The London Business School with Gower Publishing

Last year saw the most coordinated cyclical upturn in the world economy since the early I970s, with OECD output rising 4per cent, industrial production and world trade even more rapidly. The boom in demand, which followed five years of continuous expansion, has outstripped supply and prices have begun to accelerate. To tackle inflation, the G7 monetary authorities have tightened policy over the last year, reversing the short-lived drop in interest rates necessitated by the stock market crash. This tightening may have to go further, especially in Germany and Japan where the effects of a rising oil price and higher indirect taxes are being exacerbated by currency depreciation. Although the rise in interest rates came too late to stop inflation rising, it has beet pursued with sufficient vigour to prevent inflation from seriously breaching the 5 per cent level. It is on these grounds that we forecast a relatively soft lending for the world economy on output, with growth continuing at 2.5–3per cent, accompanied by a limited reduction in inflation which stays in the 4–5per cent range. Progress on current account balances is also likely to be sluggish: in the absence of a serious attack on the budget deficit, the US deficit is likely to stay in the region of $140bn a year.     

WORLD OUTLOOK

World output, which was strengthening immediately prior to last October, appears to have barely suffered in the short term from the stock market crash. Apart from an early reaction by US consumers - since reversed - demand is proving robust and in early 1988 OECD industrial production is, we estimate, 6 per cent up on year-earlier levels, with GNP more than 4 per cent higher. Indeed such is the strength of activity that the present balance of risk is not that recession is imminent but that inflation may pick up again. In the United States, where activity rates are at their highest level for eight years and unemployment is at a fourteen-year low, monetary policy has been tightened and interest rates are moving higher. The Bundesbank is keen to follow suit and the BoJ is keeping the situation under review. Nevertheless, with wages in most countries still adjusting to the low inflation rates of the last two years, there is little evidence yet that prices are accelerating.
We expect to see world interest rates edging higher in the second half of the year as recorded inflation picks lip. But we believe that underlying inflation remains low and that, even on the assumption that oil prices return to 18 a barrel, OECD consumer price inflation will peak early next year at a little over 4 per cent. Tighter monetary policy is also expected to hold back demand over the next 12 months. Consequently, we expect some weak- ness in output in the first half of next year but discount the possibility of a severe recession. GNP growth in the OECD area is forecast to decline from the 3 per cent rate of 1987–8 to a little over 2 per cent next year and to a sustainable 2½ per cent p.a. over the medium term.     

The London Business School with Gower Publishing

The world economy is just starting to emerge from the second trough of a "W-shaped" recession. Compared with the experience after the first oil shock, when industrial production fell by 12 per cent, bringing inflation quickly down from 14 per cent into single figures. the 1980 world recession was mild. Between the first and third quarters industrial output fell 5 per cent; it recovered in the fourth quarter and inflation stopped falling. As a result governments - and this is especially true of the United States - look "another bite at the cherry": monetary policy was tightened and interest rates rose. The effect over the last six months has been to produce a second dip in output. The renewed attack on inflation has, however, been successful and inflation is now well in single figures and falling. Consequently a general easing of policy is evident and a recovery of output in the second half of 1982 and into 1983 remains our forecast.     

WORLD OUTLOOK

The strength of US domestic demand is exerting a very strong pull on the world economy. Japan in particular is benefiting from soaring export demand, but the effects on European exports have been offset by weak domestic demand and, in the case of West Germany and the UK, by damaging industrial disputes which have interrupted supply. Over the next 12 months we expect the US economy to slow down under the weight of the financial and external balance pressures, which two years of very rapid but unbalanced growth have built up. For the world economy, however, we expect the slowdown in the US to be counterbalanced by expanding domestic demand in Europe and Japan, especially if a lower dollar permits reductions in interest rates. We forecast world output growth of about 3 per cent next year, well below the near-5 per cent projected for 1984 - the cyclical peak. By the second half of 1985 the world recovery will be three years old and we expect a pause in the growth of output. Against a background of stable monetary growth we expect world inflation in the 5–6 per cent range over the medium term. This is consistent with some increase in US inflation, low and stable inflation in Japan and West Germany and further progress in reducing inflation in countries such as France and Italy. Our forecast is based on the assumption that the dollar falls next year. If it does not fail we believe there is a significant risk of slower growth.     

