INTRODUCTION¹,²

B1 This chapter sets out the economic background to Budget 2000, providing updated forecasts for the UK and world economies over the next three years. The overview section discusses recent developments in the UK economy and gives a summary of the outlook for growth and inflation. The second half of this chapter focuses on domestic forecast issues and risks, and sets out the world economy background.

Table B1: Summary of forecast

UK ECONOMY OVERVIEW

The UK economy in 1999

B2 In early 1999, many commentators were predicting weak short-term prospects for the UK economy. The February average of independent forecasts showed GDP rising by just 0.6 per cent in 1999, with growth expected to remain well below trend in 2000 (Budget 99 Table A2). Within total GDP, the average expectation was for growth in domestic demand of around 1 per cent in 1999, partly offset by falling net exports and hence a significant decline in manufacturing output. Claimant unemployment was projected to rise by around 230 thousand on average in the year to the fourth quarter of 1999.

B3 The Budget 99 forecast, by contrast, projected greater resilience in economic activity. Interest rates had already been reduced by 2 percentage points from a relatively low peak of 7¹/₂ per cent in mid-1998, subsequently reaching a low of 5 per cent in summer 1999. This timely response to the deterioration in global and UK prospects came against a background of considerable strength in private sector balance sheets, partly reflected in still high levels of consumer confidence. The good prospect of a continued expansion in domestic demand underpinned the relatively buoyant Budget 99 GDP growth forecast of 1 to 1¹/₂ per cent, despite a larger expected negative contribution from net trade compared to outside forecasts.

B4 The preliminary estimates of output and expenditure now available to the fourth quarter of 1999 broadly confirm the Budget 99 forecast judgements. GDP rose by 2 per cent in 1999, exceeding the upper end of the Budget 99 forecast range. Rapid growth in domestic demand, up 3.4 per cent in aggregate and spread fairly evenly among the components of final demand, more than accounted for buoyant activity overall. This was partly offset by somewhat weaker than expected net trade, which reduced growth by 1.7 percentage points. Moreover, claimant unemployment also confounded outside expectations, falling by 140 thousand during the course of the year.

B5 Activity strengthened rapidly during 1999, with quarterly growth rising from 0.4 per cent at the beginning of the year to an average of 0.9 per cent in the third and fourth quarters. The balance of growth between sectors and the components of demand also improved. Manufacturing output grew by 1.7 per cent between the first and second halves of 1999, surpassing all expectations and so more than recouping the losses of the previous 12 months. The service sector recorded growth of 1.6 per cent over the same period, up from 1.0 per cent in the first half of 1999. This strengthening in activity through the year was shared across all regions of the UK (see Box B1).

B6 Both the level and growth of GDP at market prices in the second half of 1999 were slightly stronger than forecast in the Pre-Budget Report. Export volumes of goods and services strengthened considerably, rising 6.2 per cent compared to the first half of the year. Around mid-year this helped eliminate the previously strong negative contribution to growth from net trade, though export volumes fell back in the fourth quarter. Growth in import volumes was stronger than expected during the second half of 1999, contributing to a slightly weaker than anticipated net trade performance overall. Growth in final domestic demand has eased somewhat, largely reflecting the unsurprising dip in business investment growth which followed the earlier deterioration in survey investment intentions. Household consumption, by contrast, rose by 0.8 per cent in the fourth quarter of 1999, and was up 4.4 per cent on a year earlier. With total domestic demand growing by 1.9 per cent in the fourth quarter of 1999, albeit boosted by exceptional inventory accumulation, some further rebalancing in demand was clearly required.

Box B1: Regional economic activity in 1999 The dramatic improvement in business survey indicators over the past year has, in part, reflected a correction from excessively pessimistic readings recorded during the second half of 1998 (see Box A1 of the Pre-Budget Report). It also reflects the underlying strengthening in manufacturing and service sector growth illustrated, for example, by the improvement in the British Chambers of Commerce (BCC) deliveries balances1 between the first and fourth quarters of 1999. This survey is useful in providing a snapshot of activity across the UK regions on a much more timely basis than official indicators allow. The BCC survey recorded strong gains in the pace of manufacturing activity in nearly all areas during 1999, with a particularly sharp improvement registered in the northern regions. Unsurprisingly, given a starting position of growth much closer to trend, the strengthening in activity recorded in the service sector was less dramatic overall. Again, the survey evidence shows all regions sharing in stronger growth last year, though with gains tilted towards the north. These improvements lifted the BCC activity indicators to healthy levels in virtually all regions by the fourth quarter of 1999. This points to a buoyant expansion in activity across the board, though with Scotland and manufacturing in Wales still lagging behind the national survey results in terms of the current pace of growth. 1Positive survey balances signal an expansion in sales, and so an increase in the balance indicates a strengthening in output growth.

