3 The economy: recent developments and prospectsSummaryWorld economy3.01 Growth in the seven major countries (G7) picked up in the second half of 1993 and has increased further this year. It is forecast to be 2 3/4 per cent both in 1994 and 1995. G7 consumer price inflation is expected to rise to 3 per cent.Output3.02 In the UK, GDP growth has been stronger than forecast in the summer. It is now forecast to be 4 per cent in 1994, slowing to 3 1/4 per cent in 1995 largely as a result of slower growth of North Sea output.Inflation3.03 Underlying RPI inflation has been a little lower than anticipated in the summer and was 2 per cent in October. It is forecast to rise to a temporary plateau of 2 1/2 per cent while prices adjust to higher commodity prices and profit margins increase in the buoyant manufacturing sector.Labour market3.04 Unemployment, as measured by the claimant count, has fallen by 455,000 since December 1992 to 2 1/2 million. The Labour Force Survey shows a similar rate of decline and suggests that rising employment accounts for most of the fall in unemployment.Current account3.05 The current account deficit was much lower in the first half of 1994 than was generally expected. It is forecast to fall from £10 1/2 in 1993 to £4 billion in 1994 as a whole and to £3 1/2 billion in 1995.Financial conditions3.06 The sterling index has been fairly steady this year. The forecast is based on the conventional assumption that sterling remains close to recent levels. Long-term interest rates have risen sharply this year, but have fallen back a little recently. Short-term rates were increased from 5 1/4 per cent to 5 3/4 per cent in September. M0 growth has continued above its monitoring range; M4 growth is in the lower half of its monitoring range.Public finances3.07 The PSBR in 1993-94 was £45 1/2 billion. It is expected to fall to £34 1/2 billion in the current financial year and to £21 1/2 billion in 1995-96; £3 billion and £8 1/2 billion respectively lower than in the last Budget (after allowing for classification changes).Medium-term projections3.08 For the purposes of medium-term fiscal projections, GDP growth from 1996-97 is assumed to average 2 3/4 per cent a year. Inflation as measured by the GDP deflator is assumed to fall from 3 1/4 per cent in 1995-96 to 2 per cent by the end of the decade.The world economyActivity3.09 Output has continued to accelerate in the G7 as a whole. G7 GDP grew by 3 per cent at an annual rate in the first half of 1994, up from 1 3/4 per cent in the second half of 1993. Recovery is at last underway in mainland Europe. In the United States growth has moderated a little from its peak at the end of last year but the economy continues to expand rapidly. In Japan it is still not clear that recovery has taken a firm hold.3.10 G7 growth is forecast to be 2 3/4 per cent in both 1994 and 1995, increasing to 3 per cent in the first half of 1996. After fast growth in the US and slow growth in Europe and Japan over the past year, growth rates within the G7 should converge in 1995. The US is forecast to grow in 1995 by around 3 per cent, down from nearly 4 per cent in 1994. Mainland Europe is expected to accelerate, with growth of 3 per cent in Germany and in Europe as a whole. In Japan sustained growth is expected to resume in the second half of 1994 and to average 2 1/2 per cent in 1995. [See printed copy for table] World trade3.11 World trade has picked up sharply in 1994, particularly in Europe. It is forecast to grow by over 9 per cent in 1994 - more than three times faster than in 1993 - and to continue growing rapidly in 1995 and the first half of 1996. UK export markets will probably grow a little more slowly because trade in Europe - our main export market - is projected to rise more slowly than trade between the Asian economies.[See printed copy for chart] Commodity prices3.12 Non-oil commodity prices have risen by around 40 per cent since their trough in mid-1993. This sharp increase reflects both rising demand and problems of supply for some commodities. But prices have flattened off in recent months and are expected to grow more moderately over the forecast period. The Brent oil price has risen from a low point of $13 1/2 a barrel at the beginning of 1994 and has been trading around $17 a barrel recently. It is assumed to remain around this level in the forecast period. [See printed copy for chart] Interest rates3.13 The US Federal Reserve has increased the Federal Funds rate by 2 1/2 percentage points since it began to tighten policy in February. The German discount rate has remained at 4 1/2 per cent since May. In Japan the Official Discount Rate has been unchanged at 1 3/4 per cent since September 1993. Long-term rates drifted up over the summer in all the major countries following the sharp rise earlier in the year.Inflation3.14 Although consumer price inflation looks to have stopped falling in the G7 as a whole, immediate inflationary pressures appear weak. In Germany inflation - now just below 3 per cent - is expected to fall further. In Japan consumer prices are stable. In the US inflation rose to 3 per cent in the early autumn but has subsequently fallen back. However, with higher commodity prices and higher output, G7 inflation is forecast to increase a little, reaching 2 3/4 per cent by the end of 1995 and 3 per cent in the first half of 1996.