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.     

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In the last six months manufacturing output has risen at a rate in excess of 10 per cent while inflation has dropped to 1.2 per cent, its lowest level in a generation. Unemployment has fallen for five successive months. None of these developments was forecast - either by us or, so far as we are aware, by anyone else. How is that the British economy continues to surprise all the forecasters and will it continue to do so? We examine the shift in the forecast consensus over the last year and ask whether the revisions will have to continue. Our conclusion is that some of the most recent optimism is misplaced and that there remain setbacks ahead both in terms of output arid inflation. Nevertheless, it would appear that the risks are on the right side, that if anything output is likely to rise faster and prices more slowly than the current Consensus.     

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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.     

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The current economic outlook is dominated by fears of continued industrial unrest and uncertainty regarding wage increases. The key issues for output and expenditure will be the outcome of the almost inevitable conflict between the monetary objectives and wage inflation. The most recent indicators provide some evidence of the type of problems the economy will face during 1979. The figures for industrial output and consumption suggest that, by end of 1978, the growth of output was slowing down and the figures for wholesale and retail prices suggest that inflation was picking up. Adherence to the monetary targets is already, on a short-term basis, requiring little or no growth in the real money supply and accompanying high interest rates. The latest official longer-term indicators also point to a slowdown in domestic demand.
Inflation would probably have increased by now had it not been for the recent tight monetary policy and the resulting stability of the exchange rate. We have earlier argued that earnings increases of about 12% will be consistent with the current financial background. But earnings increases of 15% or more will put extreme pressure on the company sector and would bring into sharp focus the choice between finanacing wage increases and letting the exchange rate fall with resulting higher inflation rates: or holding the monetary targets and accepting the short-term consequences for output and unemployment.     

The London Business School with Gower Publishing

Inflation is the aspect of our economic performance which is now changing most dramatically (with the possible exception of the balance of payments on current account). Yet price changes and their measurement are many-sided, with a range of indices measuring different stages and different parts of the inflationary process. In this Forecast Release we examine the most important indicators of CJK inflation, look briefly at the relationship between them, and trace the manner in which the rapid slowdown in inflation is now filtering through the economy, having its final impact on the consumer/retail price index.     

The London Business School with Gower Publishing

In the first of this Forecast Release we update our February forecast to take account of the Budget measures and the impact of lower oil price. In the second part we examine the latest (Mark III) version of the Medium Term Financial Strategy and compare it with the earlier versions announced in the 1980 and 1981 Budgets. We conclude that there has been some relaxation of policy though less than might at first appear when account is taken of at the possible shift in the velocity of circulation and by the changed level of output.     

The London Business School with Gower Publishing

A reasoned assessment of the impact of the Budget leads to the following implications:
Interest rates over the course of the year will be higher than they are today.
The possibility of an upturn in the inflation rate before the end of 1978 is more likely than before the Budget.
The combination of this higher inflation rate and the weaker currency is likely to keep the growth of consumer spending significantly below the official (and most other) forecasts, although the 1978 growth will still be substantial.
In February we argued that on the assumption of £l½b net tax reduction in the Budget 'a responsible financial policy would require that part at least should be reversed in 1979'. The scale of the Budget tax reductions and suggestions of further net reliefs in July increase the likelihood that we will be seeing forces at work to slacken demand later this year, or in the first part of 1979.     

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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.     

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Suddenly the recovery is with us. After two months in which manufacturing output rose 2.5 per cent, there are few who doubt that a sustainable recovery is under way. While it is unlikely in the extreme that manufacturing will continue to grow at the rate of January-February, an annual rate of 15 per cent, and equally likely that there will still be some bad months, almost no one is dismissing the recent experience as another 'false dawn'. With retail sales rising steadily, and industrial surveys registering a marked upturn in business confidence, it would appear that the Chancellor's green shoots' are finally with us. Indeed, when the CSO conies to date the trough of the present cycle, it is likely to put it in the second quarter of last year. If this is the case, the first year of recovery will have been particularly weak, reminiscent of the experience in 1981-2 when the trough of the cycle was in February 1981 but it was not until late 1982 that a convincing recovery was under way. Given the apparent similarity between these two episodes, we draw comfort from the fact that (non-oil) GDP rose 1.3 per cent in 1982 and 2.8 per cent in 1983, in line with our February forecast of 1.3 per cent growth this year followed by 3.2 per cent in 1994.     

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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.     