B7 Measured from the output side, 1.8 per cent growth in non-oil gross value added in 1999 was exactly as forecast in the Pre-Budget Report, with stronger than expected manufacturing output growth offset by a slightly weaker expansion in the service sector. Non-oil output therefore is still estimated to have risen just above trend in the third quarter of 1999, with the positive output gap rising to ¹/₄ per cent of GDP by the end of the year. At current rates of expansion, this signals upward pressures on domestic costs, though such judgements are subject to wide margins of uncertainty.

B8 RPI excluding mortgage interest payments (RPIX) inflation of 2.2 per cent in the fourth quarter of 1999 was marginally higher than forecast in November. It has remained just below target since spring 1999, and is in line with the majority of forecasts made a year ago despite the rapid strengthening in UK growth. Currently subdued retail price pressures are also reflected in UK Harmonised Index of Consumer Prices (HICP) inflation of 1.2 per cent in the fourth quarter, lower than the Eurozone average for only the second time in over five years. Since then UK HICP inflation has come down further, and is now the lowest rate in the EU. This current conjuncture of strong growth combined with low retail price pressures is examined in detail later in this chapter.

The labour market

B9 Labour market performance was strong throughout 1999, with growth in employment remaining relatively firm even during the temporary slowing in GDP growth. The Labour Force Survey (LFS) measure of employment rose by 290,000 over the year to the fourth quarter to new record highs, driven by service sector jobs, and both the claimant count and ILO measures of unemployment now stand at 20-year lows. Sustained employment growth appears to have prompted a modest increase in labour market participation, lowering working age inactivity by around 200,000 over the past 18 months. Higher participation should also partly reflect the effects of Government policies to increase labour supply.

B10 Over the past year there has been a switch towards the creation of full-time rather than part-time jobs as the economy has strengthened. Full-timers have accounted for more than three quarters of the 1 per cent increase in employment; and involuntary temporary employment - those on short-term contracts who would prefer more permanent work - has fallen over the same period.

B11 Approaching three quarters of the working age population are now employed, just below the previous peak in spring 1990. Moreover, a range of indicators, including record numbers of vacancies and positive survey evidence, suggest that labour demand is likely to remain robust. Further sustained advances in the employment rate will increasingly need to be accompanied by rising labour market participation.

Chart B1: LFS employment, unemployment and participation

B12 LFS employment growth towards the end of 1999 continued in line with the ¹/₄ per cent average quarterly rate of expansion seen throughout the year. The strengthening in output growth has therefore led to a marked cyclical improvement in productivity growth back towards its assumed trend rate. Much as anticipated in the Pre-Budget Report, non-oil productivity growth is now estimated to have risen to over 1¹/₂ per cent in the fourth quarter of 1999. The slowing in productivity growth was particularly marked in this cycle, with low levels of unemployment probably encouraging firms to retain labour through a relatively shallow slowing in activity. Stronger pressures in the manufacturing sector have contributed to an increase in productivity growth to more than 5 per cent recently, helping offset sterling's impact on export competitiveness.

B13 Unemployment has continued to decline modestly on both the ILO and claimant measures, though falls in working age inactivity tended to flatten its downward trend during the second half of 1999. The ILO unemployment rate is now 5.9 per cent, 1¹/₂ percentage points below the rate in spring 1997, and numbers unemployed for more than one year have fallen by around two thirds over the same period. As the ILO measure includes only those who are both actively seeking and available to work, it is a better indicator of the downward pressure on wages than wider measures of worklessness. Although the sustainable level of unemployment is impossible to estimate with any precision, it seems likely to have fallen broadly in line with actual unemployment over the two years to summer 1999, judging by the absence of any clear trend in earnings growth over this period. However, the most recent upturn in wage growth, albeit partly influenced by millennium-related bonus payments, is a cautionary signal. Prospects for sustainable growth depend on responsible wage behaviour in both the private and public sectors.

B14 The key to further sustained improvements in labour market performance lies in expanding the effective supply of labour, allowing the economy to grow more rapidly while avoiding skills shortages and inflationary pressures. This will be helped by the improved balance between regional labour markets (see Box B2). However, in addition to the current 1.7 million ILO unemployed there are a further 2.3 million people who want a job but are economically inactive. The Government's policies are designed to help re-attach these individuals to the labour market and make them more effective at competing for jobs. Its comprehensive welfare to work strategy and policies to make work pay are described in Chapter 4 of the EFSR.