[See printed copy for chart] Demand and outputRecent developments3.15 In the UK output has risen more than expected in the summer. Growth in the second and third quarters of 1994 was stronger than forecast and growth in earlier quarters has been revised up. In the year to the third quarter GDP is currently estimated to have increased by 4.2 per cent; for non-North Sea GDP1 the increase was 3.7 per cent.1[See printed copy for chart] 3.16 GDP is now 7 per cent above its trough in the first quarter of 1992 and 3 1/4 per cent above its previous peak in the second quarter of 1990. Excluding oil and gas extraction, which has risen by over 50 per cent since 1990, GDP is 6 1/4 per cent above the trough and 2 1/4 per cent above its previous peak. Output has risen in all the main sectors of the economy: by 6 3/4 per cent in manufacturing and 4 per cent in construction, though output is still below its previous peak in both these sectors. Service sector output, which accounts for 60 per cent of the total and fell less than output in other sectors in the recession, has risen 6 3/4 per cent since its trough and is now well above its previous peak. 3.17 Over the past year the basis of the recovery has shifted away from consumer demand towards exports. In the early stages of recovery most of the growth in GDP came from consumer spending. Stocks and exports also contributed, but the contribution of exports was more than offset by rising imports. Arithmetically, therefore, net trade made a negative contribution. But more recently the growth of consumers' expenditure has slowed, exports have accelerated and imports decelerated. Net trade accounts for about half the growth in 1994 so far. 3.18 Non-North Sea GDP has been growing faster than trend since the middle of 1993. The current size of the output gap - the difference between actual and trend levels of GDP - cannot be estimated with any certainty, but there is almost certainly still a sizeable gap. In other words there is still spare capacity in the economy as a whole. This should allow the economy to continue growing faster than trend without significant upward pressure on prices. Capacity utilisation3.19 The only direct measures of capacity utilisation are based on surveys and relate to particular sectors. The CBI survey, which reflects utilisation of both labour and capital, shows capacity utilisation in manufacturing back to normal levels. Outside manufacturing, the British Chambers of Commerce and Building Employers' Confederation surveys show increases in capacity utilisation in services and construction respectively, but to levels well below those seen in the late 1980s.3.20 However, there are grounds for thinking that currently reported levels of utilisation represent less of a constraint on expansion and hence less of an inflationary threat than in the past. Under pressure to cut costs, companies have probably been exploiting opportunities to use their existing capacity more efficiently. There have been strong incentives to reduce the time plant and machinery spends idle and to remove bottlenecks. On the employment side, labour market reforms have discouraged labour hoarding. In these circumstances the key question is how quickly capacity can be expanded and at what price. For new plant and machinery lead times on installation have probably shortened. Moreover there is a large pool of available labour: unemployment remains high despite its rapid fall since the end of 1992. Nor is there much evidence of shortages of skilled labour. Prospects3.21 The pace of GDP growth is likely to slow a little from now on, while remaining above its trend rate. This largely reflects much slower growth of North Sea output following the very large increases of the past couple of years. But it also reflects a marginal slowing in non-North Sea growth, mainly accounted for by slower growth of public expenditure in volume terms and little further contribution from stockbuilding.[See printed copy for chart] 3.22 GDP is forecast to increase by 4 per cent in 1994, and by 3 1/4 per cent in 1995 - stronger than the Summer Economic Forecast of 2 3/4 per cent in each year. Excluding North Sea output, GDP is projected to rise by 3 1/2 per cent in 1994 and by 3 1/4 per cent in 1995. These growth rates are above estimates of trend growth, implying a further narrowing of the output gap. The personal sectorConsumer spending3.23 The growth of consumers' expenditure has weakened this year, with quarterly growth rates of 1 per cent in the second half of 1993 giving way to increases of around 1/2 per cent in the first three quarters of 1994. In part this reflects greater caution on the part of consumers towards major purchases. Spending on cars has slowed, and weakness in the housing market has held back expenditure on other durable goods. Elsewhere there is much less evidence of any significant weakening since the tax rises in April, and the trend in retail sales remains buoyant. Consumers' expenditure as a whole is expected to rise by 2 1/2 per cent in 1994.[See printed copy for chart] Saving3.24 As expected the saving ratio has fallen. It is estimated to have averaged 10 per cent in the first three quarters of this year, down from 12 1/4 per cent last year. Three related factors probably account for this fall:
