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.     

WORLD OUTLOOK

Over the last 12 months industrial production in the OECD area has risen by 8–9 per cent, only slightly less rapidly than in the first year of recovery from the OPEC 1 oil crisis. Much of the growth in output stems from a very rapid expansion in North America although, in the second half of 1983, output in Europe and Japan began to accelerate. We expect the recovery to be maintained during 1984 with some convergence of growth rates. For the year as a whole we are now forecasting 61/2 per cent growth of industrial production, 33/4 per cent for total GNP. By the end of 1983 the long-standing reduction in inflation had run its course and OECD consumer prices were about 5 per cent higher than a year earlier. Within the area some countries, such as France and Italy, were still reducing inflation, but this was offset by the US where inflation has been rising slowly since the summer. We expect these trends to continue in 1984, i.e. stable inflation in the OECD but accelerating prices in the US, producing in each case about 5 per cent inflation. In 1985 we are now forecasting a slowdown in the world economy. This is expected to be centred on the United States, where the problem of the Federal Budget remains to be tackled. By the time of the Presidential election the US economy will have registered two years of relatively rapid growth. This is likely to be producing upward pressure on prices and interest rates and, as a result, a pause in 1985 in the growth of output. In Europe and Japan, where output has grown more slowly, we expect the recovery to be sustained in the medium term.     

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.     

WORLD OUTLOOK

The world recovery, which began at the turn of the year, gathered pace in the second quarter. We have again revked our forecast upwards and predict an increase of 2 1/2 per cent in OECD GNP in 1983 and a further 3 1/2 per cent in 1984. In its early stages the recovery was centred upon North America, though more recently it has spread to West Germany and Japan. France and Italy, however, remain in recession. Over the next 12 months this pattern is unlikely to change significantly-in the approach to the Presidential election the US is expected to grow quite rapidly, but domestic demand will remain a restraining factor in Europe/Japan where, by historical standards, modest growth is expected. Reflecting this some inflationary pressure could re emerge in the United States towards the end of next year, though not, in this forecast, elsewhere. We continue to expect therefore that world inflation will settle in the 6–7 per cent range and that this will enable the world recovery to be sustained over the medium term.     

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.     

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.     

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.     

The London Business School with Gower Publishing

With the benefit of hindsight, we can see that the course of the world economy in 1988 was a product not so much of the stock market crash of October 1987 but of the reaction to the crash. Monetary policy and to a lesser extent fiscal policy were eased and consumer spending responded to cuts in interest rates and rising real incomes. With the world recovery in its sixth year, capacity pressures began to emerge and investment also boomed, helped by a lower cost of capital. As a result of this strong private sector demand, OECD output increased 4 per cent in 1988 as a whole and industrial production and world trade rose even more rapidly. Against the background of buoyant demand and output, inflationary fears have resurfaced. Since the spring monetary authorities in most countries have been tightening policy, raising interest rates by early 1989 above the levels which helped bring about the stock market crash. Their aim is to effect a slowdown in demand before a significant upward movement in inflation and inflationary expectations takes hold. In our judgement the present policy stance will achieve its aim of a "soft landing" for the world economy. The pick-up in world inflation is contained below 5 per cent and by the second half of this year inflation eases, paving the way for a relaxation of monetary policy. Output growth slows from 4 per cent to 3 percent in 1989 and 2 per cent in 1990, picking up again as interest rates are lowered in 1991–2.     

WORLD OUTLOOK

At the end of 1982 output in the world economy was still falling, although there were signs that the decline had very nearly run its course. We expect a radual recovery to begin in the first half o f 1983. Unlike the recovery which began in the late summer of 1980, when inflation was still in double figures, any upturn in 1983 would be set against a background of declining inflationary expectations and weak oil prices. IJ. as we expect, a falling inflation rate proves a decisive factor in keeping interest rates on a downward path, we forecast that the output will gather pace in I983 and rise reasonably strongly in 1984. Of the 4 per cent rise in industrial production which we foresee in 1984. a large part is due to the fall in real oil prices.     

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.     

The London Business School with Gover Publishing

The world economy is in poor shape. OECD industrial production fell 0.5per cent in both 1991 and 1992 arid though it may now have stopped falling it is still, on our estimates, below year-earlier levels. The US recovery continues to disappoint; recession persists in Japan and Europe; inflationary pressures, already weak, are waning. Next month's UK forecast would normally be based on the world forecast published in June's International Economic Outlook, when we were looking for G7 output to rise 1.2 per cent this year, 2.5 per cent next. But this now looks on the high side and although a detailed revision to the world forecast mist wait until the December IEO, as at1 input to the UK forecast we are shading our G7 growth forecasts - to I per cent this year and 2.25 per cent in 1994. Similar downward revisions are also in train at the OECD arid IMF, according to recent press reports. The more sluggish output performance is already having mi impact on the oil price, which has fallen below £16 a barrel. Together, these developments imply lower world inflation and, particularly in post-ERM Europe, a faster easing of monetary policy than we had allowed for in June.     

