Annex B to Chapter 3The Panel of Independent Forecasters1Short-term economic outlookMonetary and fiscal projections3B.1 Our forecasts use different projections of economic policy, which do not necessarily coincide with the policy recommendations we make.
The world economy3B.3 We expect G7 GDP growth to be about 2 1/2 - 3 per cent in 1994 and 1995, with inflation remaining close to 2 1/2 per cent. Commodity prices seem to be slowing after the strong growth earlier this year and remain at historically very low levels compared to the prices of manufactured goods. We foresee moderate increases in commodity prices from now on, but note the risk of higher inflation from this source.UK overview3B.4 The economy has continued to evolve favourably since our last meeting in May. GDP grew 3 1/2 per cent in the year to the third quarter, underlying inflation has fallen to 2 per cent, unemployment has continued to fall, and the balance of payments has improved dramatically. Even excluding the buoyant North Sea oil sector, output has risen 3 1/4 per cent over the past year. In general, these developments have been a good deal more favourable than we expected a year ago. Minford considers this to be evidence of supply-side improvement. But the rest of us would caution against drawing this conclusion - the data may simply reflect the benefits of devaluation at an opportune stage of the economic cycle, when a large degree of spare capacity staved off the inflationary effects of a lower pound; we see the experience of Sweden and Italy, which have benefited from devaluation in a similar way to us, as supporting this view.[See printed copy for table] Demand and activity3B.5 With actual data for the first three quarters of the year already available, there is little to play for on GDP in 1994, and we are all forecasting growth of 3 1/2 per cent. We all expect output to continue rising at a healthy rate next year - sufficient, for all but one of us, to result in further falls in unemployment. But we differ on how 1995 will turn out compared to 1994: three of us expect a slowdown in non-oil growth to 2 1/2 per cent growth or less, Godley sees non-oil growth turning out much the same as in 1994, while Davies and Minford foresee an acceleration to around 3 3/4 per cent.3B.6 The pessimists see recent fast growth as temporary, caused by expansionary policy measures - falling interest rates and sterling's devaluation. With the force of these measures now spent, GDP will revert to slower growth, as demand is constrained by the continuing high levels of debt, subdued asset prices, slow credit growth, and the fiscal tightening. To them the very large financial surplus run by the private sector in the first half of 1994 is evidence of retrenchment, as strong profit and income growth is channelled into debt repayment - which they expect to see continuing. But Davies, Godley and Minford think the private sector surplus will be unwound more quickly, giving stronger investment and consumption. Minford also expects continuing strong export growth. 3B.7 So our forecasts of consumption and investment generally divide into two camps in the same way as total GDP. Nevertheless we agree that over the next year the balance of growth will continue to shift away from consumption towards investment, and, for most of us, net trade. Trade3B.8 The balance of payments data released over the summer have been the biggest surprise since we last met. The current account deficit has been reduced to only about 1/2 per cent of GDP in the first half of this year, about 1 percentage point lower than in the pre-devaluation year of 1992. Arithmetically, this improvement has all been due to two factors: trade in oil and net flows on interest, profits and dividends. Although exports have risen sharply, non-oil trade is little changed. But this represents a surprisingly good performance over a period of reviving domestic demand when we would have expected to see some deterioration of the trade balance.[See printed copy for table] 3B.9 Even excluding oil and other "erratics", the latest figures show 10 per cent annual growth of goods exports in volume terms. We see the strength of exports as principally due to two factors encouraging firms to switch production towards foreign markets: the increase in export profitability following the devaluation, and the relative weakness of domestic demand. In addition, the growth of UK export markets, especially in Europe, has been considerably faster than we had anticipated. Taking on board the latest exports data leads, for most of us, to a doubling of our forecasts of export growth in 1994 since May, to around 7 - 8 per cent. We have all also revised up our forecasts of export growth in 1995, which now lie in the range 5 1/4 - 7 per cent. 3B.10 The latest data show a slight fall in import volumes. We interpret this as partly erratic and partly associated with the slower growth of domestic demand, and our forecasts of import growth are generally not greatly changed either this year or next, when they range from 4 to 7 per cent. 3B.11 Putting export and import volumes together, the data suggest that net trade will make a sizeable contribution to GDP growth in 1994, up to 3/4 per cent. We expect net trade to contribute less to growth in 1995; mostly about 0 - 1/4 per cent, though Godley expects this year's improvement to be reversed next year with a negative contribution of 1/2 per cent. [See printed copy for table] 3B.12 The terms of trade (the ratio of export to import prices) fell after sterling's exit from the ERM in September 1992, and past experience led most to expect them to remain lower. But export prices subsequently rose very quickly, bringing the terms of trade back up to pre-exit levels or above by early 1993, since when they have been fairly steady - albeit falling slightly recently. Some of