Prospects3.25 In 1995 as a whole consumption may increase by 2 1/2 per cent, the same as in 1994. This is faster than the growth of real personal disposable income, which is forecast to rise by 1 1/2 per cent. Thus the saving ratio is expected to fall again, though by less than in 1994 when real personal disposable income seems likely to be unchanged on 1993.The housing market3.26 Housing market turnover increased strongly in 1993 but has fallen back this year. House prices have moved erratically with no pronounced trend up or down. In October they were at much the same level as a year earlier. This lacklustre performance looks surprising in the face of low mortgage rates, low house prices in relation to incomes, and the continued recovery in the financial position of the personal sector. It may be the consequence of persistent negative equity and significant, though diminishing, repossessions - both unknown before the last few years. The two percentage point increase in the cost of fixed rate mortgages, the result of the rise in bond rates, may also have kept some purchasers out of the market. (Fixed rate mortgages have accounted for the greater part of new mortgage lending this year.) Finally the housing market may also still be adjusting to the changes in mortgage interest relief announced in the last two Budgets.[See printed copy for chart] 3.27 On balance the housing market indicators point to renewed recovery. Housing remains very affordable, with house prices and mortgage interest payments both low in relation to incomes. Continued economic growth, which increases the personal sector's resources and reduces uncertainty about the future, should lead to modest increases in both turnover and house prices next year. [See printed copy for chart] 3.28 A prominent feature of the recession was the move by the personal sector from deficit into substantial financial surplus, as saving was increased and investment cut. The surplus fell slightly in 1993, but it remained at a historically high level. It is forecast to fall sharply in 1994 mainly because of lower saving. Further, smaller, declines are forecast for 1995 and 1996, but the personal sector is expected to remain in comfortable surplus. [See printed copy for chart] The corporate sector and investment3.29 Industrial and commercial companies (ICCs) have transformed financial deficits of the order of 4 per cent of GDP in 1989 and 1990 into a record surplus in the first half of 1994. Strong profits growth, sharp reductions in interest and tax payments, and lower capital expenditure have all contributed to this dramatic turnaround. At the same time companies have been restructuring their balance sheets by issuing equity and repaying bank borrowing. The key issue for the forecast is whether balance sheet adjustment has largely been completed. One view is that most companies still have a long way to go in repairing damage to their balance sheets because recent financial surpluses fall well short of making good the large deficits run between 1988 and 1992. On this view companies will remain reluctant to invest and will continue to run relatively large surpluses.3.30 An alternative view, on which the forecast is based, is that companies have largely completed the adjustment. Since early 1991 ICCs have repaid over 19 billion of bank borrowing and the market has absorbed large-scale capital issues. Debt as a proportion of total financial liabilities has fallen sharply, and financial assets, particularly liquid assets, have been built up. Overall the market value of ICCs, as measured by their net financial liabilities (including equity), was almost 50 per cent higher in mid-1994 than at the end of 1990. All this suggests that companies in aggregate are now in reasonable financial shape and have little need to forgo profitable investment opportunities for the sake of sustaining substantial financial surpluses. Profits3.31 ICCs' profits rose by 13 1/2 per cent in 1993, having been virtually static throughout the recession. In the first three quarters of 1994 they showed a further gain of over 16 per cent on a year earlier. This reflects continued tight control over unit costs, rising output and expansion of margins, particularly for exports. Higher profits have fed through to company saving (retained income), which rose by over a third in 1993 and has continued to grow at a similar rate in 1994.3.32 Profitability, as measured by the real rate of return on capital, is likely to show another healthy rise in 1994. Some further increase is forecast for 1995. But with output growth slowing and only modest further rebuilding of margins, profits growth is unlikely to be sustained at recent rates. Moreover dividends and, particularly, tax payments are forecast to rise relatively quickly