been boosting Japanese exports of goods, and the further fall in the yen will give them an additional stimulus in 1990 and 1991. As table 9 shows, we are expecting the Japanese to resume their gain in export market share, albeit temporarily. We also expect that the growth in the imports of goods will also continue to slow down. These trends will both contribute to measured GNP growth in 1990, and they will also help improve the balance of payments. [Tabular Data Omitted]

First estimates of the current account surplus in 1989 suggest that it will have fallen to around 55 billion US dollars, or about 2 per cent of GNP. This is a sharp fall from the 80 billion surplus in the previous year, especially when gauged in terms of its percentage of GNP. This decline in the surplus is, we feel, a major factor behind the recent adjustment of the yen exchange rate. The current account is not the only factor behind the determination of the exchange rate, and we have argued in previous issues of this Review that the size and structure of capital account flows also matter. In a world where capital flows are not particularly restricted then the demands for stocks of assets are likely to determine both asset prices and exchange rates (see Barrell et al and Westaway and Pain for analyses along these lines concerning the UK). Portfolio equilibrium in Japan has over the last decade necessitated very large portfolio and direct investment capital outflows. (Box 6 analyses the effects of the removal of capital outflow controls on longer-term securities investment and Box 7 the structure of the Japanese capital account.) These long-term capital flows have been larger than the current account surplus, and have necessitated banking sector inflows to finance them. There is no reason why this situation is not sustainable in the long run, as banking sector inflows can be, inter alia, long-term borrowing by Japanese residents from overseas banks on a nominally short-term basis, or the capture of significant deposits in the wholesale market by domestically resident banks in Japan as a result of their increasing penetration into international capital markets. Neither activity can be seen as either necessarily `speculative' or `short term'. The structure of flows in the Japanese capital account is hence sustainable as long as the current account surplus remains over the longer term large enough to produce equilibrium flows. If it is not then the path of the exchange rate will have to change. [Tabular Data Omitted]

We believe that the yen has fallen recently in order to keep the capital and current account jointly in equilibrium over the longer term. (They are, of course, always equal and opposite in sign.) The fall in the yen will raise the current account surplus and the rise in the yen value of overseas assets will also help shift portfolio holders toward their equilibrium portfolio composition. The recent fall in the yen can be seen as a necessary correction of its price that will produce smaller long-term capital outflows, a smaller banking sector inflow and a larger current account surplus, all of which are likely to be movements in the direction of equilibrium. (The note by Pain and Westaway in the current issue of this Review addresses similar issues.) The gradual realisation that the current account surplus in 1989 would be small, along with the recognition that competitiveness elasticities for goods and services were larger than they had been believed to be were in our opinion the pieces of news that shifted the market. (Box 4 above sets out the results of a simulation of 10 per cent fall in the yen.)

Germany

In the early and mid-1980s the German economy was frequently viewed as being in poor shape, beset by structural rigidities that rendered it incapable of long-term growth in excess of 2 per cent per annum. This view appears to have been belied by the experience of the last two years in which growth has averaged 4 per cent per annum while inflation has been contained below 3 per cent. The earlier pessimism has been replaced by an optimism that has contributed to the marked rise in share prices and the exchange rate in recent months. This optimism has also been fuelled by the political developments in Eastern Europe, which appear likely to lead to economic liberalisation there, offering greater opportunities for western firms, and particularly to West German firms, given their favourable geographical location and historic links with Eastern Europe.

The events in Eastern Europe have undoubtedly important implications for the German economy in the 1990s, but for reasons of clarity these will be considered independently of the underlying economic situation. The strength of GNP growth in 1988 and 1989 owed much to the worldwide increase in economic activity, which was especially marked in areas where the German economy remains strong, notably the production of engineering and investment goods. An additional stimulus was provided by the weakening of the deutschemark over this period. Allied with a lower inflation rate in Germany than in most other economies this led to an increase in German competitiveness. These developments can be summarised by noting that an estimated GNP growth rate of 4.2 per cent in 1989 was achieved through investment expenditure growth of 7.9 per cent and a net exports contribution of 1.9 per cent of GNP.

