3.54 Long rates rose during the first half of the year, largely reflecting a rise in world bond yields, particularly in the US. UK yields initially rose by more than those of other G7 countries, but they have been falling back recently, and the differential, particularly with US yields, has narrowed. Yields on ten-year gilts, which peaked at around 8 1/4 per cent at the end of May, are now around 7 1/2 per cent. The inflation expectations implicit in gilt yields increased in the first few months of the year, but have been declining recently.
3.57 The 12-month growth rate of M4 has risen from around 4 per cent in late 1994 to 10.3 per cent in October this year, above the top of its medium-term monitoring range. Both corporate and personal liquidity have increased sharply. The underlying strength of corporate sector M4 partly reflects takeover and merger activity, but may also foreshadow higher investment spending. Strengthening personal sector liquidity is consistent with the forecast increase in consumption.
3.59 Retail goods price inflation fell from 3 1/2 per cent at the end of last year to 2 3/4 per cent in September. It rose to 3 per cent in October because of higher petrol prices and the drought-related sharp fall in seasonal food prices last October dropping out of the 12-month calculation. Excluding petrol and food, the 12-month rate ofgoods price inflation was unchanged from September. The increase in petrol prices, reflecting the sharp rise in oil prices in recent months, added 0.3percentage points to the 12-month RPI inflation rate in September and October.
3.60 Retail services price inflation increased from around 2 per cent at the turn of the year to 2 1/2 per cent in September. The rise to 3 per cent in October largely reflected insurance prices levelling out after the large falls over the past two years, particularly last October.
3.62 Weak import prices have fed through to producer input prices[1], which have fallen sharply since the end of last year. Although the latest monthly data suggest that producer input prices may now have stopped falling, in October they were still 5 1/2 per cent lower than a year earlier. This has, in turn, fed through to the 12-month rate of producer output price inflation, which has fallen from a peak of 5 per cent last summer to just 0.9 per cent in October, the lowest rate for nearly thirty years.
Labour market
Unemployment
3.49 Unemployment has continued to fall. The Labour Force Survey (LFS) measure fell by more than 150,000 over the year to the summer quarter (June to August). Claimant unemployment fell by almost 180,000 over the same period, and by a further 80,000 between August and October, suggesting that the rate of decline has gathered pace recently. In October, the claimant count was over 950,000 below its peak in December 1992.Employment
3.50 According to the LFS, employment rose by 210,000 over the year to the summer quarter, which is greater than the fall in unemployment. The employer-based survey shows a smaller rise, but the LFS data seem more consistent with other labour market indicators.Productivity
3.51 Growth in productivity (output per head) appears to have been comparatively slow over the past two years, particularly in manufacturing. This partly reflects the fact that a high proportion of the growth in employment last year was in part-time jobs - measured in terms of `hours worked' rather than `heads', productivity growth would be stronger. Firms are also likely to have hoarded labour to some extent in anticipation that demand would strengthen, and productivity is likely to accelerate as output growth picks up.Financial developments
Sterling
3.52 The sterling exchange rate index, which measures the sterling exchange rate against a basket of currencies, has risen by almost 10 per cent since the summer, taking it above its end-1994 level. It has appreciated against the Deutschmark and the Yen and, to a lesser extent, against the US dollar. The forecast is based on the conventional assumption that sterling remains close to recent levels.Interest rates
3.53 Against a background of moderate growth and little sign of inflationary pressures, base rates were reduced in four 1/4 percentage point steps - from 6 3/4 per cent at the time of last year's Budget to 5 3/4 per cent in June. Mortgage rates fell by a similar amount over the same period. Although inflationary pressures remain weak, base rates were increased by 1/4 percentage point at the end of October in response to mounting evidence of strengthening activity.Asset prices
3.55 Developments in asset prices are consistent with rising confidence and profit expectations. Equity prices rose by almost 20 per cent during 1995, and they have risen by a further 7 per cent since the beginning of this year. House prices have been rising since the middle of last year. Capital and rental values in the commercial property market, which fell back in 1995, are now rising again.Monetary aggregates
3.56 Despite the strengthening of retail sales this year, there appears to have been little underlying increase in M0 growth. It picked up during the summer months, but this was due partly to spending associated with the European football championships. Shorter-run measures have now fallen back: the three-month annualised growth rate of notes and coin in October was 6 1/4 per cent, in line with its average rise since 1993.Inflation
3.58 The 12-month rate of increase in the RPI excluding mortgage interest payments (MIPs) remained around 3 per cent for most of this year. Although retail prices were unchanged between September and October, the 12-month rate of inflation rose from 2.9 to 3.3 per cent, as the exceptional price falls in October 1995 were not repeated.Import costs
3.61 The weakening in non-oil commodity prices and the appreciation of sterling are feeding through to import prices, which levelled out in mid-1995 and have fallen in recent months. Despite the recent increase in oil prices, import prices are likely to remain weak as further effects of the recent sterling appreciation come through.Earnings
3.63 Despite continuing falls in unemployment, wage pressures have remained subdued. Manufacturing earnings growth has risen only a little over the past year. Earnings growth in the service sector has picked up from a low level, but whole economy underlying average earnings growth has now remained at or below 4 per cent for over three years. Settlements have been fairly flat, suggesting that the difference between earnings growth and settlements (reflecting payments such as overtime and bonuses) has widened a little, after being squeezed last year.