in response to the earlier strong growth of profits. Company saving could, therefore, be fairly flat in 1995. [See printed copy for chart] Business investment3.33 Business investment in the third quarter of 1994 is estimated to have been 1 1/4 per cent higher than a year earlier. With profitability up, and demand and capacity utilisation continuing to rise, the need to install extra capacity is likely to become an increasingly important motive for investment. Companies should typically be well placed to finance investment internally, having moved into substantial financial surplus and largely restructured their balance sheets. So the climate for investment is much improved. Moreover there is little sign that the rise in long-term interest rates earlier this year will prevent a significant rebound in capital spending. The first indications of a marked step up in investment intentions have recently been emerging from business surveys.[See printed copy for chart] 3.34 In 1994 business investment is expected to increase only modestly, by 2 per cent. However, it is forecast to grow by nearly 11 per cent in 1995. At some point during economic upswings it is usual to see a surge in business investment: in the early 1980s this started in 1984, three years into recovery, about the same stage as 1995 in the present upturn. Government investment3.35 General government investment in fixed assets rose by 5 3/4 per cent in 1993 and is projected to rise by 4 1/2 per cent in 1994, boosted in both years by the temporary relaxation of the rules governing spending out of local authority capital receipts announced in the 1992 Autumn Statement. As this temporary measure unwinds, local authority investment will return to more normal levels. Central government investment is also forecast to level off in 1995, following strong growth in recent years. Consequently general government investment is expected to fall back in 1995 and the first half of 1996, while remaining well above the levels seen in the 1980s.[See printed copy for chart] Whole economy investment3.36 Fixed investment in the economy as a whole is forecast to grow by 3 3/4 per cent in 1994 and by 5 3/4 per cent in 1995. Stronger business investment is partly offset by weaker growth in housing investment and the fall in general government investment.[See printed copy for table] Stockbuilding3.37 In 1993 the level of stocks in total was virtually unchanged, though manufacturers destocked for most of the year. So far in 1994 companies have been rebuilding stocks, and stockbuilding is forecast to contribute 1/2 percentage point to GDP growth in the year as a whole. Stockbuilding is forecast to continue at around recent rates, making virtually no contribution to GDP growth in 1995.[See printed copy for chart] Companies' financial balance3.38 Rising capital spending against a background of slower profits growth and higher tax payments implies a declining financial balance. ICCs' financial surplus is forecast to fall from 2 1/4 per cent of GDP in 1994 to 1 per cent in 1995.[See printed copy for chart] The labour marketEmployment3.39 Interpreting developments in the labour market is made difficult by discrepancies in estimates of employment2 between the Labour Force Survey (LFS) and the employer-based survey, especially for men. According to the LFS, which is a survey of households, the trough in employment occurred in winter 1992-93, and by summer 1994 employment had risen by 334,000, with the increase split fairly evenly between men and women. But according to the employer-based survey employment has increased by only 44,000 since its trough in March 1993, with male employment having fallen.[See printed copy for chart] 3.40 Some discrepancy is not surprising as the two series are not attempting to measure exactly the same thing. For example, the LFS counts people in employment while the employer-based survey counts jobs. Nevertheless over the past year they cannot be readily reconciled by adjusting for known coverage differences. Of the two measures, the LFS seems more consistent with what has been happening to unemployment and output. If employment had not been increasing, the fall in unemployment would imply a large decline in labour market participation, which would not be easy to explain. At the present stage of the cycle participation normally increases. Productivity3.41 Uncertainty about what has been happening recently to employment carries over to the published data for productivity, and hence unit wage costs. These are currently calculated using the employer-based, not LFS, estimates of employment. Recorded non-North Sea productivity growth has yet to show any sustained slowdown, contrary to what might have been expected two and a half years into recovery. Indeed it rose by 3 1/2 per cent in the year to the second quarter of 1994, somewhat faster than the 3 per cent recorded in 1993. This could reflect the acceleration of output in the first half of 1994, though if employment is under-recorded recent productivity growth is overstated by the published figures. But the 6 per cent rise in manufacturing productivity in the year to the third quarter is probably reasonably accurate, because the data problems lie largely outside the manufacturing sector.