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.     

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.     

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

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.     

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     

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.     

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.     

WORLD OUTLOOK

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

Forecast Summary

In comparison with our February forecast, we are more optimistic on the prospects for output and unemployment both this year and into the medium term. But in consequence we have raised our forecast for the current account deficit. GDP growth, nearly 5 per cent last year, falls back to 3½ per cent this year and 2½ per cent in 1989; from 1990 onwards output is expected to increase at its underlying trend of 3 per cent. Inflation is currently rising but, as output decelerates, it peaks at 5 per cent and drifts gradually lower over the medium term. The current account deficit is projected at £5bn both this year and next; helped by a steadily depreciating exchange rate, which boosts exports, the deficit narrows from 1990 onwards.     

THE UK'S PERSISTENT TRADE DEFICIT

The UK current account deficit reached a peak in excess of £20bn in 1989, equivalent to 4 per cent of GDP. In the next two years, as recession took its toll of domestic spending, it shrank quickly - on the latest data the deficit was only £4.4bn last year, 3/4 per cent of nominal GDP. Over the same period the trade gap narrowed front £25bn to £10bn, in each case taking the deficit back to the levels of 1987, before the late 1980s' boom really got under way. Since 1989, therefore, both 011 trade and the current account, there has been a significant reduction in the external deficit. Yet it remains the case that, despite the length of the recession - non-oil GDP has fallen for six successive quarters - the current account is still in deficit. Moreover, despite there being no concrete data to point to the beginnings of recovery, the shortfall is widening. The low point was the second quarter of last year, with a rare current surplus recorded in June, since when the trade deficit has steadily widened again as the consequence primarily of a 5.5per cent increase in the volume of imports over the last 12 months. Why is it that, in contrast with the experience in the 1980-81 downturn, this recession has not produced a trade or even a current account surplus? Does this mean that the recovery, when it does come, will inevitably widen the deficit with the possible consequence that ‘balance of payments problems’ will undermine the pound inside the ERM? We conclude that, while it is disappointing that UK producers have not managed to claw back more of the domestic market - in contrast with the experience of exporters in world markets - our forecast of a current account deficit of 0–2 per cent of GDP should be relatively easily financed and will riot therefore cause serious problem for economic policy. This conclusion would riot necessarily hold if the recovery occurs more rapidly than we expect arid sucks in a greater volume of imports. It may be the case that the UK will continue to run a current deficit with Japan in particular as the counterpart to ongoing Japanese direct investment in this country.     

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     

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 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 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.     

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.     

The London Business School With Gower Publishing: FIGHTING YESTERDAY'S BATTLES

With still no firm evidence at home of a recovery in non-oil GDP, the government's main worries centre on the path of output ahead of the General Election. In a forecast, which relies heavily on exports to stimulate demand in 1992, the Treasury cannot regard the rising probability of renewed recession in the US or the very sharp slowdown currently taking place in Europe as the post-unification German boom runs out of steam with equanimity. The fear mist remain in Conservative politicians' minds that there will be no meaningful recovery within an electorally significant timescale. We sketch out this background, but our focus here is not on the prospects for recovery; rather we ask whether the recession has achieved its objectives. The recession was, it should be remembered, the direct product of government policy - interest rates were raised to 15per cent ahead of ERM membership - aimed at reversing the excesses of the late 198Os'boom and in particular at bringing inflation quickly down to acceptable European levels and reducing the deficit on the current account, which at its peak in 1989 amounted to 4 per cent of GDP. Our answer is that, over the last year of recession, considerable progress has been made: the rate of inflation is now in line with that in Germany and the current account deficit has fallen to under 1 per cent of GDP. But, on the government's own forecasts contained in the Autumn Statement, there will be some slippage on both counts in 1992. It is this worrying feature that we consider here. Our overall conclusion is that the recession has not completely delivered its objectives and that, even as the politicians turn their attention to recovery, we still have to fight yesterday's battles.     

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.     

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.     

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.