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The theory of employment is reasonably well understood. Producers are confronted with a given level of aggregate demand. They decide how much they can profitably produce, and decide on the mix of capital and labour in response to a given set of relative prices. Over most of the post-war period variations in employment were accounted for mainly by variations in aggregate demand, but that situation changed dramatically during the 1970s. As unemployment has mounted, so has the interest in so-called supply-side explanations of the problem, since it has become obvious that an increase in employment on the scale required can hardly come from a demand stimulus alone. In our account of the 1980 recession, we tended to focus on profitability as a key element in the decision to supply. If the price of goods is too low relative to the price of the factors of production needed to produce them, then the supply of output will fall. In the 1980 recession the price of all the factors of production rose dramatically: real wages shot up following the Clegg awards; real interest rates were at record levels; and the price of energy had recently soared following the OPEC II oil shock. At the same time goods prices were being constrained by the government's counter-inflationary strategy, and most notably by a strong exchange rate. Under these circumstances a substantial proportion of firms, especially in the traded goods sector, found it unprofitable to continue producing. When unprofitable production lines were abandoned, the associated capital equipment was scrapped. These decisions, once taken, were for the most part irreversible even if, as must have happened in some cases, subsequent movements in factor prices would have made production profitable once again. We discussed this phenomenon in the April Forecast Release and showed that, on the assumption that capital-labour ratios had remained at their trend levels, some £25bn of capital equipment (at I980 prices) had been scrapped. The fact that manufacturing output and employment have remained far below their 1979 levels, even though total output at home and abroad is at or well above that level is, we believe, mainly due to this capital scrapping. The jobs in manufacturing will not be re-created - even though UK competitiveness has been restored to pre-1980 levels - until the capital stock is re-built. The scrapping phenomenon is important because it creates a link between employment and too-high real wages (or other factor costs) that is often ignored. In standard production theory a rise in real wages leads to the substitution of capital for labour and employment may fall (if the rive in real wages does not create a more than offsetting increase in aggregate demand). However, production theory is complicated by the fact that capital and labour are complements as well as substitutes. Since a large part of the nation's productive-capacity, once built, uses capital and labour in fixed proportions, a rise in real wages may render part of the existing capital stock uneconomic. High real wages thus destroy capital as well as jobs. In our April Forecast Release, in order to estimate the scale of the scrapping problem, we made the simplifying assumption that capital-labour ratios remained on trend. In practice they vary in line with movements in relative factor prices. In the present Forecast Release we look more closely at the role of factor prices. We find some evidence that changes in relative factor prices affect the capital-labour mix. However, the substitution elasticities are small. The conclusion of this analysis is that the job losses which resulted from too-high factor prices (mainly wages) during the recession cannot be quickly reversed.     

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Over the lastfive years events in the United States have been repeated throughout the OECD area, with a lag of 6–12 months. A repeat of this pattern in I982 would mean that the recovery in Europe and Japan, which has been progressing slowly since the middle of last year. would not last into 1983. The present forecast excludes this possibility. The argument, which we have put previously, is that the US recovety of 1980 was premature and that the current recession Jollows a renewed attempt by US policy-makers to reduce inflation. There are already signs that they will be succes & Consequently we do not expect the US recession to be prolonged In the second haIfof the year we expect an expansion of output to be in progress, both in the US and elsewhere; in the next few months, however, world activity is likely to remain subdued.     

The London Business School with Gower Publishing

Last year earnings growth fell below the lowest rates of increase experienced in the 1980s. At the time this was seen as primarily the result of the deflationary squeeze produced by ERM membership. It was too early to proclaim a new era of responsible wage bargaining until the recovery had occurred. Since then not only has sterling lost its E m anchor, and suffered a sharp depreciation, but an upswing in activity has also been established. However, in spite of the revival in potential inflationary forces, earnings growth has continued to decelerate in 1993. It is clear that the last recession has had a more pronounced effect on nominal wages than its predecessor. In terms of real wages, however, there appears to have been little change, implying that the fall in nominal wages is due solely to lower price inflation. The important question for the present pay round is how will the labour market respond to the recovery? Have the supply-side policies pursued in the 1980s had a decisive effect, allowing the UK to make the transition to low, stable inflation rates in the 1990s? Or will there be a reversion to traditional inflationary practices?     

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The prospects for the industrial countries in 1980/81-already poor at the time of our last "World Outlook" in October 1979 - have weakened further as a result of the latest round of oil price increases. In the last 12 months oil prices have doubled, and, because of the greater weight of oil compared with 1974/75, we estimate that the real impact of the latest increase is three-quarters of the earlier rise when prices quad-rupled. But compared with the events of the mid-1970's the difference is that the earlier crisis was largely unexpected, which is not true of recent events. For this reason we expect the world economy to be less badly affected than in 1974/75.     

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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.