[See printed copy for chart] 3.42 Productivity growth in both the manufacturing sector and the non-North Sea economy as a whole is forecast to revert towards trend rates in 1995. This is usual once recoveries become more mature, and consistent with companies operating at a satisfactorily high level of labour utilisation. Unemployment3.43 Unemployment has continued to fall at a fairly rapid rate. Again there are two alternative measures, but they both tell much the same story. The LFS measure (on the internationally agreed definition) shows a fall of 273,000 in unemployment in Great Britain from its peak in winter 1992-93 to summer 1994. Over the same period the GB claimant count fell 334,000. The main differences in coverage between these measures are that LFS unemployment includes non-claimants who are looking for work, and the claimant count includes a similar number of people who are not classified as unemployed in the LFS. The latest LFS figures show a slower rate of decline since the spring than the claimant count, which is consistent with rising participation. This is the normal pattern as economies continue to expand, with more people being encouraged to seek work.[See printed copy for chart] 3.44 Total claimant unemployment in the UK was 2.52 million in October 1994, 455,000 down on its peak at the end of 1992. Over the past six months it has fallen by 27,000 a month on average, rather faster than the average monthly decline of 21,000 a month since the peak. Looking ahead, improving job prospects, demographic factors and the new Incapacity Benefit medical test are likely to increase the number of people participating in the labour market. This means that unemployment is likely to fall less than employment rises. Trade and the balance of payments3.45 The current account deficit has declined sharply this year. In the second quarter it was £0.7 billion, the lowest figure since 1987. Much of this improvement arose from a stronger invisible surplus, with net investment income at its highest ever level. The visible deficit also fell, largely the consequence of higher oil output. But more recently the non-oil balance has shown a noticeable improvement too. In the three months to August the non-oil deficit was £3.1 billion compared with £3.6 billion a year earlier.[See printed copy for chart] Competitiveness3.46 The recent improvement in the performance of non-oil visible trade is in part the result of better competitiveness:
[See printed copy for chart] 3.47 The differences between cost and price competitiveness result mainly from the rebuilding of profit margins by UK exporters. These were squeezed sharply during sterling's membership of the ERM, when firms held export prices down in the face of rising costs. Margins regained their pre-ERM levels by the third quarter of this year, although the discontinuity in export prices means that published figures probably exaggerate the increase. Higher margins encourage firms to supply the export market, and this appears to be more than offsetting any reduction in demand for UK exports because of higher prices. Recent figures for manufacturing export volumes and survey indicators of the state of firms' order books do not suggest any fall off in overseas demand for UK goods - quite the reverse. The export orders balance in the November CBI Survey was at its highest level since March 1988. While margins are not expected to grow any further, the favourable prospects for unit labour cost growth in the UK mean that the incentive to export should remain strong, notwithstanding increases in other costs. [See printed copy for chart] Exports3.48 Exports of non-oil goods increased by 10 1/2 per cent in volume terms in the three months to August compared with a year earlier. This strong growth was well spread across categories. Non-oil exports to other European Union countries rose by 14 per cent, comfortably in excess of market growth. UK exports to other countries rose by 5 1/2 per cent in the three months to October compared with a year earlier. Exports overall appear to have increased faster than UK export markets. This gain in share is consistent with a positive effect from improved cost competitiveness and higher margins.3.49 The prospects remain good. UK export market growth, forecast to be 8 per cent in 1994, is expected to be around 7 1/2 per cent in 1995, as stronger growth in Europe largely replaces weaker demand growth from North America. Exports of manufactures are expected to rise by 9 1/2 per cent in 1994, and they more than maintain their improved market share in 1995, increasing by 8 per cent. Non-oil exports in total are expected to grow at a similar rate. [See printed copy for chart] Imports3.50 Non-oil import volumes have been subdued this year. They were lower in the three months to August than in the first quarter, even though demand increased. Compared with a year earlier they have risen by 5 1/2 per cent. Non-oil imports are expected to be 5 1/4 per cent higher in 1994 than in 1993. This is a modest increase in relation to the anticipated demand growth of 4 per cent - normally imports have grown 3 to 4 per cent faster than demand, the consequence of continuing specialisation of world production. This improved import performance is probably the result of better competitiveness in the UK. It is expected to continue, with import growth of 6 per cent in 1995, around 2 1/2 percentage points faster than demand.