The London Business School Gower Publishing

The worldwide monetary tightening, which was necessary to contain the inflationary effects of last year's cyclical upturn, is close to having run its course. The boom is giving way to a period of slower but more sustainable growth, while the distribution and structure of demand has turned out to be more favourable than could have been anticipated. The US economy has successfully slowed (but recession seems unlikely), whilst Japan and Europe are still expanding rapidly. The world economy thus continues to grow at a rate of around 2.75 per cent, allowing modest reductions in international current account imbalances. The impact of interest rates has been felt mainly by consumers and in the housing market, and has had only a limited effect on investment and trade. So demand has been reduced but not at the expense of a capacity expansion which will, through productivity gains, dampen inflationary pressures. We expect world inflation to fall slowly front a little above 4 per cent currently to around 3 per cent by 1992. This is above the declared objectives of policy makers but is as close to the hoped-for soft landing as may be achievable.     

Forecast Summary

In themselves the drop in interest rates and the fall in the exchange rate following the ERM débâcle of "Black Wednesday" will have an expansionary effect on demand in the UK economy. But because of the way in which the policy shift was handled, any positive impact is likely to be offset by lower business and consumer confidence with the result in our forecast that recession continues well into next year. It is another six months before output stops falling and a rise of as little as 0.9per cent is in prospect for 1993 as a whole. Such a weak recovery will, however, limit the inflationary impact of a lower pound and, helped by lower mortgage interest rates, retail price inflation is forecast to be almost unchanged over the next 12 months. In 1994 and beyond, the inflationary effects of devaluation are more evident and we assume that the Government will tighten its monetary stance, raising interest rates back above 10 per cent to stabilise the pound, possibly re-entering the ERM at a new central parity of DM2.40. On this policy stance, output rises 3 per cent in 1994 but slows thereafter and the peak in inflation is held to 6 per cent late in 1994. The J-curve effects of devaluation enlarge the current account deficit to f20bn next year- The weakness of output over the next 12 months is the main factor behind a rise in unemployment to 3.2 million and a steady increase in the PSBR, which reaches a high of f43bn in 1995-6, equivalent to 6per cent of nominal GDP.     

WORLD OUTLOOK

Clear signs that the world recovery is underway have e merged in the first half of 1983. We have revised our forecast upwards and predict an increase of 1 3/4 per cent in OECD GNP in I983 and a further 3% per cent in 1984. By hirtorical standards such a recovery would be extremely modest and would not be expected to trigger off a resurgence in inflation. If so GNP could advance a further 2% per cent in each of I985 and 1986. However, there is a danger that the relaration of monetary policy in the US in conjunction with the expansionary fiscal stance will bring about a very rapid upswing in the second half of 1983, thereby generating upward pressures on US interest rates. If, as the Presidential election approaches, these pressures are resisted and US monetary growth maintains its recent rapid expansion, an increase in the rate of inflation would be likely in 1984. If this were met with a tighter policy response (higher interest rates both in the US and elsewhere) after the election, the prospects would be for a sharp slowdown in the world economy in 1985.     

POST-CRASH INDICATORS

The stock market crash has inevitably awakened fears that the world economy may be on the brink of recession. We examine the movement in output pre- crash and the evidence which is so fat available for the fourth quarter. The response of policy makers is also considered. We conclude that, ahead of the crash, output was rising strongly and that there are no signs yet of a slowdown. In the US consumer confidence has been dented, but elsewhere easier fiscal and monetary policy may fully compensate for the crash     

WORLD OUTLOOK

After six years of steadily rising OECD output, fears of a significant rise in world inflation are now increasing. In the last year there has been a slight pick-up in inflation with producer prices up nearly d per cent. But prompt action by the Federal Reserve to raise interest rates before the presidential election appears to have damped inflationary expectations in the US and has given Japan and Germany an opportunity to tighten monetary policy without causing major currency fluctuations. It is also apparent that the other possible source of world inflation, commodity prices, is not a problem. OPEC over-production has ensured that the oil price remains weak and other commodity prices appear to have stopped rising after a brief acceleration at the beginning of the year. Nevertheless the major imbalances in world trade are declining only slowly and without a change in fiscal policy in the major economies it is difficult to believe that minor changes in monetary policy will be sufficient if the process of adjustment begins to falter. Despite these risks, we take a sanguine view of world prospects. Tighter monetary policy should effect a slowdown in world growth next year (already indicated by recent developments, particularly in the US) and this should be sufficient to control inflation which we expect to peak at just under 5 per cent at the beginning of next year. From 1990 onwards we see steady growth accompanied by low inflation.     