Demand and output

B15 Forward-looking indicators have yet to provide clear evidence of the anticipated slowing in domestic demand in early 2000. Although the millennium is a possible complicating factor, it appears to have had fairly limited real economy impacts. The vast majority of business surveys, for example, have signalled only a very partial easing in the pace of activity during the first quarter of 2000.

B16 Household spending in particular continues to be driven by rising real incomes, falling unemployment and continued strong gains in wealth, the latter underpinned by the recent acceleration in house prices. Retail sales volumes grew rapidly in the three months to February, and headline consumer confidence has remained close to record levels early this year, despite higher interest rates. Household consumption is forecast to grow at an annualised rate of 4 per cent during the first half of 2000. For a period, this is likely to be partially offset by more moderate business investment growth, with company spending strengthening only gradually from its temporary dip in autumn 1999. Growth in export volumes during the first half of 2000 is also likely to be much less rapid than in mid-1999, when trade performance rebounded exceptionally from a weak base.

B17 Domestic demand growth is expected to rise to 3³/₄ to 4 per cent during 2000 as a whole, 1 percentage point higher than forecast in the Pre-Budget Report. This largely reflects much stronger than anticipated underlying strength in consumer demand. Household consumption is now forecast to grow by 3¹/₂ to 3³/₄ per cent in 2000, only partly reflecting higher real income growth, and the saving ratio is now projected to fall to 5¹/₂ per cent, ³/₄ percentage point lower than forecast in the Pre-Budget Report. Stronger household spending is accompanied by similar upward revisions to forecast growth in fixed investment and government consumption.

B18 More buoyant domestic demand is offset by a weaker forecast for net trade, partly due to correspondingly faster growth in import volumes. However, the recent unexpected strength in sterling is also likely to impact on underlying trade performance, and net exports are now forecast to reduce growth by 1 percentage point in 2000. Overall, GDP is expected to grow by 2³/₄ to 3¹/₄ per cent in 2000 as a whole, an upward revision of ¹/₄ percentage point from the Pre-Budget Report forecast.

Chart B2: Gross Domestic Product (GDP)

B19 The starting point of RPIX inflation below the Government's target creates headroom for above trend economic growth in 2000. The economy is expected gradually to rise further above trend in the first half of 2000, with a positive non-oil output gap of around ¹/₂ per cent projected at the end of the year. Although downward retail price pressures can be expected to persist for a period, the positive output gap means that the economy cannot afford to out-run its trend growth rate in later years. This underlines the importance of a return to more sustainable rates of expansion in domestic demand, and household consumption in particular.

B20 The Monetary Policy Committee of the Bank of England has again moved pre-emptively, raising base rates by 1 percentage point since September last year. Within a credible policy framework, such moves are likely to have a significant impact, and a marked slowing in household spending growth is expected from the second half of 2000. Household consumption growth is forecast to fall to 2 to 2¹/₂ per cent in 2001. This is expected to drive a deceleration in domestic demand next year, much in line with the latest independent consensus. With the negative net export contribution to activity projected broadly to unwind, this implies a more modest easing in overall GDP growth back to its trend rate of 2¹/₄ to 2³/₄ per cent in 2001, and remaining within this range in 2002.

B21 As always, the economic outlook is subject to considerable uncertainties - average absolute errors in forecasts over the past ten years are reported in Table B6. In particular, there is a strong risk of more rapid growth in domestic demand, at least in the near term. Upside risks to the outlook for consumption and investment spending are discussed in the second half of this chapter. They are balanced, to some extent, by the possibility of a correction in global equity prices and sharper slowing in US and world growth. This would have direct implications for UK stock prices, export demand and sterling. Moreover, it would pose the risk of a sudden deterioration in private sector balance sheets, prompting a much sharper deceleration in domestic spending.

Chart B3: The output gap

Trend output growth

B22 The mid-points of the GDP forecast ranges are anchored on an assumption of 2¹/₂ per cent a year trend output growth in the medium term. This neutral assessment of non-inflationary growth prospects was set out in detail in the Pre-Budget Report. Projections for the public finances (Chapter C) are still based on the low end of the forecast ranges, consistent with a deliberately cautious assumption of 2¹/₄ per cent trend growth.

B23 The neutral 2¹/₂ per cent assumption is broadly in line with most independent analyses, though a wider range of views exists in terms of the prospective contributions from trend productivity growth and changes in the employment rate. Within the neutral assumption, productivity is projected to grow by 2 per cent a year which, in underlying terms, is in line with trend performance during the 1990s. As forecast in November, latest data now signal a cyclical recovery in productivity growth back towards this neutral rate. The neutral view also includes a modest 0.1 percentage points a year contribution to trend growth from an increasing employment rate, comprising small falls in both inactivity and unemployment rate components. The trend decline in inactivity reflects some assumed continuation of longer-term trends, particularly towards higher female labour market activity, outweighing the expected upward shift in the population distribution towards age cohorts with lower activity rates.