[See printed copy for chart] Trade prices3.51 Export prices have risen sharply since sterling left the ERM as margins have been rebuilt, although as already noted the published figures may overstate the increase (see paragraphs 3.46 and 3.47). Even so, recorded export prices have not increased as much as import prices. Thus the non-oil terms of trade are 2 per cent below pre-ERM exit levels, with import prices up 15 1/4 per cent and export prices up 13 per cent. While the rise in export prices is largely accounted for by higher margins, the rise in import prices is more than accounted for by the impact of the lower exchange rate and the growth of world prices. Non-oil import prices are expected to rise by around 2 1/4 per cent in 1995, a little less than in 1994 partly because of slower growth in commodity prices. Export prices are forecast to rise by around 3 per cent in 1995, much the same as domestic producer output prices but a little faster than competing world prices.[See printed copy for table] The North Sea3.52 North Sea output in the third quarter of 1994 was nearly half as high again as at the start of 1993. In 1994 as a whole it is expected to be 27 per cent higher than in 1993. But growth of less than 2 per cent is forecast for 1995 because most of the major new developments are now on stream. The increase in output has benefited the current account. Despite a fall of about 9 per cent in the sterling oil price, the oil balance is expected almost to double between 1993 and 1994, rising from £2 1/2 billion to £4 1/2 billion. A small further increase is expected in 1995.Invisibles3.53 The surplus on invisibles increased sharply in the first half of 1994 to £3 1/2 billion, £1 billion more than in the second half of 1993. This was more than accounted for by higher investment income (the earnings on the UK's net holdings of overseas assets) which rose to over 4 billion, the highest figure ever recorded. Although figures for investment income are notoriously erratic and prone to revision, outturns over the past couple of years suggest it should continue to make a significant contribution to the surplus on invisibles.3.54 Despite a weak outturn in the second quarter of 1994, the prospects for the balance of services are also favourable. It should benefit from improved competitiveness and the recovery in world activity. The overall surplus on invisibles is expected to fall back to around £3 1/2 billion in 1995 from £5 billion in 1994, with the turnaround more than accounted for by erratic movements of investment income. [See printed copy for table] Current account3.55 The current account deficit is expected to more than halve from £10 1/2 billion in 1993 to £4 billion in 1994. It is forecast to fall a little further in 1995 to £3 1/2 billion. The improvement in 1994 is largely the result of a fall in the visible deficit. A further fall in the visible deficit more than accounts for the projected fall in the current account deficit in 1995.[See printed copy for chart] Pattern of financial balances3.56 With the financial surpluses of both the personal and ICC sectors projected to decline, the financial surplus of the private sector as a whole is forecast to fall to 3 3/4 per cent of GDP in 1995 and 2 per cent of GDP in the first half of 1996. This compares with surpluses of around 6 per cent in both 1993 and 1994. The main counterpart is a lower public sector deficit, consistent with the substantial fall in the PSBR. The current account deficit is expected to fall from around 1 3/4 per cent of GDP in 1993 to about 1/2 per cent in 1994 and to remain at that level in 1995 and the first half of 1996.[See printed copy for chart] Financial developmentsExchange rates3.57 Sterling has remained stable against a basket of currencies this year, although it has appreciated against the dollar and depreciated against the main European currencies and the Yen. For the most part the sterling index has been in the range of 79 to 81, averaging a little over 80 in recent weeks.