The deutschemark has strengthened markedly in the last three months, and this of course has major implications for the current account and for income growth. This year we expect that the growth of worldwide economic activity will decelerate, and that the deutschemark will be 6 1/2 per cent higher than in 1989. Accordingly the export and investment-led growth which characterised Germany in 1989 will not be maintained. The decline in the contribution of these two factors will however be partly offset by an increase in the growth of consumers' expenditure, following a 24 billion deutschemark cut in income taxes enacted at the beginning of 1990. Government expenditure may also grow more rapidly than last year in response to the needs of the inflow of immigrants and also as fiscal control is relaxed prior to the general election to be held in December. However, the prospect of a unified Germany may completely change the overall fiscal stance. Monetary policy is however likely to remain tight until the Bundesbank becomes convinced that inflationary pressures associated with the recent strength of economic activity have been resisted successfully.

The most immediate effect of recent events in Eastern Europe arises from the wave of immigration into West Germany which accelerated at the end of last year. The effects of this influx are hard to judge. The short-term effect will be a boost to demand which will benefit both consumer goods and the construction industry. In the medium term the new immigrants should also increase the supply potential of the economy, especially as many of them are young and well educated although some retraining may be required. In particular we would expect that the increase in the supply of labour would put downward pressure on wages. In 1990 the boost to domestic demand that will be produced will provide an additional counter measure to declining external demand. We have accordingly revised up our forecast of GNP growth this year to 3 per cent. Box 8 analyses the effects of an influx of immigrants on the West Germany economy. [Tabular Data Omitted]

The continued inflow of immigrants from East to West Germany requires an urgent policy response. In the past month it appears that the governments of both states view monetary union as the most immediate step that they can take, as a prelude to political reunification within the next two years. A common currency combined with freedom to travel to the West would enable East Germans easy access to goods and services not yet currently available in the East. It would also enable western capital to invest in the East without having to do so in a currency which is not tradeable outside the GDR. In addition it would provide a strong signal from the East German government of their intentions to develop their links with West Germany. It should therefore considerably allay the fears that are fuelling the present migration. A reduction in migration is in the interests of both states, since the East cannot afford to lose important members of its population, and the West cannot easily absorb continued immigration on the present scale.

Further benefits from Eastern Europe lie in the possible liberalisation of these economies, allowing greater trade with the West and increased investment in Eastern Europe by western companies. These benefits are however heavily contingent on political developments. It would be foolish and premature to expect that the demise of communism necessarily entails an orderly adjustment to democratic governments and a market-based economic system. Economic links between East and West can therefore be expected to evolve relatively slowly until the East achieves greater political stability. We would therefore expect the political change in Eastern Europe to have a fairly muted effect on German economic prospects for 1990, but an increasingly important effect in later years, provided that the East negotiates the transition to economic liberalisation successfully. In the medium term the benefits of such a transition are likely to considerably outweigh those that might emerge from the European Commission's establishment of a single West European market.

The question of possible German reunification provides an additional element of uncertainty in constructing our forecast. At the time of writing it seems reasonable to expect German reunification within the next two years, as this appears to be in line with popular opinion in both states, and also seems to be acceptable to other governments in both Eastern and Western Europe. It is possible that significant steps could be made within the next three months, particularly following the elections due to be held in East Germany in March. Reunification will lead to a major reorganisation of both economies as East German industry is restructured and West German firms seek to invest in the East. Our forecast indicates German domestic demand growth of around 4 per cent in 1990, 1991, and 1992, much of this due to high investment. Early and successful reunification may result in even higher investment and domestic demand growth than is contained in our forecast, but we have decided not to treat this as our central case.

