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.     

Forecast Summary

The recovery that we forecast in February remains intact, though its composition is shifting between external and domestic demand. As we reported in International Economic Outlook earlier this month, the recession in Europe is intensifying so that, even with the devaluation-induced improvement in competitiveness, exports are being held back The weaker world outlook is the main factor behind a lower growth forecast next year. For 1993, however, we are continuing to forecast growth of 11/2 per cent, principally on the basis of more buoyant consumer spending. But the boost from consumption, while welcome in the first stage of recovery, is short-lived since the higher taxes already announced for next year hold back the growth of disposable incomes. Again this is desirable for the share of consumption, private and public, in GDP has been rising steadily and needs to be reversed in order to devote resources to reducing the two deficits: the PSBR and the trade gap. Over the forecast as a whole it is exports and investment which drive demand, not consumption. Underlying inflation has fallen below 3 per cent for the first time in twenty years, but it is now at its cyclical low point. We expect some increase in inflation from now on, though the Government's 1–4 per cent target is not likely to be breached this year. Next year and beyond, however, without more action on the budget deficit or a sharper increase in interest rates than we are assuming, inflation is forecast to settle in the 4–5 per cent range. Unemployment has fallen in recent months but the underlying trend remains upwards. We expect the three million level to be reached in the second half of the year.     

Executive Summary

Our assessment of the outlook for the UK economy over the next two years has become slightly more cautious in the wake of the additional fiscal tightening announced in the November Budget. Although we had anticipated tax and public spending measures of the right magnitude in 1994/95, the Budget was more severe in 1995/96 and beyond than we had expected. We have scaled back our estimates of growth for 1995 and 1996 accordingly. On a more positive note, we expect the outlook for inflation to be better than we indicated last October. The mid-1990s are' likely to see a period of sustained low inflation which has not been seen since the 1960s. The government's target measure - RPI excluding mortgage interest - is not expected to test the 4 per cent target ceiling though it is stuck in the 3-3.5 per cent range for most of the forecast period. Despite expecting slower growth, we are now more optimistic about unemployment, which we expect to fall below 2.4 million in 1997. We now believe that increased labour market flexibility should allow the economy to grow on a lower real wage and productivity growth path, at least while unemployment remains so high. However, whether this improved performance would allow the UK to sustain an unemployment of below 2 million without a serious resurgence of inflation is still open to question.     

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 London Business School with Gower Publishing

The Budget embodies many of the recommendations that we have put forward over the last year -on personal savings and the appropriate stance of macroeconomic policy - but a void remains on the key issue of ERM entry. With inflation set to rise above 9 per cent in the short term, there is a danger that an inflation l sterling depreciation cycle becomes entrenched. In fiscal terms, the Budget was broadly neutral and the Chancellor con- firmed that the strategy is to rely on high interest rates to support the exchange rate and tame inflation. This year, with base rates of 15 per cent, we expect the pound to remain reasonably stable but in 1991-2, as interest rates fall -which they are bound to ahead of the election -the pound could well come under pressure, so putting the government's inflation objectives at risk. ERM entry would provide the obvious support and is consistent with the Treasury forecast. Without it, inflation is unlikely to fall below 5 per cent next year.     

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.     

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     

THE AUTUMN STATEMENT

The Treasury's forecast, published with the Autumn Statement, has been widely heralded as showing a surprisingly cheerful picture for next year as far as both output and inflation are concerned. In fact it is close to the forecast which we produced in October. Here we compare the two forecasts and then consider how our forecast is affected when we adopt the Treasury assumptions on asset sales and the exchange rate. We find that the Treasury is more optimistic than we are on investment and that holding the exchange rate - which is needed to produce the official inflation forecast - requires rather higher interest rates than we assumed in October and this widens the gap between our forecast for GDP and the Treasury's forecast.
We also consider how the government should respond to lower North Sea oil revenues. Taking a permanent income approach, we suggest that the PSBR should be allowed to rise by £2bn on this basis. The same approach, however, suggests that an extra £71/2bn of asset sales should be used to cut the PSBR not taxes. On balance therefore this analysis indicates that next year's PSBR target should be lowered by £1/2bn from the £71/2 bn contained in the 1985 MTFS.     

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.     

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 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.     