[See printed copy for chart] Interest rates3.58 Base rates were reduced by 1/4 percentage point to 5 1/4 per cent in February. In September, as the strength of the recovery became evident, and to ensure that no risks were taken with inflation, base rates were raised by 1/2 percentage point to 5 3/4 per cent. Other short-term rates have followed a similar pattern: variable mortgage rates are back at the same level as a year ago, having been 1/4 percentage point or so lower in the first half of 1994; deposit rates have moved similarly.3.59 Long rates rose steadily in the first half of the year. This was to a large extent prompted by developments abroad, especially in the US, which led to a rise in bond rates world wide. UK rates initially rose by more than other G7 countries' rates, but they have been declining recently and the differential with other G7 rates has narrowed. Yields on ten-year gilts, which peaked at 9 1/4 per cent in mid-September, are now 8 3/4 per cent. The future rates of inflation implicit in gilt yields remain well above most forecasts of inflation. Although the rise in long rates may have contributed to the renewed weakness in the housing market (see paragraph 3.26), there is no evidence that it has been a significant drag on recovery in other sectors. [See printed copy for chart] Asset prices3.60 House prices have moved erratically over the past couple of years. They are currently around the same level as a year ago. The commercial property market is in the early stages of recovery, though rents and capital values remain very depressed. Equity prices rose sharply in 1993 and in early 1994 before falling back with the decline in world bond markets. Since the spring they have fluctuated with no apparent trend. In late November they were about 15 per cent below their peak in February and little changed from a year ago. The dividend yield is about 4 per cent.Monetary aggregates3.61 The 12-month growth rate of M0 was 7.3 per cent in October. It has been above its 0 to 4 per cent medium-term monitoring range since the start of 1993. A period of rapid M0 growth is normal when interest rates are reduced as the public adjusts its cash holdings to reflect their lower cost in terms of interest forgone. M4's 12-month growth rate was 3.8 per cent in October. So far this year it has remained in the range 3 3/4 to 5 1/2 per cent, below the middle of its medium-term monitoring range of 3 to 9 per cent.[See printed copy for chart] Credit3.62 The growth of M4 lending - bank and building society lending to the UK private sector - has continued to be weak. In October its 12-month growth rate was 3.8 per cent - the highest figure for the year to date. Lending secured on residential property has been growing more rapidly - its 12-month rate has been over 6 per cent. But industrial and commercial companies, as they have moved from financial deficit to surplus and taken opportunities to exploit cheaper forms of finance, have continued to repay bank debt.Inflation3.63 The economy now appears to be running with less spare capacity than previously expected, particularly in the manufacturing sector, implying less disinflationary pressure. Yet underlying inflation, as measured by the RPI excluding mortgage interest payments (MIPs), has continued to fall by more than forecast, recently reaching a 27-year low of 2 per cent.3.64 Taken together, these factors suggest little overall change in the balance of inflationary pressures, compared to the assessment made in the Summer Economic Forecast. While there may be a small pick-up next year, inflation is expected to remain low by historical standards. Despite increasing capacity utilisation, there is still scope for output to expand without posing a serious inflationary threat (see paragraphs 3.19 and 3.20). [See printed copy for chart] 3.65 However, in the shorter term the buoyancy of the manufacturing sector is likely to afford opportunities for manufacturers to rebuild margins further. In addition, there is upward pressure on costs from higher commodity prices. Producer output price3 inflation has already started to show signs of picking up. As these effects feed through, underlying RPI inflation is expected to rise temporarily from its current very low level. But the rise is expected to be limited by the intensity of competition in the retail sector. Earnings3.66 Underlying average earnings growth picked up from its low of 3 per cent in autumn 1993 to 3 3/4 per cent in January this year. Since then it has remained remarkably flat, only occasionally rising to 4 per cent in months when earnings were temporarily boosted by high bonus and overtime payments. Moreover settlements generally are still very low, although they have been edging up over the past year. Latest data from the CBI show settlements in the third quarter of 2.9 per cent in manufacturing and 3.4 per cent in services, both about 3/4 percentage points up on the fourth quarter of 1993. No doubt rising demand, good productivity performance and increased profits have relieved some of the pressure on companies to contain earnings, while allowing them to keep unit labour costs under tight control.Costs and producer prices3.67 Unit wage costs in the non-North Sea economy are estimated to have risen by only 3/4 per cent in 1993, and to have barely changed at all in the year to the second quarter of 1994. These figures may be somewhat flattering if the employer-based estimates of employment (to which they are linked) have been under-recording job creation over the past year to the extent suggested by the LFS (see paragraph 3.41). Nevertheless, unit wage cost performance has undoubtedly been impressive.3.68 This is particularly true in the manufacturing sector, where the data are more reliable. Manufacturing unit wage costs have been falling: in the third quarter of 1994 they were 1.4 per cent lower than a year earlier. They also seem likely to be lower in 1994 as a whole, following a small rise in 1993. This probably explains why producer output price inflation continued to fall through to the summer, when it reached 2 per cent. But with a sharp increase in input prices, up 7.1 per cent in the year to October, and with manufacturers seeking to increase domestic margins, output prices have already picked up in recent months. The annualised three-month rate of producer output price inflation in October was 3 1/2 per cent, up sharply from its low point of 1 per cent in April. 