For German policy makers there is a problem of shaping policy to accomodate both the potential short-run and medium-run developments occurring outside their country and the actual developments within the economy itself. The primary macroeconomic concern remains the need to prevent the recent economic upturn leading to overheating and consequently to inflation. This concern led to the Bundesbank increasing interest rates by 0.5 percentage points in January, April and June of last year and by a further 1.0 percentage point in October. The aim was both to dampen the growth rate of domestic demand and to increase the value of the deutschemark, in order to dampen inflationary pressure.

The most recent economic data suggests that the economy remains close to capacity. Preliminary figures for third quarter GNP show a decline compared to both first and second quarters caused by lower investment. Despite this quarter-on-quarter fall GNP remained 3.3 per cent higher than a year earlier. Business survey evidence indicated that capacity utilisation may have increased further in the third quarter, while the business climate indicator for October, although down from its peak in July, remained higher than during the first five months of the year. New orders in manufacturing also continued to rise in the third quarter, up 6.3 per cent in September on a year earlier, with orders for investment goods up 9.4 per cent over the same period.

Labour market figures indicate that unemployment remained little changed in the first three quarters of 1989, but vacancies continued to rise during the same period, reaching 360,000, seasonally adjusted, in October, up by 105,000 on a year before. Hourly earnings in manufacturing showed no sign of responding to tighter market conditions, increasing by 4.3 per cent in the year to the third quarter. The 1990 wage round is however expected to be more significant, as a number of long-term wage contracts are due to be renegotiated.

Through most of 1989 consumer price inflation hovered around 3 per cent per annum. Increases in indirect taxes at the start of 1989 may have added half a percentage point to the inflation rate, leaving underlying inflation at 2.5 per cent. Subject to the outcome of the current wage round it seems likely that inflation can be contained at around 2 per cent, aided by the strengthening of the deutschemark at the end of 1989. It is likely however that the Bundesbank will maintain a tough monetary stance until there are clear signs that the inflationary threat has been contained. We have therefore retained our assumption that interest rates are reduced gradually in the course of the year.

Our forecast for GNP and its components is shown on table 10. We expect domestic demand growth to rise to 4 per cent this year, fuelled by extra investment and and by at least 4 billion deutschemark of extra government expenditure to meet the changing political situation, and also by increased consumption, caused both by the income tax cuts at the start of the year and by the extra demand from the increase in population. The increase in population has of course also increased the labour force and we expect that employment will increase by as much as 400,000 in the course of the year. [Tabular Data Omitted]

The increased labour force should maintain downward pressure on wage increases, which we expect to be on average under 4 per cent. Trend unit labour costs may consequently fall. As import prices should also fall following the deutschemark's appreciation we expect that inflation will decline to 1.5 per cent for the year as a whole.

As noted above political uncertainty makes longer-term forecasting more hazardous than usual. German GNP growth is likely to remain at around 3 per cent in 1991 and 1992, and may be higher if reunification is successfully enacted. Inflation should however remain low as further additions to the labour force help to keep unit labour costs down, and a gradual appreciation of the deutschemark contributes to moderate rises in import prices. Higher internal demand should contribute to a slow reduction in the German current account surplus without entailing further substantial adjustment of the exchange rate. However, our forecast is predicated on a belief that net outward capital flows will continue on a large scale and hence that the current account surplus will be maintained. There is a risk that the deutschemark may be forced to appreciate further, causing tensions in the ERM which could result in a major realignment of ERM central exchange rates. [Tabular Data Omitted]

France

French GDP is estimated to have grown by 3.1 per cent in 1989, down from 3.4 per cent in 1988, but comfortably above the 0.7-2.5 per cent range achieved earlier in the decade. The pattern of growth has also changed. In 1988 domestic demand grew by 3.7 per cent, with net exports reducing GDP growth, whereas in 1989 domestic demand growth appears to have been only 2.7 per cent, but net exports increased GDP growth. The French economy has hence been boistered by the strength of demand abroad, aided by a gain in competitiveness caused by a weakening exchange rate in 1988 and 1989.