| Percentage changes on a year earlier | |||||
| Forecast | |||||
| 1995 Q4 | 1996 Q4 | 1997 Q2 | 1997 Q4 | 1998 Q2 | |
| RPI excluding MIPs | 3 | 3 | 2 1/2 | 2 1/2 | 2 1/2 |
| Producer output prices(1) | 4 1/2 | 3/4 | 1/2 | 1 | 1 1/4 |
| Percentage changes on a year earlier unless otherwise stated | ||||
| 1995 Budget | 1996 Summer Economic Forecast | 1996 Budget | ||
| Gross domestic product | 1996 | 3 | 2 1/2 | 2 1/2 |
| 1997 | - | 3 1/4 | 3 1/2 | |
| RPI excluding mortgage | 1996 Q4 | 2 1/2 | 2 1/2 | 3 |
| interest payments | 1997 Q4 | - | 2 1/4 | 2 1/2 |
| Current account (£ billion) | 1996 | -5 | -3 1/2 | -2 1/4 |
| 1997 | - | -1 1/2 | -4 1/4 | |
| PSBR (£ billion) | 1996-97 | 22 1/2 | 27 | 26 1/2 |
| 1997-98 | 15 | 23 | 19 | |
| Percentage changes on a year earlier unless otherwise stated | ||||||
| 1996 | 1997 | |||||
| Budget | Independent Panel | Budget | Independent Panel | |||
| Average | Range | Average | Range | |||
| Gross domestic product | 2 1/2 | 2 1/4 | 2 1/4 to 2 1/2 | 3 1/2 | 3 1/2 | 3 to 4 1/4 |
| RPI excluding mortgage interest payments (Q4) | 3 | 3 | 2 1/2 to 3 1/4 | 2 1/2 | 2 1/2 | 2 1/4 to 3 1/4 |
| Current account (£billion) | -2 1/4 | -2 | -5 1/2 to 1 3/4 | -4 1/4 | -5 1/2 | -10 1/4 to 0 |
| PSBR (financial year, £ billion) | 26 1/2 | 26 | 24 to 27 3/4 | 19 | 21 1/2 | 18 to 25 1/2 |
| Percentage changes on a year earlier unless otherwise stated | ||||
| Forecast | Average errors from past forecasts(3) | |||
| 1995 | 1996 | 1997 | ||
| Output at constant prices(2) | ||||
| Gross domestic product (GDP) | 2 1/2 | 2 1/2 | 3 1/2 | 1 1/2 |
| Non-North Sea GDP | 2 1/2 | 2 1/2 | 3 1/2 | 1 1/2 |
| Manufacturing output | 2 1/4 | 1/4 | 3 | 2 |
| Expenditure components of GDP atconstant prices(2) | ||||
| Domestic demand | 1 1/2 | 2 1/4 | 3 3/4 | 1 3/4 |
| Consumers' expenditure | 2 | 3 | 4 1/4 | 1 3/4 |
| General government consumption | 1 1/2 | 1 | 3/4 | 1 1/4 |
| Fixed investment | - 1/4 | 3 | 6 1/4 | 4 |
| Change in stockbuilding(4) | 0 | - 1/2 | 0 | 1/4 |
| Exports of goods and services | 7 3/4 | 6 1/4 | 5 3/4 | 2 |
| Imports of goods and services | 4 | 7 | 6 3/4 | 3 |
| Balance of payments current account | ||||
| £ billion | -4 | -2 1/4 | -4 1/4 | 8 |
| per cent of GDP | - 1/2 | - 1/4 | - 1/2 | 1 |
| Inflation | ||||
| RPI excluding mortgage interest payments (fourth quarter) | 3 | 3 | 2 1/2 | 1 |
| Producer output prices (fourth quarter)(5) | 4 1/2 | 3/4 | 1 | 1 |
| GDP deflator at market prices (financialyear) | 2 1/2 | 2 1/2 | 2 | 1 1/4 |
| Money GDP at market prices (financial year) | ||||
| £ billion | 708 | 746 | 787 | 15 3/4 |
| percentage change | 4 3/4 | 5 1/4 | 5 1/2 | 2 |
| PSBR (financial year) | ||||
