THE AUTUMN STATEMENT

The Treasury's forecasts, published with the Autumn Statement, are close to those we presented in October. For domestic demand the main difference is that the Treasury has consumption growing by 3 per cent next year whereas we had forecast a growth of only 2 percent. Behind this difference lies a significant different in policy assumptions. In October we estimated that there was no scope for tux cuts, yet the Treasury's forecast assumes that there will be net cuts in taxation (over and above indexation) of £11/2bn in the next Budget. In this Forecast Release we show that the main differences are (a) that the government has raised its forecasts of sales of assets and council houses arid (b) that it expects more North Sea Oil Revenue than we do. The latter forecast depends critically on what happens to the exchange rate.
We present a revised forecast based on the new information in the Autumn Statement and incorporating the £1 1/2bn tax cuts. It is very close to the Treasury's forecast.
We also discuss the relevance of changes in North Sea oil revenue to fiscal policy and we suggest that it is misleading to treat it on a par with other sources of revenue. We then show that the suggested tax cuts of £11/2bn in the next Budget are effectively £4bn less than was indicated last March. Finally we argue that the Chancellor's claim to have kept within his Planning Totals for spending in the last three years has only been achieved by increased asset sales.     

THE 1981 BUDGET

In this Forecast Release we examine the short-term prospects for the UK economy in the light of the Budget and other developments. Compared with our February forecast the Budget has raised taxes by about £2 bn but it has also increased public expenditure by a similar amount The net effect on the PSBR, compared with our February forecast, is therefore small, especially if the Treasury's estimates for nationalised industry profits and/or public sector wages prove over-optimistic. We therefore believe that the outturn for the PSBR in 1981-82 could be close to the figure of £12 bn presented in our last forecast.
We also believe that the prospects for output and inflation are little changed The Budget by itself will have raised prices by about 1 per cent compared with our previous forecast but because we had probably over-estimated indirect tax receipts, the net effect on prices is small For output, the likely reduction in consumers' expenditure is more or less offset by higher public spending. We continue to expect a fall in output between 1980 and 1981 of 1–11/2 per cent, inflation during the year at about 10 per cent, a current account surplus of £3 bn, monetary growth of 8 to 9 per cent and a PSBR of £12 bn.     

THE OUTLOOK FOR 1988

We have updated our October forecast to take into account recent events in equity and foreign exchange markets as well as the Autumn Statement. As far as the prospects for the world economy are concerned, we have taken a gloomier view than the Treasury. On this basis we also obtain slower growth in the UK next year: output is forecast to rise 2.2 per cent compared with 2.8 per cent in October and 2.7 per cent in the official forecast. Inflation and the balance of payments are little changed from October. For next year's Budget we continue to assume a cut in the standard rate of income tax to 25 per cent though, on our calculations, this requires a PSBR it 1988–9 of newly £2bn whereas the Autumn Statement forecast assumed a constant PSBR of £1bn     

Assumptions–Central Forecast

We continue to make our best guesses about likely policy developments rather than assuming 'unchanged' policies. In the central forecast we assume that the broad thrust of policy is unchanged, i.e. we have made the technical assumption that the present government is returned in the next General Election. But, because an election must be held within the next 15 months, we also consider the medium-term prospects under alternative economic policies. (For details see p. 19.) In the central forecast. e herefore. we assume that policy will continue to be guided-though not completely determined-by an extended Medium- Term Financial Strategy (MTFS). For 1983-4 the MTFS requires the PSBR to be 23/4% per cent of GDP at market prices. Given official inflation and output forecasts, the Chancellor is therefore aiming for a 1983-4 PSBR of £8bn (Autumn Statement, p. 13). In the central forecast. however, we have assumed that the Budget of 15 March will give greater weight to the political objectives of cutting income tax and maintaining the attack on inflation, even if this implies slippage from the MTFS targets. Specifcally we have assumed that the standard rate of income tax will be cut by lp. that personal tax allowances will be raised by 12 per cent and that indirect taxes will be raised by only half the amount required for full revalorisation. This amounts to a total tax giveaway (compared with unchangedpolicy) of £1 1/2 and results in a PSBR of just over £9bn. 3.1 per cent of GDPat market prices.     