B24 In all areas, the Government is aiming for a better outcome. Its comprehensive range of policies to raise productivity growth and get more people into work is described fully in EFSR Chapters 3 and 4. Building upon the platform of economic stability on which sustained increases in output and employment depend, they offer the clear potential for stronger non-inflationary growth in the medium term. This is illustrated by the upper ends of the forecast ranges, based on 2³/₄ per cent a year trend growth in the medium term.

B25 However, there are still further possibilities for upside potential. The share of business investment in real GDP has risen to record levels over recent years and, within that, spending on Information and Communications Technology (ICT) appears to have been particularly strong. It is too early to assume that the rapid adoption of 'new economy' technologies has raised potential output growth, though the highly favourable growth and inflation performance of the US economy in recent years suggests this is possible.

B26 In particular, the growth of e-commerce has the potential to increase competition and efficiency, through a combination of lower market entry costs, enhanced price transparency, rationalisation of supply chains and reduced inventory holdings. However, whereas the overall effect could be higher sustainable growth and lower prices, the process of transition could see greater dispersion in economic performance. Businesses failing to keep up with the pace of diffusion of e-commerce may risk falling casualty to on-going margin squeeze. Significant impacts will probably take time to emerge, even though the current low
weight of e-transactions in overall UK activity probably understates its influence. Behaviour of firms, even in sectors where internet usage is low, is likely to be increasingly affected by the spur of competition associated with e-commerce.

Inflation

B27 RPIX inflation has been just below its target level since April 1999, averaging 2¹/₄ per cent for the year as a whole. This modest undershoot has persisted rather longer than expected a year ago, despite stronger than expected growth in output and unit labour costs, and the oil price more than doubling during 1999. These factors were outweighed
by a sharp squeeze in business margins and continued weakness in non-oil import prices.

B28 The deflationary trend in retail goods prices more than accounts for recent inflation outturns. Retail goods inflation has fallen to around zero, down from well over 1 per cent early last year. However, abstracting from the impact of higher petrol prices, goods prices have fallen quite sharply. Underlying output price inflation (excluding food, beverages, tobacco and petroleum) has also remained subdued. Falling import prices have intensified competitive pressures on both domestic producers and retailers, prompting a very sharp compression in aggregate business margins during 1999. There is much evidence of keener price competition and discounting among retail outlets, with recent inflation rates for both food and clothing and footwear standing at 40-year lows. A similar story is found even in some areas of strongest demand last year, such as household goods.

B29 Such factors have had much less impact in the services sector, which is less directly exposed to the level of sterling. Excluding rent and utilities, services inflation rose from 4¹/₄ per cent to 5¹/₂ per cent during the course of 1999, providing a clear reflection of rapid growth in domestic demand and a tight labour market. While stronger productivity growth led to some moderation in unit wage cost pressures during 1999, nominal earnings have accelerated sharply recently and are now growing in excess of the 4¹/₂ per cent rate that the Bank of England has said is consistent with the inflation target in the medium term. Growth in total costs is also being buoyed by the flatter trend in non-oil import prices.

B30 RPIX inflation is expected to remain below target throughout 2000, gradually returning to 2¹/₂ per cent in early 2001. This partly reflects a moderating contribution to inflation from indirect taxes compared with 1999 and also utility price cuts in water, electricity and gas from April 2000 onwards. Sterling's recent strength is likely to extend the deflationary trend in goods prices in the near term, slightly prolonging RPIX inflation's undershoot of target compared to the Pre-Budget Report forecast. However, even at constant UK interest rates, for example, an uncovered interest parity exchange rate condition would imply a growing contribution from rising import price inflation thereafter. Together with a declining negative contribution from falling business margins during the course of 2000 and into 2001, this is expected to offset some further easing in unit wage cost growth, returning RPIX inflation to its target level early in 2001.

Chart B4: RPIX

B31 On the HICP measure, which was developed to facilitate comparisons between EU countries, the UK now has the lowest inflation rate in the EU. In February UK HICP inflation was just 1 per cent, following a record low of 0.8 per cent in January. This provides a further reflection of weak price pressures in the UK goods sector. In the Eurozone, by contrast, goods inflation has been pushed up by the euro's depreciation and related stronger impact from rising oil prices. As in the Pre-Budget Report forecast, the current 1.2 percentage point divergence between UK HICP and RPIX inflation is expected to narrow over the next few years.

