The London Business School with Gower Publishing

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

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.     

The London Business School with Gower Publishing

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.     

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

The economic recovery, which was gathering momentum in the second half of last year, was stopped in its tracks first by the US-led resurgence of interest rates last A utumn, and then by the harsh winter. There were some encouraging signs of recovery again this Spring, but the latest indicators, most notably from the recent CBl Survey, are disquieting. This time last year we took the view that a spontaneous recovery would occur as destock-ing came to an end. That forecast has proved correct on demand but over-optimistic on output - a very high proportion of the extra demand was met by imports. The scope for further spontaneous recovery is now limited and our growth forecast, especially for 1983, depends on the authorities taking some reflationary action.
It is now being debated how and when such reflation should take place - there is talk of an Autumn Budget. In effect the authorities have to decide a) whether there is scope for reflationary fiscal action within the PSBR guidelines of the Medium-Term Financial Strategy; b) if so, whether such action is more appropriately taken in the A utumn or next Spring; c) if in the meantime interest rates could be brought down while respecting the MTFS targets.     

The London Business School with Gower Publishing

In the last month there have been three major items of economic news. First there was Mr Healey's package of 26 October; then there was the announcement on 31 October that the Government's exchange rate policy would change; finally on 1 November there was the news that the miners had rejected the National Coal Board's pay offer. In terms of our view of the outlook for the longer-term development of the economy, the most significant change is the move to free the pound. The effects of Mr Healey's package upon total output are to leave 1977–78 much where it would have been had the Treasury's original public expenditure plans been realised; the shortfall in spending has been made up by tax reductions and, in turn, consumer spending increases.     

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 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.     

The London Business School with Gower Publishing

In October we forecast 1 per cent output growth in 1993 accompanied by little change in retail price inflation, an increase in unemployment to 3.2 million by the end of the year and a £20bn deficit on the current account of the balance of payments. Since then we have revised our view of the international outlook and the Chancellor has made his Autumn Statement. There are also some hopeful signs in the latest data on retail sales, manufactured exports and the money supply that demand may be picking up both domestically and overseas. How do these developments affect our short-term forecast? The simple answer is very little: the outlook on output and inflation in 1993 is barely changed since October (Table I). We have lowered our forecasts for world inflation and for German interest rates which means that the pound can be held steady against the DM at lower UK interest rates and that the inflationary consequences of devaluation, though significant, are slightly less over the medium term than we made out in October. There is one revision of major significance, and that relates to the PSBR, which is now likely to reach f45bn in 1993-4, more than 7per cent of nominal GDP. The change is not on the spending side - the Autumn Statement confirmed existing expenditure plans - but on revenues, notably corporate taxes and tares 011 spending, which have fallen far more quickly than we envisaged. This, in combination with a projected near-2'per cent of GDP deficit on the balance of payments, poses a difficult medium-term policy dilemma. To escape from the twin deficits requires either deflation of demand, which conflicts with the Government's new-found commitment to growth, or a more buoyant economy to boost tax revenues and a competitive pound to underpin export-led growth. Of the two the latter is self-evidently more inflationary. This highlights the policy dilemma: at some stage the Government may have to choose between reducing the deficits and its 1–4 per cent inflation target or sacrifice its commitment to growth.     

The London Business School with Gower Publishing

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.     

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 with Gower Publishing

Stage 3 is being widely heralded as a success. In fact compared with the government's initial aspirations, the guidelines particularly in the private sector have been exceeded by 50 per cent. Far from marking continued restraint. Stage 3 allowed massive - and unsustainable - increases in real take home pay thanks to favourable factors on inflation and generous tax cuts. The outcome has proved very close to forecasts we made before any guidelines were prepared and it suggests that incomes policy has played little part in holding down earnings in the private sector.
Looking ahead to Stage 4, we discuss the ability of firms to pay high wage increases given the development of the exchange rate and world prices. If the exchange rate is held (which is possible if current monetary policy continues) the increase in earnings in 1978/79 should be restricted to about 11–12 per cent.     

The London Business School with Gower Publishing

There are enough similarities in the performance of the British and Spanish economies in recent years to make the entry of the peseta into the EMS on 19 June an event of interest to UK observers. Faced with the problem of overheating, the Spanish authorities have chosen to use the external discipline of a fixed exchange rate as a way of fighting inflation. In similar circumstances, the UK has opted for autonomy, preferring to use internal monetary discipline to bring inflation back down to the European average - itself one of Mrs. Thatcher's conditions for EMS entry. Over the next year or two it should be possible to form a view on the relative merits of the two approaches to counter-inflation policy.