WORLD OUTLOOK

The recent weakness of the world economy does not undermine the relatively optimistic forecast for 1987 which we presented in May. At that time we suggested that activity would be sluggish for most of this year as a result of the impact effect of the OPEC III oil price collapse. But we also argued that by the end of the year there would be clear signs of a consumer-led recovery as the personal sector adjusted to the real income gains and lower inflation benefits of the lower oil price and the reduction in nominal interest rates which followed. There is mounting evidence of rising consumer spending, particularly in Europe and it is something of a puzzle that output has not risen to meet this demand. The explanation is partly that producer confidence has lagged behind that of consumers, so that demand has been met from stock, and partly that spending has been supplied from countries outside the OECD, especially the NICs in the Far East. Nevertheless, we are convinced that our earlier view of OECD output prospects next year remains the most likely though, in recognition of the growing importance of non-OECD competition, we have adjusted the output forecast down slightly. OECD GNP is expected to rise 2.6 per cent this year, with an acceleration to over 4 per cent in 1987 arid 1988. Moreover, we believe this can be achieved without a rebound in inflation, which is forecast to be stable at about its present level of 2 1/2 per cent.     

The London Business School with Gower Publishing

The Government has recognised that the balance of risks has shifted in the last six months. Even though the pound has been devalued by around 15 per cent and suspended from the ERM, the probability of a significant pick-up in inflation over the next 12 months is low: the more serious risk is that the recession, which showed signs of deepening in the third quarter, turns into a slump. It is for this reason that the Autumn Statement announced measures, both monetary and fiscal, to increase demand and more particularly to try to rebuild confidence which has taken a battering over more than two years of recession, most notably in the housing market, where in the immediate aftermath of the ERM diédâle prices continued their sharp fall. On the fiscal side the measures were constrained by a seriously adverse trend in the PSBR, with some imaginative use of ‘time-limited’ measures which will boost demand in the short run without adding to government borrowing in the medium term. On the monetary side the Chancellor sanctioned the third 1 percent reduction in interest rates since the pound has been in free float. He was responding partly to criticism that the earlier two cuts had achieved rather little, though Mi. Lamont might have been advised that steering the economy by monetary policy is akin to steering an oil tanker: it takes a considerable time to respond. The danger, especially if rates come down to 6 per cent before the end of the year or even, as some are urging, to Sper cent, is that rates will have to rise sharply again before the end of next year to head off a renewed bout of inflation. This may seem a remote possibility at the present time but, as Milton Friedman taught us long ago, the lags in monetary policy are long and variable: it is nonsense to imagine that the cuts in rates that we have seen in the last two months could have yet had any impact on the economy. The worry is that, with the pound I5 per cent down on ERM levels, they will have an adverse effect on inflation in, 1994-5.     

WORLD OUTLOOK

The world recovery, now 18 months old, suffered two major setbacks in May: heightened political tension in the Middle East and a crisis in financial markets following a rise in US interest rates. On the assumption that oil supplies are not disrupted, we forecast that industrial production in the OECD area will rise by 7per cent in 1984 compared with 1983 and that total GNP will be 4 per cent higher. The Fed3 decision to tighten monetary policy, and run the risks of a US banking crisis, underline its determination to prevent the re-emergence of high inflation in the US. Higher interest rates are expected to produce a pause in the US recovery later this year, but, by reining back the economy and dampening down inflationary expectations, they should avert both a return to high inflation and the need for a more pronounced US recession at a later date. Compared with the January forecast, therefore, in which we assumed that, for political and debt-crisis reasons, the US authorities would avoid a rise in interest rates, the present forecast embodies higher interest rates and an earlier pause in the American recovery but, in the medium term, lower inflation and steadier growth of output. For the European and Japanese economies, where policy has remained more restrictive throughout, we have not changed our view that inflation will continue either to remain low (West Germany, Japan) or to moderate (France, Italy), thereby underpinning a sustainable medium-term recovery.     