Despite two years of strong growth, France has experienced only a moderate increase in inflation, from 2.7 per cent in 1988 to 3.1 per cent in 1989. There is some evidence that inflationary pressures could develop. The rate of capacity utilisation in manufacturing rose in both the third and fourth quarters of 1989, while the unfilled vacancies count increased from 66,000 to 77,000 in the year to November. However, unemployment remained flat through 1989 and hourly wage rates in industry increased by only 3.8 per cent in the year to the third quarter, suggesting that strong growth has not induced inflationary pressure in the labour market, at least thus far.

Macroeconomic policy over the past year has been shaped by the commitment to maintain the value of the franc within the EMS. Through the force of this commitment the government has attempted to establish a credible anti-inflationary discipline. The success of the strategy has prompted the government to press for the further evolution of the EMS to a full monetary union. However, the pace of this development may be called into question by the recent political changes in Eastern Europe, particularly as these are likely to have asymmetric effects on the French and German economies.

The commitment to maintain the franc's EMS parity has resulted in a 4.5 per cent appreciation of the effective exchange rate for the franc since mid-September, principally caused by the strength of the deutschemark in response to the developments in Eastern Europe. We have made our normal forecasting assumption that rational efficient forward-looking foreign exchange markets imply that the exchange rate will depreciate only gradually from its new level, in line with the interest-rate differential between the franc and other currencies. This means that we expect the effective exchange rate to be on average 5 per cent higher in 1990 than in 1989. As inflation differentials are less than this, France will have thereby lost competitiveness. As a consequence we are forecasting that net exports, which added 0.2 percentage points to GDP growth in 1989 will reduce the growth rate by 0.7 percentage points in 1990.

The expected worsening of net exports largely accounts for our forecast of a deceleration in GDP growth from 3.1 per cent in 1989 to 2.3 per cent in 1990, as domestic demand growth is expected to be little changed at around 3 per cent. We expect some decline in investment expenditure in response to both higher interest rates than last year, and to the general decline in economic activity. This decline is however compensated by an increase in Government expenditure, which was tightly controlled in 1989.

Table : Table 13. French trade

 Percentage change
 1987 1988 1989 1990 1991 1992
Export volume(a) 4.9 6.9 8.0 3.7 3.6 4.0
 Market growth 5.8 7.7 6.7 4.5 5.5 5.6
 Relative prices(b) 3.4 -5.1 -0.8 4.9 0.6 1.0
Import volume(a) 9.1 8.9 7.5 5.2 5.6 6.2
 TFE 3.1 4.4 3.9 2.9 2.9 3.2
 Relative prices(c) -1.4 -1.9 -0.1 -2.6 -1.0 -0.8
Visible balance, $bn -5.2 -5.4 -5.4 -1.4 -4.3 -8.2
Current balance, $bn -4.1 -4.0 -3.4 1.5 -0.1 -1.2
 As % of GDP -0.5 -0.4 -0.4 0.1 0.0 -0.1

(a) Goods only. (b) A fall is a gain in competitiveness. (c) A rise is a gain in competitiveness.

The French budget for 1990 includes provision for a net increase of 7800 public sector jobs, and highlights education, research and public housing as spending priorities. The highest rate of VAT has been cut from 28 to 25 per cent, and additional cuts made on the corporate tax on undistributed profits and on personal income tax. The buoyancy of economic activity however means that revenue growth is still expected to exceed expenditure growth, leading to a projected decline in the budget deficit from 100 billion francs last year to 90 billion francs this year. The overall stance of the budget should support GDP growth this year.

The appreciation of the franc at the end of last year together with our forecast decline in GDP growth should combine to reduce inflation to 3.1 per cent this year. Import prices are forecast to decline by 4 per cent this year as a result of the appreciation but increases in unit labour costs are likely to keep some upward pressure on domestic inflation. We anticipate that with inflation subsiding in both France and Germany, the French authorities will be able to reduce interest rates gradually. This easing of monetary policy will provide a further stimulus to economic activity in 1991 and beyond.