WORLD OUTLOOK

Unless the international debt situation or the crisis in the US domestic financial system worsens or there is a further lurch into protectionism, we expect world output to advance more rapidly over the next 2 months than it has over the last year. We argued in May that the world recovery was pausing, just as it did in 1977, and that conditions were falling into place for a pick-up in output. The requirements were seen as a lower dollar, to improve US competitiveness and to alleviate protectionist pressures, and stronger domestic demand elsewhere, to offset the resulting loss of US markets. Since then the case for a lower dollar has been recognised by the Group of Five Finance Ministers, interest rates have fallen and, at the G5 meeting, West Germany and Japan tentatively revealed a further modest stimulus. Output optimism is underpinned by the fall in world inflation to levels not seen since the early 1970s which, our forecast suggests, will be consolidated over the next 12 months. This reflects falling real oil and non-oil Commodity prices and decelerating earnings, which makes a further tightening of policy unlikely. In these circumstances the prospects for output are improving and over the next 12 months we forecast an increase in OECD output of 4per cent.     

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.     

THERE'S MANY A SLIP…

There has to be a General Election at some time in the next eighteen months. It has long been clear that the economy will not be in the best of shape in time for the election and that the best the Conservatives can hope for is a significant reduction in inflation and interest rates together with modest output growth. Our October forecast suggested that this combination was feasible and that the government would be able to go to the country with base rates of 12 per cent, retail price inflation at half its present level and output growing at a rate of 2per cent after a relatively short and shallow recession. It may turn out that this is an overly optimistic central forecast and in this Forecast Release we examine some of the ways in which it could go wrong. In a worst possible scenario the government may have to face the electorate with the economy in recession, inflation high and interest rates still at or close to their present levels.     

Options for ERM Entry

After years of being blocked, UK entry to the Exchange Rate Mechanism now looks very probable either later this year or early next. But if the issue of entry is largely settled, the form of entry remains open. We examine the different dimensions of this question, and consider five separate options for entry. We consider two strategies driven largely by political considerations, but reject them as too high risk. We also reject the 'deep-discount' option as being far too inflationary. Instead we argue for entry at a relatively high exchange rate in line with or slightly above the current market rate. With entry next spring, we would favour a narrow band. But if entry is in the autumn, entry in the lower half of a broad band is more appropriate, leaving greater room for manoeuvre in interest rates. But a move to narrow bands in the course of next year would then be required to give maximum anti-inflation benefits. On this strategy ERM entry will provide appreciable benefits in bringing down inflation, but it will not be costless: as our forecast suggests, the economy will undergo several years of depressed growth of output. But this should lay the basis for steady growth combined with low inflation from 1993 onwards.     

Forecast Summary

The sluggish response of the current account to severe monetary tightening has put pressure on the exchange rate, which was instrumental in the decision to raise base rates to an eight-year high of 15 per cent. In so doing, the government has declared itself ready to risk recession to hold the pound - its main bulwark against rising inflation. Our forecast illustrates the risk. Compared with June, when we saw the economy avoiding a hard landing in the short term (at the cost of a protracted battle to reduce inflation over the medium term), the present forecast projects a sharp deceleration in output next year. Over the medium term output grows a disappointing 2 per centp.a., unemployment starts to rise and it is not until 1992 that retail price inflation is back below 5 per cent.     

Forecast Summary

The lower exchange rate offers UK industry a remarkable competitive advantage in world markets which, we believe, will be expanding rapidly over the next two years. As domestic demand is also likely to be strong in the run-up to the General Election, output is forecast to rise 3 per cent both next year and in 1988. But, even so, the short-term supply response is not expected to be sufficient to prevent the current account from recording a large deficit next year. Excess demand pressures also point to a higher rate of inflation from now on. We forecast a steady increase in inflation to 3¾ Aper cent by the end of next year and a peak of 4½ per cent in late 1988.     

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.     

Forecast Summary

As the Chancellor recognised in his Mansion House speech, sterling M3 is once again proving to be a wayward indicator, and it is the exchange rate which is currently the principal instrument of the government's policy to reduce inflation. The strength of sterling, reinforced by the Group of Five commitment to a lower dollar, is the main factor behind decelerating retail prices and we endorse the Chancellor's forecast that inflation will fall to under 4 per cent in the middle of next year. A strong exchange rate, however, hits UK competitiveness and results in a slower rate of growth in output next year. Output growth, over 3% per cent this year including the post-strike rebound, remains at 2% per cent in 1986 and comes down to an underlying 2 per cent in the medium term.     

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.