The Dollar, the Oil Price and Policy Divergence

There is currently a clear divergence of policy between the United States, Japan and Germany. With the US in recession and concern growing over the severity of the slump, interest rates have been cut in a move to revive the economy. In contrast Japan and Germany are both experiencing strong growth and monetary policy remains tight to combat inflation. This divergence was seen most clearly when the Federal Reserve Board lowered its discount rate to 6 per cent on 1 February, the day after the Bundesbank had raised its Lombard rate to 9 per cent. With G7 increasingly concerned about domestic factors, less emphasis is placed upon stable exchange rates and as a result the dollar is at an all-time low. The last two G7 communiqués have stressed ‘stability oriented monetary policies’, an ambiguous phrase which fails to define ‘stability’ either in terms of exchange rates, inflation or growth. Thus both the German and Japanese policy of high interest rates to reduce inflation and low US interest rates aimed at stimulating the economy can be termed as ‘stability oriented’. This analysis focuses on these divergent policy responses in two alternative scenarios to the world forecast we presented last month. The first scenario considers what might happen if the Federal Reserve Board were to stimulate the US economy by further cuts in interest rates, whilst Japanese and German rates were unchanged in the face of inflationary pressures. This case may be relevant if the recent US loosening of monetary policy is not sufficient to encourage growth because of a ‘credit crunch’, so that a more expansionary policy is required by the Fed. As a consequence, policy diverges further and the dollar weakens. The second scenario focuses upon a reduction in inflationary pressures in Japan and Germany brought about by an oil price fall. In this case we assume that US policy is already loose enough to avoid a prolonged recession, but that German and Japanese monetary policy is relaxed as inflationary forces recede. In this case policies converge. Each scenario thus concentrates on one of !he two features which are causing the policy divergence amongst G3 countries: recession in the US, inflation in Germany and Japan.     

Forecast Summary

A pause in world activity held back UK industry in the first quarter of the year and, even though we expect faster growth from now on, we forecast total output growth of only 2 per cent this year. But next year a stronger world economy and pre-election tax cuts lift growth to 3 1/4per cent. Lower oil prices and falling interest rates help keep inflation at its current level both this year and, as long as wages respond, next. In the medium term we expect the growth rate to fall back but, assuming that a fairly tight fiscal policy is pursued by whichever government is in power, we predict that inflation stays below 3 per cent     

WORLD OUTLOOK

The world recovery, now three years old, has proved more resilient than many expected and will be sustained in 1986 by lower oil prices. Fears that the early-1985 slowdown would turn into renewed recession have proved unfounded, as output in both the United States and Europe picked up in the second half of the year. The improvement stemmed from lower interest rates, falling inflation and weak commodity prices and was further helped by the sharp correction to the value of the dollar following September's G5 agreement. To these factors, which will remain supportive this year, is now added a lower oil price. The recovery in world output has not produced an increase in oil demand and, as the oil price rise of 1979-80 gave a further boost to supply from non-OPEC sources, a severe imbalance has emerged in the oil market. To maintain a £26 marker price (itself cut from £29 last July) has required a cutback in production of ever-increasing magnitude from Saudi Arabia in its role as OPEC's swing producer. Now that Saudi Arabia has abandoned this role in favour of stabilising its market share, oil prices have fallen sharply. We assume that the oil price will fall to £20 by the end of this year, a fall in real terms of 30 per cent. As a result the world recovery is given renewed impetus and output accelerates over the next twelve months. A cyclical peak in activity emerges in 1987, after which output growth settles at 2%-3 per cent and inflation at 4–5 per cent.     