| £ billion | 31 1/2 | 26 1/2 | 19 | 11 |
| per cent of GDP | 4 1/2 | 3 1/2 | 2 1/2 | 1 1/2 |
| £ billion at 1990 prices, seasonally adjusted | ||||||||||||
| Consumers' expenditure | General govern- ment consump- tion | Total fixed invest- ment | Stock- building | Domestic demand | Exports of goods and services | Total final expendi- ture | Less imports of goods and services | Less adjust- ment to factor cost | Plus statistical discre- pancy(1) | GDP at factor cost | ||
| 1995 | 363.7 | 119.2 | 99.2 | 3.3 | 585.4 | 167.4 | 752.8 | 169.2 | 75.5 | 0.3 | 508.4 | |
| 1996 | 374.8 | 120.3 | 102.1 | 1.1 | 598.3 | 177.7 | 776.0 | 181.1 | 76.8 | 2.6 | 520.7 | |
| 1997 | 390.7 | 121.1 | 108.4 | 1.0 | 621.2 | 188.0 | 809.2 | 193.4 | 80.0 | 2.8 | 538.7 | |
| 1995 1st half | 181.2 | 59.5 | 50.0 | 0.8 | 291.4 | 82.5 | 373.9 | 83.2 | 37.8 | 0.0 | 252.9 | |
| 2nd half | 182.5 | 59.8 | 49.2 | 2.5 | 293.9 | 84.9 | 378.9 | 86.0 | 37.7 | 0.3 | 255.5 | |
| 1996 1st half | 185.6 | 59.8 | 50.9 | 0.9 | 297.1 | 87.8 | 384.9 | 89.7 | 38.1 | 1.1 | 258.2 | |
| 2nd half | 189.2 | 60.6 | 51.2 | 0.2 | 301.2 | 89.9 | 391.0 | 91.3 | 38.7 | 1.4 | 262.5 | |
| 1997 1st half | 193.4 | 60.6 | 53.4 | 0.4 | 307.8 | 92.5 | 400.3 | 94.9 | 39.6 | 1.4 | 267.2 | |
| 2nd half | 197.3 | 60.5 | 55.0 | 0.6 | 313.4 | 95.5 | 408.9 | 98.4 | 40.4 | 1.4 | 271.4 | |
| 1998 1st half | 200.4 | 60.7 | 56.5 | 0.5 | 318.1 | 98.6 | 416.7 | 101.4 | 41.1 | 1.4 | 275.5 | |
| Percentage changes on a year earlier(2) | ||||||||||||
| 1995 | 2 | 1 1/2 | - 1/4 | 0 | 1 1/2 | 7 3/4 | 2 3/4 | 4 | 2 1/4 | 0 | 2 1/2 | |
| 1996 | 3 | 1 | 3 | - 1/2 | 2 1/4 | 6 1/4 | 3 | 7 | 1 3/4 | 1/2 | 2 1/2 | |
| 1997 | 4 1/4 | 3/4 | 6 1/4 | 0 | 3 3/4 | 5 3/4 | 4 1/4 | 6 3/4 | 4 1/4 | 0 | 3 1/2 | |
| 1998 1st half | 3 3/4 | 0 | 5 3/4 | 0 | 3 1/4 | 6 1/2 | 4 | 6 3/4 | 3 3/4 | 0 | 3 | |
| Percentage changes on previous financial year | ||||||
| 1996-97 | 1997-98 | 1998-99 | 1999-00 | 2000-01 | 2001-02 | |
| Output (GDP) | 2 3/4 | 3 1/2 | 3 | 2 1/2 | 2 1/2 | 2 1/2 |
| Prices | ||||||
| GDP deflator | 2 1/2 | 2 | 2 | 2 | 2 | 2 |
| RPI ex MIPs | 3 | 2 1/2 | 2 | 2 | 2 | 2 |
| Money GDP | 5 1/4 | 5 1/2 | 5 | 4 1/2 | 4 1/2 | 4 1/2 |
3.73 Business surveys suggest that capacity utilisation is relatively high in some sectors. The CBI survey shows capacity utilisation in manufacturing above its 30 year average, and the BCC survey suggests that capacity utilisation in services may now be back to its 1989 levels. But these measures do not cover the whole economy and take little account of the degree of slack in the labour market. There is little evidence of shortages of skilled labour emerging and wage pressures have remained very moderate.