The London Business School with Gower Publishing

The Autumn Statement updated the government's spending plans and its forecast from those announced in the Budget in March. On both counts there is very little difference between the Treasury view and our own forecast released in October. The Treasury supports our projection that output and demand will decelerate in 1989, that inflation will peak in the first half of the year at about 7 per cent and fall back to 5 per cent by the end of the year and that the deficit on the current account of the balance of payments will narrow only marginally over the next 12 months. On public spending in 1989–90, our October forecast was close to the unchanged official figures. It was clear to us - though not to most City commentators - that savings on unemployment benefit, debt interest and elsewhere would enable greater spending on programmes within an unchanged planning total. In later years the government has upped its expenditure plans from those announced a year ago, as we had assumed it would. As a result, the Autumn Statement projects significant increases in real public spending from now on. We show that, under a more appropriate inflation forecast, public spending rises nearly 2 per cent next year but falls back in 1990–92. Finally we argue that, unless the Chancellor decides to run an even larger PSDR (public sector debt repayment) than the £12bn built into our forecast - and the Autumn Statement forecast assumes a PSDR in 1989–90 similar to the expected outturn in 1988–9 of £10bn - the scope for tax cuts remains intact.     

Forecast Summary

Backed by the lowest interest rates in fifteen years and a competitive exchange rate, we see the economy moving off the corrugated bottom of last year and recovery gathering pace as this year progresses. We expect output to rise 1.4 per cent this year, 0.5 per cent more than we forecast in October when we were expecting a far more cautious approach on interest rates, and 3 per cent in 1994. Here we have factored in another 1 per cent cut in base rates to coincide with the Budget on 16 March but this may prove to be the floor, especially if, as is rumoured, the Prime Minister has vetoed tax increases in the Budget for fear of derailing a fragile recovery. By the end of the year, however, we expect the trend in interest rates to be upwards to halt a sliding exchange rate and to cap the devaluation-induced price increases that will be feeding into domestic prices by then. On this basis we believe that inflation can be contained at 4 per cent underlying this year, 5 per cent in 1994 - outside the Chancellor's target range. While we are more sanguine than before on the outlook for output and inflation, major problems remain on the PSBR and the balance of payments. Beginning in the December Budget, the Government will have to raise taxes to avoid a debt spiral on the budget deficit and channel resources into net exports. Even on the basis of a £4bn tax hike in the first of the unified Budgets, we expect the PSBR to run along close to £50bn and the current account deficit in the £15bn-20bn range.     

THE 1987 BUDGET

Our pre-Budget forecast published last month correctly anticipated the main Budget measures (with the exception of the decision not to re-valorise excise duties) and is very close to the Treasury's own forecast. We have updated the forecast for the Budget measures and other new information. Compared with the February Economic Outlook, our post-Budget assessment has revised down slightly the short-term forecast for output, inflation and the current account deficit. Consequently we share the Treasury's view that output will rise 3 per cent this year, but we are a little more optimistic on the outlook for inflation and the current account.
In holding the PS BR to last year's expected outturn of £4bn, and more particularly in cutting the PSFD by £11/2zbn, the Budget represents a tightening in fiscal policy. Whether the overall policy stance is tightened depends on the response of the monetary authorities. Early indications are that the government will prevent interest rates from falling as far or as fast as they would otherwise do and that the exchange rate will be allowed to rise. This implies a tightening of policy in order to head off problems on inflation or the balance of payments. This argument is supported by the Treasury's own forecast, which is more pessimistic on both inflation and the current account than its predecessor in the Autumn Statement, and explains the Chancellor's decision not to re-valorise excise duties. The post-Budget forecast incorporates this change in policy. We now assume that the sterling index averages 70 this year and that base rates fall to 9 per cent by the end of the year.     

Forecast Summary

Even if output recovers in the second quarter (as we expect), it looks as if there will be no increase in GDP this year in comparison with 1991. This reflects the weak start to the year, in which non-oil output registered its seventh successive quarterly decline. Through the year (fourth quarter to fourth quarter), however, we expect GDP to rise 1.5 per cent, laying the basis for a stronger recovery in 1993. Even so, it is not until late next year that output returns to its previous peak Paradoxically, we have raised our forecast of domestic demand from February (on a milder stock rundown) but imports are taking a disproportionate amount of the extra demand, holding back domestic output and aggravating the current account deficit. From nearly £9bn this year, we see the deficit rising to over £14bn by the middle of the decade, equivalent to 1³/4 per cent of GDP. While this is disappointing, it should be relatively easily financed even with lower interest rates providing the pound is held at its present DM 2.95 parity. we assume no ERM realignment which underpins a further drop in inflation to 4 per cent later this year and to 3-3 1/2 per cent by the mid 1990s. The weakness of output means that unemployment continues to rise for another 12 months, peaking in the middle of 1993 at three million, and that public sector finances will move still further into deficit - we project a PSBR this year of £30bn and a peak of £34bn in 1993-4, equivalent to 5 1/4 per cent of GDP.     