The London Business School with Gower Publishing

Output has stagnated in the main industrialised countries this year but we expect the benefits of lower oil prices to show up in rapid growth from now on. The present weakness in the world economy stems from tighter US fiscal policy and the oil price shock itself. These have combined to reduce domestic demand in the United States, and hence to cut the market for Japanese exports in particular, and also to reduce expenditure by energydependent countries and companies. A further factor is that, with prices of oil-based products falling, there is an incentive to delay expenditure. We expect this impact effect of OPEC III to be short-lived and to give way to its positive effects in the second half of this year. Specifically, we expect consumer spending to lead the recovery as real incomes will be boosted by the terms of trade gain from lower oil prices - equivalent to 3 per cent of GNP in the OECD area as a whole. On the basis of oil prices holding at $15. we forecast OECD output growth of 3 per cent this year, rising to 41/2 per cent in 1987. Additionally, we expect lower oil prices to produce a significant reduction in world inflation. Zero growth of producer prices is forecast on average this year arid consumer price inflation is expected to fall to wards 2 per cent in the course of the year.     

Forecast Summary

The recovery in demand, which began in the second half of 1982, produced output growth of about 23/4 per cent in 1983. We expect this growth rate to be maintained, if not bettered, in 1984. The long-standing reduction in inflation has now come to an end but we do not expect prices to accelerate. Over the next four years a stable inflation rate of 5–6 per cent is forecast.     

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.     

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.     

Economic Viewpoint Bringing Counter-Inflation Policy Back on Course

There is no doubt that the monetary limit for the first year of the Government's Medium-Term Financial Strategy will be grossly exceeded, The reported figure for sterling M3 is likely to show a growth of 16 per cent to 18 per cent for the financial year compared with the upper limit of 11 per cent. This is a setback for the government's counter-inflationary policy but not a disaster. The likely overshoot can be largely (but not completely) explained by the removal of the Bank of England's Supplementary Special Deposits Scheme (the corset). Its significance is best understood if we re-examine monetary history since June 1978. (when the corset was imposed). A reasonable interpretation is that the money supply has effectively been growing at an annual rate of 15 to 16 per cent for the past three years (Details are shown in Table 4 on p. 12.) In retrospect it can be said that last year's monetary policy (but not that of the previous two years) was defensible in the light of the shock to prices caused by the oil price rise and the increase in VAT. We did in fact argue in Economic Outlook of June/July 1979 (“Price Shocks and the Economy”) that if the UK'S past record of monetary control had been better we would advocate a relaxation of monetary policy to accommodate these shocks. In the event monetary policy was relaxed (albeit unintentionally) and the squeeze on the real money supply was less severe than appeared at the time. However, there must be a steady reduction in monetary growth from now onwards if the government is to maintain its current progress in reducing inflation. We believe that such a policy is feasible and will be successful However the government must stick to the fiscal policy set out in the Medium Term Financial Strategy (MTFS). Our preliminary estimates suggest that, if Current public expenditure plans are fulfilled, there may be little or no scope for a reduction in personal taxation in 1981-82. Further ahead, the danger point, on past experience, will be 1983 when the economy should be on a strong path of recovery and inflation should be well below current rates. That is the point at which upward pressures on the money supply are likely to reappear and will have to be resisted     

WORLD OUTLOOK

In the course of 1984 growth rates in the major economies came together. This reflects a slowdown in the United States, and to a lesser extent Japan, from the middle of the year and continuing recovery in Europe. This convergence is expected to continue in 1985 when total output in the OECD area is forecast to increase by 3 per cent. Within this total it is likely that the US, West Germany and the UK all achieve about 3 per cent; Japan should grow more quickly, France more slowly. In spite of a rapid recovery in output from the late-1982 trough, inflationary pressures remain weak. Measured in dollar terms, non-oil commodity prices have fallen and the oil price is under considerable down wards pressure. We expect inflation to stay at about its preset level in the US, West Germany, Japan and the UK and decline further in France, Italy and other countries where policy reaction to the 1979-80 oil price shock was delayed. In the medium term we expect the world economy to experience steady growth combined with a constant or slightly increasing inflation rate. This reflects a stable policy environment and falling real oil prices. After the excesses of the 1970s and early 1980s it is possible that the rest of the decade will experience u greater stability than at any time since the 1960s.     