3.74 Given this rather mixed evidence, there is a large margin of uncertainty over the degree of spare capacity in the economy as a whole. But it seems plausible to assume that there is still a negative output gap of between 0 and 3per cent of GDP. This range encompasses most of the estimates given by the Panel of Independent Forecasters in their special report in June on the output gap.
3.76 Quantitatively, trend productivity growth is the most important of these elements. Supply-side reforms, which have strengthened competition and sharpened incentives, have contributed to the substantially faster rates of productivity growth achieved since the 1970s, particularly in manufacturing. It is assumed that this improved performance is sustained over the rest of this decade, and trend productivity growth is in the range 1 3/4 to 2 per cent, in line with performance over the 1980s.
3.77 The labour supply contracted during the early 1990s, reflecting the rapid expansion of numbers in further and higher education, earlier retirement, and continued growth in the number of Invalidity Benefit claimants. However, the labour supply is probably now expanding again. The population of working age is projected to grow by between 1/4 and 1/2 per cent a year over the rest of the decade, and participation in the labour market is likely to increase as a result of continued improvement in job prospects and a levelling off in the numbers entering higher and further education.
3.78 An improvement in labour market performance is also likely to contribute to the economy's ability to supply extra output without leading to higher inflation. After rising steeply from the late 1960s to the early 1980s, the rate of unemployment that would be consistent with low, stable inflation appears to have declined significantly since the mid-1980s. In the last recession, unemployment peaked at a lower level than in the previous cycle for the first time since the 1960s, whilst wage inflation has remained historically low, despite steadily falling unemployment over the past four years.
3.79 Much of the fall in unemployment can be credited to reforms begun in the early 1980s, for example labour market deregulation, trade union reform, competition policy, and tax and benefit changes to improve incentives. A further wide ranging programme of labour market measures, including enhanced training and job placement services, has continued in the 1990s. There is much evidence that the labour market is more flexible: working patterns are more varied, wage determination has become more decentralised, the links between pay and performance are stronger and regional differentials in unemployment have narrowed.
3.80 A steep fall in the number of long-term unemployed, who tend to be more detached from the jobs market, should also help to reduce the rate of unemployment consistent with continuing low inflation.
3.81 Taking all these factors into account, it is reasonable to assume that trend output growth over the rest of the 1990s will be around 2 1/2 per cent per annum. This is similar to the average growth rate achieved over the post-war period as a whole. It is also similar to the average of estimates made by the Panel of Independent Forecasters in their special report in June. It is quite possible that trend growth will be higher; for example, the impact on productivity growth of the recent expansion in higher and further education or of supply side reforms could be greater than allowed for. But in planning for the public finances it is sensible to err on the side of caution.Trend growth
3.75 The trend rate of growth can be broken down into three components: the trend in productivity, trends in labour supply, and changes in the rate of unemployment. In other words, economic growth depends on how productive each worker is, how many workers are available, and how fully this labour force can be employed without putting upward pressure on inflation.
| Percentage points | |||||
| 1996-97 | 1997-98 | 1998-99 | 1999-00 | 2000-01 | |
| Real GDP growth | - 1/4 | 1/2 | 1/4 | - 1/4 | - 1/4 |
| Inflation (GDP deflator) | - 1/4 | - 1/2 | - 1/4 | 0 | 0 |
| Money GDP growth | - 3/4 | 0 | 0 | - 1/4 | - 1/4 |
[Prepared November 1996]