B32 The main upside risk to the inflation outlook is that domestic cost pressures could turn out to be stronger than expected. An examination of previous cycles shows that current inflation outturns are a poor guide to prospects (Box B3). With the economy estimated to be above its trend level and, as yet, few signs that the pace of domestic demand has slowed to more sustainable rates, there is a risk that domestically-generated inflationary pressures could pick up rather than ease. Combined with rising import price inflation, this could lead to stronger than forecast RPIX inflation later this year and into 2001.

B33 The December national accounts release included major upward revisions to GDP deflator inflation over the past two years, with implied inflation rates for both private and government consumption now higher. However, GDP deflator inflation is still forecast to fall from 3.3 per cent in 1998-99 to around 2¹/₂ per cent in 1999-2000 overall. This reflects a smaller contribution from the terms of trade and lower consumers' expenditure deflator (CED) inflation, subsequently pushing GDP deflator inflation down further to 2¹/₄ per cent in 2000-01. GDP deflator inflation is forecast to return to 2¹/₂ per cent in 2001-02.

Independent forecasts

B34 Independent forecasts for the UK economy have strengthened further since the publication of the Pre-Budget Report. The independent consensus for GDP growth is 3.1 per cent for 2000, an increase of ¹/₂ percentage point since the autumn. For 2001, the average independent forecast is for GDP to grow by 2.6 per cent, a modest easing to a more sustainable rate of growth. The Budget 2000 growth forecasts, following the small upward revision in 2000, are almost exactly in line with the independent consensus both this year and next.

Table B2: Budget and independent¹ forecasts

¹ 'Forecasts for the UK Economy: A Comparison of Independent Forecasts', March 2000.

B35 Like the Budget 2000 forecast, independent forecasters expect the current combination of strong growth and subdued retail price pressures to persist for a period. The average independent forecast for RPIX inflation in the fourth quarter of 2000 is now 2.1 per cent, down around ¹/₄ percentage point since November. It is expected to return gradually to the Government's 2¹/₂ per cent target by the end of next year.

B36 Independent forecasts for the balance of payments current account have changed little over recent months, and deficits equivalent to between 1¹/₂ and 1³/₄ per cent of GDP are expected in both 2000 and 2001. However, there exists a considerable range of views around these average forecasts. Larger than expected current account deficits would provide a warning signal of stronger than expected demand, borrowing and inflationary pressures.

FORECAST ISSUES AND RISKS

The household sector

B37 Household consumption rose by 4 per cent in 1999, in line with the Pre-Budget Report forecast, and readily explicable in terms of the fundamental drivers of consumer demand. Growth in real household disposable incomes was somewhat weaker than forecast, despite a sharp rise to 3¹/₄ per cent, which reflected a continued robust expansion in employment incomes and a significant decline in growth in taxes on income as the impact of self-assessment worked through. Stronger underlying growth in spending therefore led to an unexpected fall in the saving ratio, with rapid gains in household wealth perhaps boosting spending by more than 1 percentage point relative to incomes last year. In particular, house prices accelerated unexpectedly sharply from mid-1999. Falling interest rates in the year to June 1999 also supported above trend consumption growth during the first half of the year.

B38 While growth in total spending is reported to have eased during the course of 1999, latest indicators are very strong. Slower recorded growth in vehicles spending is uncertain due to the change in the system of vehicle registrations, and reported easing in purchases of non-durable goods and services contrasts with the sharp acceleration in retail sales volumes and still strong services output growth. Household consumption is now forecast to grow by 3¹/₂ to 3³/₄ per cent in 2000 as a whole, 1 percentage point higher than in the Pre-Budget Report, reflecting both stronger growth in employment incomes and lower than previously expected saving. Precautionary motives for saving have fallen sharply with enhanced macroeconomic and job prospects: the proportion of households expecting higher unemployment has fallen sharply over the past year and consumers' confidence in their future financial situation has stabilised around record levels.

Table B3: Household sector¹ expenditure and income

¹ Including non-profit institutions serving households.

² At constant prices.

B39 Consumption growth is, however, expected to ease later in 2000, subsequently falling just below trend rates during 2001 with the saving ratio rising to 6 per cent. This slowing will partly reflect the direct impact of recent increases in interest rates. Rising mortgage interest payments, together with the abolition of MIRAS and increased stamp duty, are likely to dampen growth in housing demand and prices. This should indirectly restrain growth in consumer spending into 2001 via the effects on household wealth and borrowing. Household consumption growth is forecast to fall to 2 to 2¹/₂ per cent in 2001, broadly in line with independent forecasts, and to ease a little further in 2002.