us interpret this experience as evidence that the UK should now be viewed as a small open economy which takes the world price rather than influencing it. In the extreme case, the economy can sell as much of its output abroad as it wants, with the balance of payments deficit simply representing the difference between domestic capacity and domestic demand. While the rest of us mostly accept that the UK is becoming more like this model, we think UK exports are still primarily determined by world demand and relative prices. In this view, the post-devaluation experience shows firms seizing the opportunity to raise profits as quickly as possible by raising prices, rather than trying to expand immediate market share, though higher export profitability may boost supply and market share over time. 3B.13 Whatever our views on the implications of the behaviour of the terms of trade, none of us expect them to change dramatically in the short term - though there is a risk of fast import price growth due to commodity price increases. So our forecasts of the visible trade deficit follow our different views on net trade volumes. Adding on invisibles, which have benefited from a very large improvement to net investment income, leads to sharp revisions to our forecasts of the 1994 current account deficit, which have halved since May to lie in the range £3 1/2 - 6 1/2 billion. Our forecasts for 1995 range widely, from a deficit of £12 billion to a surplus of £2 billion. This not only reflects differences of view on net trade, but also the extent to which we think the improvement to investment income will turn out to be erratic. The labour market3B.14 Interpretation of recent developments in the labour market is confused by the discrepancy between the two principal sources of employment data: the Labour Force Survey (LFS) of households and the employer-based data. The former has shown a rise of 330,000 in the recovery while the latter has yet to show any sustained upturn at all. We are strongly inclined to believe the LFS figures, which are consistent with the unemployment numbers and closer to the usual experience that participation increases during the recovery stage of the cycle. Possible reasons why the employer-based data may be under-recording employment include: - failure to pick up employment in new businesses; - rising employment in the construction industry, which is very cyclical but notoriously difficult to measure; - the general switch to employing workers on short-term fixed contracts, whom firms may not regard as employees.3B.15 The two sources of unemployment data, the LFS and the claimant count, are much more consistent. Both show falls of around 300,000 since the peak, and are evolving much as we expected in May. Our forecasts for the end of this year are therefore little changed since then, at close to 2 1/2 million. Most of us project a fall of around 1/4 million through 1995. However Currie forecasts slower growth to lead to unemployment rising slightly during part of next year before resuming its downward trend, while Minford forecasts a sharp fall, to below 2 million - partly because he expects strong growth and partly because he believes unemployment will revert to a much lower trend rate than experienced during the 1980s. Monetary developments3B.16 The monetary indicators have surprised us again. After showing signs of slowing down earlier in the year, M0 growth has picked up again to around 6 1/2 - 7 per cent since the summer, well above the Government's 0 - 4 per cent monitoring range. Most of us regard M0 as heavily influenced (in a somewhat unpredictable way) by the transition to a low inflation, low interest rate environment. In the light of other indicators, we are inclined to give it relatively little weight in our inflation forecasts. But Davies pays it more attention, noting that whatever its shortcomings, it has proved the best single leading indicator of inflation in the past. We expect narrow money growth to slow over the next year or so, to the region of 4 per cent.3B.17 M4 has followed entirely the opposite course to M0, slowing down recently after picking up earlier in the year. It would have been weaker still without the underfunding the authorities have been engaged in recently. But it is easier to be confident of the reasons for the slow growth of broad money, as it matches the slowdown in growth of consumer credit associated with the weak housing market, and low company sector borrowing. Although surprised by the developments, we are not generally concerned by the broad money figures in themselves. We mostly expect a modest rise in M4 growth in 1995, to around 5 - 6 per cent by the end of the year. Inflation3B.18 There has been little change since May in the averages of our underlying inflation forecasts, at 2 1/4 per cent at the end of 1994 and 3 per cent at the end of 1995. Although there is still a fairly large range to our forecasts for next year, we all expect inflation to remain very subdued by the standards of anything but the most recent past, and within the Government's 1 - 4 per cent target range. Differences between our inflation forecasts do not reflect our views on growth in the way a simple output/inflation trade-off model would suggest: if anything, there is a rough tendency for the growth pessimists also to be inflation pessimists and the growth optimists to be inflation optimists. This reflects, at least in part, the response of policy to keep inflation on target.[See printed copy for table] 3B.19 Congdon and Minford are the optimists on inflation, though for different reasons. Congdon believes that a negative output gap - the degree to which output is below its trend level - will continue to exert strong downward pressure on inflation. Minford believes that supply-side improvement to the UK economy, coupled with strong competition from abroad (principally from the newly developed Asian economies), is leading to a world of permanently lower inflation. 