A BUDGET FOR STERLING AND A BUDGET FOR JOBS

In our assessment macroeconomic policy is now tighter as consequence of the Budget than we had assumed in February. We interpret the Budget speech as indicating higher interest rates (tighter monetary policy) and, in consequence, a stronger exchange rate. On this basis we find that the prospects for inflation are slightly better than before, though output is weaker. Additionally we forecast a PSBR in 1985-6 of £ 63/4bn, below the official forecast of £7.1bn but in line with our February forecast. Of £7.1bn but in line with our February forecast. Because output is lower, however, this implies a tighter fiscal policy.
The other main change to our forecast is unemployment. The changes to National Insurance Contribution scales represent a very cheap way of reducing the cost of employing the lower paid, and we estimate that these measures, together with the extension of the Youth Training Scheme and Community Programme, will create an extra 375,000 jobs and training places by 1988. However these effects are partially offset by the effects on output of the higher interest rates and higher exchange rate that we are now forecasting. When account is also taken of the increase in labour supply that follows any increase in employment, the net effect on unemployment is to reduce it by 300,000 by 1988 compared with our February forecast.     

THE 1992 BUDGET FOUR LEGS GOOD; TWO LEGS BETTER

In framing his Budget, the Chancellor, Mr. Lamont, sought to balance two mutually exclusive goals: the political imperative of establishing the Conservatives as the party of low taxation on the one hand; the deterioration in the financial position of the public sector on the other. Inevitably the Budget fell between these two stools. The net cut in taxes, though cleverly angled towards the low paid, was a modest £2.2bn, 0.4 per cent of GDP, which is unlikely to 'buy' many votes on 9 April. This may largely free the Government of the charge of trying to bribe the electorate, yet it still leaves the PSBR at £28bn in the coming financial year, £36bn excluding privatisation receipts, which is equivalent to 6 per cent of nominal GDP. Over the medium term Mr. Lamont reaffirmed the Government's commitment to a balanced budget, though on the Treasury projections this is not achieved by 19967, despite the assumption that growth averages 3.5 per cent a year from 1993 onwards. On our calculations, a return to budget balance is unobtainable even on the Treasury's optimistic growth projections without a move to tighter fiscal policy. The Conservatives' maxim that 'budget balance is good; budget deficits are bad' may not have been formally jettisoned, but it is in the process of being re-written as 'budget balance is good; budget deficits are better, as long as they are prudent'.     

The Nominal Framework for Economic Policy

The next Budget will almost certainly be the last one before a General Election. Despite the temptations to make electorally attractive cuts in income tax or increases in public spending, we believe the opportunity should be taken to re-affirm the government's intention to move steadily towards price stability. This is particularly important at a time when our exceptionally high real interest rates may reflect fears about a future change in policy. We provide a nominal framework which extends the Medium Term Financial Strategy to 1992–3. Given the buoyancy of revenue and the likely growth of money GDP next year, we argue that the PSBR should be no higher than £6bn next year. There is a good case for keeping it at this year's expected level of £5bn.     

Forecast Summary

Although hard evidence of recovery is still elusive, our forecast indicates that the trough of the recession occurred in the second quarter and that output fell 4 per cent peak-to-trough. We estimate that GDP rose 112 per cent in the third quarter - though only because of a rebound in North Sea oil production - and that for 1991 CIS a whole it will be 2 per cent down on 1990 levels. Next year GDP is forecast to rise 2 per cent but it is not until 1993 that the 1990 output peak is passed. Unemployment therefore still has a considerable way to rise - to a peak of 2.8 million in 1993. In the first year of full EMS membership, the economy has made an accelerated transition to European levels of inflation. Against a background of modest growth, it should be possible to consolidate this progress and we expect retail price inflation to average little more than 3 per cent over the next four years. Similar rapid progress has been achieved on the balance of payments where there is a trade surplus on manufactured goods for the first time since 1982. Here, however, we are less confident that the reduction in the trade gap can be sustained. In the recovery phase we expect imports to rise more rapidly than exports with the result that the current account deficit rises from £6bn this year to £8bn in 1992 and £10bn-£12bn in 1993-5.     

THE AUTUMN STATEMENT

The short-term prospects for output are weaker than our October forecast suggested - manufacturing output fell 1.8per cent in the third quarter and the CBI survey indicates a sharp decline in business confidence. This is reflected in the Treasury's Autumn Statement forecast of GDP growth this year of only 1 per cent followed by 0.5per cent in 1991. With inflation now passing its peak, there would be a case for lowering interest rates but this is not possible with the pound below DM2.90 - the ill-judged reduction in base rates on ERM entry combined with the challenge to Mrs. Thatcher's leadership has pushed sterling deep into its lower ERM band. The principal unknown in the Autumn Statement forecast is the level of interest rates which, in the Treasury's judgement, will be necessary to keep sterling at or close to DM2.95. The Treasury may envisage only a very modest decline in base rates to 13 per cent next year. This could explain why their forecast is relatively gloomier than ours; alternatively the Treasury's underlying view could simply be more pessimistic. Nevertheless we show that the gap between the two forecasts can be eliminated if we change a limited number of assumptions - notably on interest rates, North Sea oil output, general government consumption and stock-building.     