B40 There are clear upside risks to the outlook. The tight labour market poses a direct upside risk to growth in earnings and hence consumer spending, at least in the short term. Moreover, there remains a strong possibility that households may choose to react more positively to rapid gains in wealth over recent years. As a proportion of household income, total household wealth is estimated to have risen to a record level in the fourth quarter of 1999. One way of releasing such gains to boost spending is through secured borrowing above that needed for house purchase or improvements, known as mortgage equity withdrawal. Although still substantially lower than in the 1980s, the Bank of England estimates that equity withdrawal rose quite sharply in the second half of 1999, bolstering already strong growth in consumer credit. Box B4 discusses the housing market outlook and risks in more detail.

Companies and investment

B41 Business investment growth eased further in the second half of 1999, as slower private service sector spending combined with continuing weakness in manufacturing. A temporary retrenchment was anticipated in the Pre-Budget Report and earlier forecasts, in lagged response to the earlier deterioration in business optimism, profit and output expectations. These factors were subsequently reflected in an estimated ³/₄ percentage point reduction in private non-financial companies (NFCs) profits as a per cent of GDP in 1999. Fears of potential millennium bug related problems may also have contributed to the slowdown, with major ICT projects increasingly held off as the date change drew near.

B42 Most indicators suggest that the climate for investment has improved significantly over the past year. With stronger economic growth, NFC profits have begun to recover, rising an estimated 4 per cent by the fourth quarter of 1999 from their trough in the first quarter, though partly reflecting buoyant North-Sea incomes. Rising capacity utilisation and buoyant output expectations have prompted continued improvements in investment intentions overall. BCC survey evidence shows that plant and machinery investment intentions have risen back to their strong 1995-97 average in the service sector. In manufacturing they are also above the longer-run average, though CBI survey evidence paints a weaker picture. These cyclical improvements have reinforced existing incentives to invest. Company rates of return are high relative to the cost of capital, the buoyant stock market has tended to lower the cost of equity finance, and corporate income gearing (the ratio of debt service costs to corporate income) remains low.

B43 However, NFC's net borrowing is estimated at around 2 per cent of GDP in 1999 and is forecast to rise to around 3 per cent of GDP in 2000. While larger deficits were recorded in the late 1980s, the forecast cautiously assumes that companies will aim to curtail borrowing gradually in the period ahead, implying more modest rates of expansion in capital spending compared to recent years. Overall business investment is forecast to grow by 2¹/₄ to 2³/₄ per cent in 2000, strengthening fairly gradually from its dip last autumn in lagged response to stronger output growth. It is forecast to rise by 2 to 2¹/₂ per cent in 2001, reflecting the general easing in economic growth, remaining within this range in 2002.

Chart B5: Business and non-residential investment ratios

B44 As a per cent of GDP, this would maintain the business investment ratio very close to its recent record level, locking in the strong gains of recent years (see Box B5). However, the forecast is subject to upside risks, and a return to much more rapid rates of investment growth is quite possible. Strong capital spending has partly reflected faster depreciation as a result of the increasing share of ICT and other specialist equipment with shorter asset lives, and such investment might be expected to move progressively into higher gear as new technology opens up ever more opportunities. Moreover, company balance sheets on standard aggregate measures remain strong, suggesting larger financial deficits to support stronger investment spending might be readily financeable. Against that, the comfortable levels of capital gearing and the ratio of company financial assets to loans outstanding are vulnerable to equity valuations; and company liquidity, as measured by the ratio of deposits and currency to loans outstanding, declined through 1999.

B45 Total fixed capital formation is likely to be boosted this year by a stronger expansion in private dwellings investment, as house builders react to strong price gains and enhanced profitability. It is also buoyed by strong growth in general government investment over the forecast period reflecting the Government's commitment to the renewal and modernisation of the public sector capital stock, delivering the desired level of improvement within the fiscal rules (see EFSR Chapters 2 and 5).

Table B4: Gross fixed capital formation

¹ Includes costs associated with the transfer of ownership of land and existing buildings.

² Private sector and public corporations' (except National Health Service Trusts) non-residential investment. Includes investment under the Private Finance Initiative.

³ Excludes purchases less sales of land and existing buildings.

⁴ Includes National Health Service Trusts.