In the medium term we expect that the French economy can maintain a growth rate of around 2.5 per cent per annum with an inflation rate of 2-3 per cent per annum. Domestic demand is expected to average 3 per cent per annum. The franc's effective exchange rate is expected to remain stable, with a slight appreciation against the dollar, sterling and the lira compensating for a slight depreciation against the yen and the deutschemark. Our forecast therefore assumes a continuation of the present ERM arrangements rather than a move towards full monetary union. Such a move would reinforce the anti-inflationary discipline exerted by the current ERM, and it is likely that French firms and workers would adjust their wage and price-setting behaviour accordingly. In the absence of any such adjustment the inability to depreciate against the deutschemark implied by monetary union would result in a loss of competitiveness compared to our forecast and hence a lower medium-term growth profile than we are forecasting.

Italy

Italian GDP grew by 2.9 per cent in the year to the third quarter of 1989. We estimate that the figure for the year as a whole will also be 2.9 per cent, down from 3.9 per cent in 1988, but probably closer to the growth rate of capacity. This decline is almost wholly explained by the slower growth of domestic demand in 1989, which in turn is explained by a decline in the growth rate of government spending and by less stockbuilding than in 1988. Net exports reduced the GDP growth rate by 0.3 percentage points, with exports and imports both growing in excess of 10 per cent.

Inflation picked up during the course of the year to over 6 per cent per annum. This may be attributed in part to an increase in import prices in response to the depreciation of the lira at the end of 1988 but the economy has been working close to full capacity for some time, and this has also been putting upward pressure on prices. Average earnings continued to increase at around 6 per cent per annum, and trend unit labour costs by 3 per cent per annum. An increase in VAT in January 1989, and increases in tariffs on petrol products and electricity rates introduced in September are estimated to have added 1 percentage point to the inflation rate.

A key element of the Italian anti-inflationary strategy is its participation in the exchange-rate mechanism of the EMS. Until January of this year the lira was permitted to diverge by up to 6 per cent from its central ERM rate, as opposed to the 2.25 per cent divergence permitted to all other participating currencies aside from the peseta. The wider band for the lira reflected its high inflation differential in the early years of the 1980s. By the end of the decade that differential had narrowed considerably. The monetary authorities have therefore decided that the economy can now tolerate being confined to a 2.25 per cent ERM band. From the beginning of January the central rate was depreciated by 3.8 per cent and a narrow band instituted. There was no actual depreciation of the lira, since it was already trading at around its new central rate. The implementation of a narrow band for the lira was an attempt to reinforce the anti-inflationary discipline and credibility associated with Italian membership of the ERM, and an attempt to prepare the way for the possible future evolution of the ERM into a full monetary union.

Domestic economic policy is dictated by the need to restrain the growth of the public sector deficit, whilst maintaining economic growth and restraining inflation. In 1989 the public sector deficit was 130,000 billion lira. This is in excess of the original budget, but down as a proportion of GDP from 11.5 per cent in 1988 to 11 per cent. Net of interest payments the deficit stood at 2 per cent of GDP. Part of the overrun can be attributed to higher than anticipated interest payments following interest-rate rises during the year. These were dictated by the need to maintain the value of the lira within the ERM and were a response to rising rates in Germany. We expect that interest rates will be reduced within Europe during the course of the year, which should in turn reduce the size of the budget deficit.