Government Popularity and the Economic Cycle

In June 1987 the Conservatives under Mrs. Thatcher were re-elected with a majority of over 100 seats against Labour. They received 42.3 per cent of the total vote, the size of the majority owing much to the significant number of votes received by third parties. But it is also believed that the Conservatives' share of the vote, unchanged from 1983, reflected the performance of the macro economy. In the four years of Mrs. Thatcher's second term, output rose more than 3 per cent a year and by the time of the election inflation was below 1 per cent, interest rates were under 10 per cent, and unemployment had come back below 3 million. If Mrs. Thatcher and her Cabinet colleagues had planned an economic strategy for the next four (or five) years in order to be in a strong position to win a fourth term of office, it might have included the following factors: output growth of 2–3 per cent a year; inflation staying around 1 per cent; interest rates of 10 per cent or thereabouts; unemployment down further from the near-3 million mark of June 1987. On our current forecast, that is, with the exception of output, the economic record of the Conservatives' third (Thatcher/Major) term. Yet the Conservatives have been running neck and neck with Labour in tile opinion polls and, barring unforeseen developments, the coming election will be extremely close, with the possibility still of either a small Conservative majority or a small Labour majority or even a hung Parliament. Why is it that, against the background of a similar economic performance in aggregate, the Conservatives have lost popularity? The arguments are complex and a full explanation would include the introduction of the community charge arid the fall of Mrs. Thatcher herself. But the economy is part of the explanation. The economic literature on Government popularity examines the state of a number of economic variables at the time of the election. At its most extreme, some believe that all a Government has to do to be re-elected is deliver a low mortgage rate in time for the election. Other analysts have explained Government popularity in a simple regression framework, with a lagged dependent variable to capture sluggish adjustment. A weakness of this research is that it implicitly believes all the Government has to do is to ‘get it right on the night’. As long as the economy falls into place by the time of the election, re-election is certain. This implies that the electorate both forgets and forgives, and is indifferent to the course of the economy in the previous three or four years. But it cannot be the case that the electorate evaluates only the average performance of the economy over the lifetime of a Parliament or even the most recent developments. As in any simple utility maximisation problem, it is not just the mean of the distribution that counts but also its variance. In other words the combination of late 1980s' boom and early 1990s' recession counts against the Government in a way that four or five years of steady progress would not have done. If this is correct, it may not be sufficient for the Government to deliver low inflation and interest rates and some recovery in output in time for the election; it may simply be that the electorate remains unforgiving of a five-year track record of boom and bust.     

Briefing Paper: Why has the economy recovered?1

By the end of last year GDP (though strike affected) was 9 per cent higher than in the first half of 1981, an annual growth rate of 2.5 per cent. In this Briefing Paper we seek to explain the recovery from the recession. We conclude that much of the recovery represents a natural response of the economy after the oil and price shocks of 1979-80. The recovery occurred in spite of the deflationary Budget of 1981 and the sharp rise in interest rates in the autumn of 1981. Since 1981 fiscal policy has been stable, whereas the original intention was to tighten fiscal policy progressively in subsequent years. This stability and the fall in the inflation rate that accompanied it allowed growth to resume. We believe that the upturn would have been rather weaker (though inflation would have been lower) if the progressive tightening of the original Medium- Term Financial Strategy had been adhered to.     

WORLDOUTLOOK

German monetary unification is expected to result in a major expansion in autonomous demand from East Germany. In economic terms this is equivalent to a fiscal shock to West Germany broadly similar to that experienced in the US in the early years of Mr. Reagan's Presidency. Led by the Bundes bank, the monetary authorities' response is again likely to be a tightening of policy, leading to several years of high real interest rates. Overall, the combined monetary-fiscal shock should strengthen growth with only moderate increases in inflation. Germany is expected to grow very rapidly in the -per cent range for several years, with only a slight upturn in inflation. Japan, after a pause over the next year, should be able to return to its under lying growth path fairly quickly. However the US situation is more precarious. FUN adjustment from the previous Reagan shock has not yet taken place, leaving the US vulnerably dependent on increasingly scarce imported capital. In the absence of a significant *peace dividend: the result is the necessity of continued tight policy and sluggish growth in the American economy. US growth stays around 2 per cent, but this allows a substantial reduction in the current account deficit.