Trade and the balance of payments

B46 The current account has deteriorated in recent years, mainly reflecting the increased deficit in trade in goods and services, which rose to £15.4 billion last year from a position of broad balance in 1997. This was compounded in 1999 by an estimated £7 billion fall in the surplus on investment income, exceptionally buoyed in 1998 by losses made by
UK-based foreign-owned banks and oil companies in the wake of global financial turbulence. The current account deficit is now estimated at around £12 billion in 1999, as forecast in the Pre-Budget Report.

B47 A growing trade in goods deficit with non-EU countries has dominated performance since 1997, largely reflecting weak export growth. Excluding oil, growth in total goods export volumes fell to rates of under 3 per cent in both 1998 and 1999, driven first by sharp falls to non-EU countries as turbulence in Asia and other emerging markets reached its peak, and later compounded by weakening expansion in demand from EU countries. The deterioration partly reflected, though outpaced, the sharp slowdown in UK export markets growth from
10 per cent in 1997 to just 6 per cent last year. Thus UK exporters lost market share, particularly during the course of 1998 as the Asian currency devaluations and earlier appreciation of sterling against European currencies began to bite. Such losses have, however, been partly contained by reductions in export prices, which have fallen 12 per cent since 1996, and efforts to restore cost competitiveness. By late 1999, manufacturing productivity growth was up around 5¹/₂ per cent on a year earlier with unit wage costs falling for the first time since 1994.

B48 The significant turnaround in UK export performance since last spring partly reflects a sharp upturn in UK export markets with growth in Europe and Asia surpassing expectations during the second half of 1999, bolstering a still remarkable expansion in US activity. These developments, together with continued falls in UK export prices, appear to have offset the effects of further sterling appreciation, particularly against the euro. Survey measures of export confidence and demand have risen further, though in the fourth quarter of 1999 export volumes eased from high levels. UK export markets are now expected to grow by 7¹/₂ per cent in 2000 and 6¹/₂ per cent in 2001, upward revisions of ³/₄ percentage points since the Pre-Budget Report forecast. Forecast growth in export volumes of goods and services has, however, been revised down to 5¹/₂ to 6 per cent in 2000 reflecting sterling's recent strengthening. This still implies a sharp improvement on performance in 1998 and 1999, and growth in export volumes is expected to continue at the same rate in later years.

Chart B6: Balance of payments current account

B49 With import volumes boosted by falling prices and strong growth in domestic demand, net trade overall has continued to exert a significant drag on UK activity. Near-term strength in domestic spending will prolong this trend, though stronger export growth is expected to lower the negative contribution to growth from net trade to around 1 percentage point in 2000, unwinding further thereafter as import growth eases to trend rates. This implies some further widening in the trade in goods and services deficit, to around 2¹/₂ per cent of GDP in 2000, which is ³/₄ percentage point more than forecast in November. The current account deficit is also forecast to be larger, stabilising at around 2¹/₄ per cent of GDP in both 2000 and 2001 before starting to narrow.

Table B5: Trade in goods and services

¹ Average value indices.

² Ratio of export to import prices.

B50 There are clear downside risks to the outlook. Despite improvements in Europe and elsewhere, global demand remains heavily reliant on the US economy which would falter if equity values fell sharply. Persistent strength in sterling might also lead to a sharper fall in UK exporters' market share and stronger import penetration. However, attempting to target both the inflation rate and exchange rate in the short term would lead back to the policies that caused economic instability in the past: maintaining low inflation and sound public finances is essential to secure a stable and competitive exchange rate in the medium term.

Table B6: Summary of economic prospects¹

¹ The forecast is consistent with the national accounts and balance of payments statistics to the fourth quarter of 1999, released by the Office for National Statistics on 28 February 2000. See also footnote 1 on the first page of this chapter.

² The size of the growth ranges for GDP components may differ from those for total GDP growth because of rounding and the assumed invariance of the levels of public spending within the forecast ranges.

³ Average absolute errors for current year and year-ahead projections made in spring forecasts over the past ten years. The average errors for the current account are calculated as a percent of GDP, with £ billion figures calculated by scaling the errors by forecast money GDP in 2000 and 2001.

⁴ Further detail on the expenditure components of GDP is given in Table B7.

⁵ Includes households and non-profit institutions serving households.

⁶ Contribution to GDP growth, percentage points.

⁷ Excluding excise duties.

Table B7: Gross domestic product and its components £ billion at 1995 prices, seasonally adjusted

THE WORLD ECONOMY

Overview

B51 The global recovery is gathering momentum with strengthening growth in the Eurozone, Asia surpassing expectations, and a hesitant recovery in Latin America. Continuing US strength has helped compensate for weakness in Japan, and fears of global recession have given way to concerns about inflationary pressures. Investor sentiment towards emerging markets has improved. Divergences in the pattern of global demand and associated exchange rate developments have led to substantial increases in external current account imbalances, particularly in the US.