The small open macroeconomy and the yield curve: A state-space representation

This study extends a state-space representation of the yield curve and the macroeconomy to a small open economy in order to study the dynamic interaction between the yield curves in Canada and the U.S. The framework treats the U.S. term structure of interest rates as being exogenous to both the Canadian yield curve and macroeconomy. The empirical results support very strong links between the yield curves in the two countries, with the U.S. yield curve accounting for as much as 45 per cent of the variation of the movement in the level and about 30 per cent of the movements in the slope and the curvature of the Canadian yield curve. Canadian yield-curve factors are found to account for about 50 per cent of the variation in output and the monetary policy rate, and about 25 per cent of the variation in inflation, much larger than the yield curve effects found for future developments of the macroeconomies of other countries. A relatively strong bilateral relationship is found to exist between the yield curve and the instrument of monetary policy, supporting recent studies that find the dynamic relationship between the yield curve and the macroeconomy is due to the pivotal role that monetary policy plays in the macroeconomy.     

Forecast Summary

Nearly two years after the I990peak in output, the economy continues to 'bump along the bottom' of an L-shaped recession, which has turned into as severe a downturn as its predecessors in 1974-5 and 1980-1. The origins of the recession lie in the weakness of domestic demand, which has failed to respond to the 4.5per cent cut in interest rates that has taken place since we joined the ERM. It is now the turn of fiscalpolicy: public spending was raised in the Autumn Statement and, as the General Election approaches, the odds are on tax cuts in next month's Budget. This relaxation of monetary and fiscal policy should produce recovery and we see output moving ahead from the second quarter onwards. Nevertheless, the outlook for I992 is weaker than before: we forecast a rise in GDP of a little over I per cent, rather less for manufacturing industry. In 1993 and beyond n growth rate of around 2112per cent should be possible but it is the second half of next year before output passes its previous peak. This suggests that unemployment will rise for at least another year - to a peak in the summer of I993 of 2.8 million. The combination of a stable exchange rate inside the ERM and protracted recession has produced a rapid reduction in inflation and the current account deficit. As long as the pound maintains its present parity, inflation should moderate further, to the 3–4 per cent range by the end of the year and beyond. On the trade side, in contrast, imports have already bottomed out and exports are struggling in a weak world economy. This suggests that, as the recovery gets under way, the deficit on current account will widen from last year's £6bn to £8bn this year and £10bn by I995.     

The London Business School with Gower Publishing

In October we forecast 1 per cent output growth in 1993 accompanied by little change in retail price inflation, an increase in unemployment to 3.2 million by the end of the year and a £20bn deficit on the current account of the balance of payments. Since then we have revised our view of the international outlook and the Chancellor has made his Autumn Statement. There are also some hopeful signs in the latest data on retail sales, manufactured exports and the money supply that demand may be picking up both domestically and overseas. How do these developments affect our short-term forecast? The simple answer is very little: the outlook on output and inflation in 1993 is barely changed since October (Table I). We have lowered our forecasts for world inflation and for German interest rates which means that the pound can be held steady against the DM at lower UK interest rates and that the inflationary consequences of devaluation, though significant, are slightly less over the medium term than we made out in October. There is one revision of major significance, and that relates to the PSBR, which is now likely to reach f45bn in 1993-4, more than 7per cent of nominal GDP. The change is not on the spending side - the Autumn Statement confirmed existing expenditure plans - but on revenues, notably corporate taxes and tares 011 spending, which have fallen far more quickly than we envisaged. This, in combination with a projected near-2'per cent of GDP deficit on the balance of payments, poses a difficult medium-term policy dilemma. To escape from the twin deficits requires either deflation of demand, which conflicts with the Government's new-found commitment to growth, or a more buoyant economy to boost tax revenues and a competitive pound to underpin export-led growth. Of the two the latter is self-evidently more inflationary. This highlights the policy dilemma: at some stage the Government may have to choose between reducing the deficits and its 1–4 per cent inflation target or sacrifice its commitment to growth.     

Forecast Summary

The outlook is conditioned by our assumption that sterling enters the ERM, probably in the autumn, at a central DM parity not very different from the current rate and that this exchange rate is held over the medium term. Fiscal and monetary policy have to be made consistent with a stable pound, which rules out tax cuts and restricts the fall in base rates to 12 per cent. The benefits of the ERM are to be seen in a reduction in the underlying rate of inflation to below 5 per cent by 1992. But ERM participation is not costless. The downside is four years of output growth averaging below 2 per cent and higher unemployment. The ERM offers the possibility of low inflation and steady growth in the second half of the 1990s: it is not a 'quick fix' for the current problems facing the UK economy.