3.69 Looking ahead, unit labour cost growth is likely to pick up a little as productivity growth slows down and earnings growth increases. Moreover manufacturers are expected to take advantage of buoyant markets to push through further increases in domestic margins. Some may also be looking to pass on higher imported input and other raw material costs, despite offsetting effects from unit labour costs. Price expectations as measured by the CBI survey certainly point to further upward movement in output prices in the months ahead. As a result, producer output price inflation is forecast to rise temporarily to 3 1/4 per cent by mid-1995. It is expected to fall back to 2 1/4 per cent by mid-1996, as upward pressure on margins eases and import cost inflation recedes. [See printed copy for table] Retail prices3.70 Underlying RPI inflation was 2 per cent in October, and is now expected to average 2 per cent in the fourth quarter of 1994. This is 1/2 percentage point below the Summer Economic Forecast, and 1 1/4 points below last November's Budget forecast. It is forecast to rise to 2 1/2 per cent by the end of 1995, mainly as a result of higher producer output price inflation. The forecast rise in underlying RPI inflation is, however, much less pronounced than for producer output price inflation, because competition in retailing is expected to remain tougher than in the more buoyant manufacturing sector.[See printed copy for chart] 3.71 The recent increase in interest rates and the further reduction in mortgage interest relief in April 1995 will tend to keep all-items RPI inflation above the underlying rate. But the outlook for the all-items rate will also depend on what happens to interest rates from now on. Other things being equal, each 1 percentage point change in mortgage rates changes the level of the all-items RPI by just over 1/2 per cent. GDP deflator3.72 Prospects for the GDP deflator differ from those for retail prices primarily because of its wider coverage. It is forecast to rise by 2 per cent in 1994-95, 2 percentage points less than in the last Budget forecast. Most of this downward revision reflects the outturns for the first two quarters of the financial year which show domestic prices, particularly for investment, growing more slowly and the terms of trade slightly less favourable than previously forecast. In 1995-96 the GDP deflator is forecast to increase by 3 1/4 per cent. This acceleration is expected to be temporary and mainly reflects a rebound in investment prices from extremely low levels and the projected rise in the terms of trade.Risks and uncertainties3.73 All forecasts are subject to risks and uncertainties. Average errors from past forecasts, shown in Table 3.8, are one illustration of their possible extent. The errors increase the further ahead the forecast looks. Obviously errors on any individual forecast may be larger than the average.3.74 The forecast of GDP growth in 1994 has been revised up by 1 1/4 per cent since the Summer Economic Forecast and by 1 1/2 per cent since the last Budget. The inflation forecast has been revised down, by 1/2 per cent since the Summer Economic Forecast, and by 1 1/4 per cent since the last Budget. The forecast of the current account deficit in 1994 was the same in the Summer Economic Forecast as in last November's Budget, but has now been revised down significantly. The forecast of the PSBR in 1994-95 has been progressively revised down but only by £3 1/2 billion in total since the last Budget. [See printed copy for table] The Panel of Independent Forecasters3.75 A further indication of the forecast uncertainties can be obtained from the range of views of members of the Panel of Independent Forecasters. For example, the Panel's forecasts of growth in 1995 range from 2 1/2 per cent to 3 3/4 per cent and its forecasts of inflation at the end of 1995 range from 2 per cent to 4 per cent. The Treasury forecast of growth in 1995 is a little above the Panel average, though the Panel's forecasts were completed before the latest upward revisions to GDP data. The Treasury forecasts of inflation and the current account deficit are slightly lower than the average of the Panel's forecasts. The Panel's views are set out in more detail in Annex B.[See printed copy for table] [See printed copy for table]
1 GDP excluding oil and gas extraction.(go back) 2 Employees plus self-employed (GB).(go back) 3 All references to producer prices exclude the food, beverages, tobacco and petroleum industries.(go back)
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