The London Business School with Gower Publishing

Collapsing oil prices and a falling dollar set the background to a Budget in which the Chancellor, hamstrung by lower oil revenues, was seen as having little room for manoeuvre. In fact the sharp fall in the sterling price of oil has provided him with the perfect excuse for not making significant cuts in personal income tax that were largely irrelevant to the needs of the economy. Instead of a boost to household demand we have had, thanks to OPEC, a transfer to companies in the form of a reduction in costs. This should enable them to expand output against a background of falling inflation. Our post-Budget assessment of macroeconomic prospects (Section I), made on the Treasury's assumption of a $15 oil price, shows output growing by 2 1/2 per cent this year and inflation falling below 3 per cent in 1987. We are thus less optimistic than the Treasury about output but more optimistic about inflation. How was the Chancellor able, within the confines of the Medium-Term Financial Strategy, to give anything away having lost so much oil revenue? A detailed analysis of the PSBR forecast (Section II) reveals good reasons why non-oil tax revenues should be some £3 1/2n higher than forecast this time last year. But, because we still expect public spending to be above the official figures, our PSBR forecast is £1bn higher than the Treasury's. Although the macroeconomic impact of the Budget was small (especially in relation to that of the fall in oil prices which preceded it), it continued the process of tax reform. We focus, in Section III, on the new proposals to deal with the problem of the pension fund surpluses to which we drew attention in the November issue of Financial Outlook. We conclude that the proposed measures could have a larger effect on tax revenues in the longer term than is indicated by the Treasury's Budget estimates.     

The London Business School with Gower Publishing

Last year the Chancellor followed "the path of prudence and caution", cutting taxes by £4bn and budgeting for a public sector surplus of £3bn. This year - rather more compellingly - he is travelling the same route. Against the background of a record current account deficit and rising inflation, Mr. Lawson has tightened fiscal policy, cutting taxes in 1989–90 by nearly £2bn - less than is needed to offset real fiscal drag. His main priority, reaffirmed in the Budget speech, is to tackle inflation and, to this end, he chose not to revalorize excise duties. This was reinforced by a reduction in national insurance contributions, which not only benefits the low paid in relative terms, but also sharpens the incentive to supply labour at the bottom end of the wage spectrum. But this reform of national insurance is not cheap. Even though it is not practicable to implement the changes until October, the cost in 1989–90 is estimated at £1bn, rising to £2.8bn in 1990–1. This is equivalent, in PSDR terms, to a 2 per cent cut in the basic rate of income tax arid, in our post-Budget forecast, precludes further tax cuts in 1990. Unless there is an unexpectedly large rebound in personal savings, the Chancellor is likely to find himself in his present position in a year's time: presiding over a large budget surplus but unable to reduce it significantly for fear of rekindling inflation or aggravating the current account deficit. Simply writing declining numbers for the PSDR into the MTFS offers no genuine guidance on medium-term fiscal policy and may even be positively misleading to financial markets.     

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.     

BRITAIN'S FISCAL POLICY NIGHTMARE

What should the Chancellor do about the burgeoning budget deficit or Public Sector Borrowing Requirement. Brian Durrant, of the futures brokers GNI Ltd, outlines the problems posed by a PSBR that could exceed £50bn.     

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

Led by manufacturing industry, output has accelerated and GDP growth approaching 4 per cent is likely this year. But strains are emerging and we expect slower growth from now on. Over the medium term GDP is forecast to rise at a sustain- able 3 per cent rate, nearly 31/2 per cent for non-oil output. This should enable the reduction in un- employment to continue, though at a slower pace than in the last year. Against a background of rising activity, we expect inflation to remain at its present underlying rate of about 4 per cent and the current account deficit to settle at about £2bn p.a. We show in the Focus how this forecast might change if the stock market fails to recover from its mid-October crash     

(5) Focus: Forecast Revisions

In this section we examine the current forecast together with its immediate predecessors to see how the forecast itself has changed over the last year. The conclusion is that we have become progressively more optimistic in the last 12 months about prospects for both output and inflation. The two are connected: the lower inflation outturn has contributed to higher consumers' expenditure and hence to output. On the PSBR and the current account of the balance of payments, given the large margins of error attached to these forecasts, we have not changed the main thrust of the forecast: in the next four years a declining PSBR and approximate current account balance remain the most likely outturn.