Table B8: The world economy

1 Estimates, except consumer price inflation.

2 G7: US, Japan, Germany, France, UK, Italy and Canada.

3 Final quarter of each period. For UK, RPIX.

4 Other countries' imports of manufactures weighted according to their importance in UK exports.

G7 activity

B52 In 1999 the US expansion continued to show resilience, with a recent pick up in exports complementing robust consumer and investment spending. Strong productivity gains and moderate wage growth have so far ensured little upward pressure on unit labour costs. However, rapid domestic demand growth and higher oil prices have contributed to a widening current account deficit. Stock market valuations remain high by most traditional measures, increasing the risk of financial market instability if these imbalances were to unwind rapidly. The US economy is likely to slow this year and next, as monetary policy tightening takes effect and domestic demand growth moderates.

B53 The Eurozone recovery continues to strengthen, helped by low interest rates, the depreciation of the euro, and improved external demand. In Japan, the outlook remains uncertain, with limited evidence, as yet, of a sustained private sector recovery. Ongoing fiscal stimulus and higher exports, helped by the sharp recovery in Asia, should stabilise the Japanese economy this year.

B54 GDP growth in 2000 is expected to become more balanced among the three main industrial country blocks, as the European recovery takes hold, Japan's economy stabilises and the US begins to slow. G7 growth is projected to rise to 3 per cent in 2000, before falling back to 2¹/₂ per cent in 2001.

Chart B7: G7 GDP and world trade

G7 inflation

B55 Rising oil prices added to headline consumer price inflation in the major economies in 1999, and there was some upturn in the rate of growth of the prices of intermediate inputs. Nevertheless, core inflation - excluding energy and food prices - remained low. Stronger world growth and higher commodity prices are likely to continue to put pressure on G7 inflation in the short term. But considerable spare capacity in Japan and relatively subdued inflation in Europe should restrain the increase in international prices. Moreover, the overall impact of any given rise in commodity prices on the major industrialised economies has been lessened by the growing importance of services in total output and new energy-saving investments, which have helped to reduce the share of commodities in production and trade. G7 inflation is expected to rise in 2000 to an annual average of 2 per cent. Moderate increases in interest rates in the industrial countries are likely over the next 12 months, reflecting expected developments in activity and inflation.

Developing countries

B56 In developing countries, recoveries in Asian economies will progress and there are early signs of a turnaround in Latin America. The adjustment in some of the countries worst hit by the recent financial crisis, including Russia and Brazil, has been less severe than previously expected. Sharp increases in oil prices have clearly benefited the major oil-exporting developing countries.

B57 An improving external environment, rising commodity prices, ongoing adjustment and structural reform in emerging markets, and increasing confidence among both domestic and foreign investors, should help spur growth in developing countries this year. However, a sharp rise in world interest rates or a correction in global equity markets could trigger new financial disturbances which, together with necessary policy responses, would result in weaker shorter-term growth prospects.

Chart B8: G7 consumer price inflaion

World trade

B58 World trade grew by 5 per cent in 1999, driven by continued strength in US demand and the recovery in much of Asia. By contrast, trade in Europe remained sluggish. In 2000 world trade is expected to grow by 7 per cent, with the expansion in Asia and other emerging markets more than compensating for a modest slowing in US trade growth. World trade growth of 6¹/₂ per cent is forecast in 2001.

B59 UK export market growth slowed to 6 per cent in 1999, but still outstripped world trade growth due to the UK's relatively strong dependence on the US economy. Weaker imports in many of the UK's key export markets contributed to the slower growth. However, with improved prospects in Asia, Europe, Africa and the Middle East, UK export market growth is expected to increase to 7¹/₂ per cent this year, falling back to 6¹/₂ per cent in 2001 as the US economy slows.

¹ The forecast is consistent with output, income and expenditure data to the fourth quarter of 1999 released by the Office for National Statistics (ONS) on 28 February 2000. This release also contained revisions to earlier quarters of 1999 which the Treasury has carried through to other national accounts series that the ONS did not revise, such as household saving and sectoral net borrowing. A fully consistent national accounts dataset for 1999 will not be published by the ONS until 27 March. A detailed set of charts and tables relating to the economic forecast is available on the Treasury's internet
site (http://www.hm-treasury.gov.uk), and copies can be obtained on request from the Treasury's Public Enquiry Unit (020 7270 4558). [back]

² The forecast is based on the assumption that the exchange rate moves in line with an uncovered interest parity condition, consistent with the interest rates underlying the economic forecast.[back]