Our forecast for Italy is shown in table 14. We expect that domestic demand growth will decline to 2.5 per cent, as consumption and investment are both restrained by the interest-rate rises in the latter half of last year and in the first quarter of this year. Net exports are expected to have little effect on the GDP growth rate. Visible trade is likely to worsen following the appreciation of the lira along with the other ERM currencies in the fourth quarter of 1989 and the first quarter of this year, but invisible trade should be boosted by the soccer world cup, due to be staged in Italy in the summer. [Tabular Data Omitted]

The prospects for inflation also appear promising. The exchange-rate appreciation will help to restrain import price rises, while the expected decline in the growth rate should help to alleviate domestically generated inflation. The new ERM narrow band can be expected to reinforce the anti-inflationary resolve of Italian firms. Italian inflation is still higher than that of other ERM competitors, entailing a loss of competitiveness unless further price control is achieved. This tendency to higher inflation than in Germany is a feature of our forecast in the medium term, and we expect that it will put continuous pressure on the ERM.

Subject to satisfactory performance in bringing down inflation, and to interest-rate developments elsewhere in Europe, we anticipate that Italian interest rates will be reduced later this year with further reductions possible in the early 1990s. This should help to stimulate economic activity in the medium term, and enable growth to average around 3 per cent per annum. The ERM commitment should also help to secure further reductions in inflation. Strong growth carries the risk of a deterioration in the current account deficit, and we anticipate that fiscal policy will remain tight in order to curb the growth of both the public sector and the current account deficit.

Canada

Canadian output rose by 5 per cent in 1988, driven largely by domestic demand growth of 6 per cent. The strength of domestic demand can be attributed to the rapid growth in business investment, which grew by 18.5 per cent in 1988. During 1988 the current account deficit widened slightly to US$9.7 billion, reflecting both the buoyancy of domestic demand and the appreciation of the Canadian dollar. The appreciation of the currency has exerted downward pressure on prices and the rate of increase of consumer prices slowed to 4 per cent in 1988. However, average earnings grew by 7 per cent in 1988 and the rate of increase of producer prices accelerated to 4.3 per cent. In response to the threat of higher inflation Canadian fiscal and monetary policies have been set on a restrictive course. In the 1989 federal budget the authorities introduced a package encompassing both reductions in public expenditure and measures aimed at enhancing tax revenues. Short-term interest rates rose during 1988 and firmed further in 1989, contributing to the continued strength of the Canadian dollar. As a consequence we are anticipating that output growth will have slowed considerably in 1989. Indeed, we expect the slowdown to continue into 1990, reflecting in part our assumption that fiscal policy will remain restrictive. Our forecast for Canada is given in table 15. [Tabular Data Omitted]

The tighter policy stance and associated reduction in demand growth are beginning to show signs of reducing the rate of inflation. The consumer price index inflation rate in October was 5.1 per cent, as compared with 5.2 per cent in August and September and 5.4 per cent in June and July. This has been the result of unchanged consumers' expenditure between the second and third quarters of 1989 and an increase in the savings ratio. However, the continued success of the present government's counter-inflationary strategy is threatened by an acceleration in labour costs. Unit labour costs were up 5.8 per cent in the third quarter of 1989 from the same quarter last year, in turn reflecting the largest increase in wage settlements for six years. A positive feature, however, has been the second consecutive quarterly decline in corporate profits, indicating that firms have been forced to concede smaller profit margins rather than to pass higher labour costs on to consumers in the form of higher prices and risk a deterioration in their competitiveness. Overall though, we do expect the output slowdown to have some effect, with consumer price inflation falling to 3.7 per cent in 1990.

Canadian interest rates exceed those in the US, and as a consequence of our use of the open arbitrage condition (adjusted for 1 per cent risk premium on Canadian financial assets relative to those in the US) in setting our exchange-rate projection, we expect the Canadian dollar to depreciate against its US counterpart. Whilst a depreciation is likely to increase inflationary pressures, it is also likely to lead to an improvement in the current account position and, in the long run, we expect the current account to return to a position of balance.

REFERENCES

Barrel, R. Gurney, A., Pesaran, B. and Wren-Lewis, S. (1988), Three forward looking exchange rate equations and their simulation properties, National Institute of Economic and Social Research, mimeo. Westaway, P. and Pain, N., (1989), `Towards a structural model of the UK exchange rate,' National Institute Discussion Paper no. 165.