3B.20 The rest of us accept that increased flexibility of the supply-side could have contributed to the low inflation outturns so far, as freer labour and product markets meant prices and wages responded more to slack capacity and weak demand. But in our view this would not necessarily mean that inflation would be lower in the future than previous relationships would imply. Indeed, more flexible markets might mean a greater response of prices and wages to tightening capacity and rising demand - leading to higher inflation as the economy continues to grow. However low inflation now does affect the future path of inflation as it becomes entrenched through lower expectations. 3B.21 Our average earnings forecasts are all close to 4 per cent for 1994 and 4 - 5 per cent in 1995, with Congdon and Minford at the lower end of the range, in line with their inflation forecasts. Public finances3B.22 Our forecasts of the public finances are obviously heavily influenced by the projections we make of fiscal policy. All but Minford, who thinks the response of the public finances to strong growth and low inflation will allow the Government to cut taxes significantly from next year on, project tax rates as set out in last year's Budget. Congdon, Currie, Davies and Minford all assume unchanged real spending in the Budget, implying cash spending in 1994-95 around £5 billion lower than planned in last year's Budget because prices have turned out lower than projected. Britton and Godley make their own forecasts of government expenditure based on Government plans and also attempt to anticipate future changes in them.3B.23 We mostly expect the PSBR to come in reasonably close to the latest Government forecast of £36 billion this financial year. Davies and Minford foresee somewhat lower figures, reflecting their views on public expenditure. Our forecasts for 1995-96 are mostly close to each other, in the range £24 - 27 billion, despite differences on growth and inflation. However Godley has a significantly higher PSBR forecast, and Minford a significantly lower one. [See printed copy for table] Medium-term prospects3B.24 This section presents our views on the medium-term prospect. Our medium-term projections are summarised in Table 3B.6. This does not include input from Congdon, who thinks medium-term projections give a misleading impression of precision. Nevertheless, if appropriate policies are maintained he believes the UK could enjoy many years of stable growth and low inflation.3B.25 We all expect continuing GDP growth over the medium term. However, Britton expects growth to be relatively subdued, partly reflecting the effects of monetary and fiscal tightening. The rest of us expect growth to be somewhat higher over the medium term. Continued growth is sufficient to produce further reductions in unemployment, projected to fall below 2 million by 1997 in Davies's and Minford's forecasts. However, Britton and Godley expect slower growth over the medium term to lead to a levelling off in unemployment. 3B.26 We all expect inflation to remain subdued over the medium term. Minford and Congdon expect inflation to remain in the bottom half of the Government's target range. The rest of us expect inflation to pick up slightly over the next few years, and Britton and Godley project a rise in inflation slightly above the top of the target range. In all but Minford's forecasts, further increases in interest rates are assumed to be needed to keep inflation within the target range. Nevertheless, the margins of error on these projections are quite large and we put more emphasis on the fact that we expect inflation to remain subdued than on the particular part of the target range in which it is likely to lie. 3B.27 Although none of us expects a significant deterioration in the balance of payments over the short term, Davies and Godley continue to see medium-term trends as problematic. They are not convinced that the UK's underlying trade performance has improved much in recent years, viewing the current account improvement as being due mainly to one-off special factors, and to the benefits of a successful devaluation. The rest of us do not expect the current account deficit to change markedly over the medium term. Our views on the balance of payments and its implications for policy were set out in our previous report. 3B.28 We all project a further significant fall in the PSBR over the medium term. All of us, except Godley, would expect the PSBR on unchanged policy to fall sufficiently that the debt to GDP ratio would stabilise by the end of the decade. Although our projections typically do not assume unchanged policies, differences in our growth forecasts account for more of the differences in our PSBR projections than do different policy assumptions. Minford is the most optimistic, expecting a PSBR of 1 per cent of GDP by 1997-98 even allowing for some tax cuts. Godley takes the most pessimistic view of the public finances: he expects large deficits to persist over the medium term, largely because the tax increases already announced are barely sufficient to compensate for the loss of revenue from North Sea oil, and thinks further restriction will eventually be needed to achieve the sustainability of the internal and external position. [See printed copy for table ] 1 This annex reproduces the sections on the short-term and medium-term economic outlook from the report of the Panel of Independent Forecasters submitted to the Chancellor of the Exchequer on 2 November 1994. The full report, which includes members' individual submissions on the economic outlook and policy, is available from HM Treasury.(go back) To continue or to go to contents
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