The Economy

INTRODUCTION[1],[2]

A1  This annex sets out the economic background to the Budget. It provides overviews of domestic and world economic prospects for the next three years, followed by a more detailed account of the UK outlook.  

A2  Projections for GDP growth are again presented as opportunity ranges, illustrating the potential for higher sustainable growth and employment based on improved supply-side performance of the UK economy. The ranges do not represent general forecast uncertainties: key short-term risks are examined later in this annex and average errors on past forecasts are shown in Table A7. A detailed explanation of the opportunity ranges was provided in the November 1997 Pre-Budget Report - Box A1 sets out the key points. Projections for the public finances (Annex B) are based on the lower end of the opportunity ranges.

Box A1: Opportunity ranges for GDP growth The Economic and Fiscal Strategy Report sets out the Government's strategy to improve longer-term economic performance. The New Deal programmes and tax and benefit reforms are likely to raise potential output over a number of years by raising the sustainable rate of employment. The range of measures being pursued to improve the UK's productivity performance should raise the economy's potential growth rate more permanently, though the timing and magnitude of improvements is uncertain. For this reason, projections for GDP growth at the low end of the opportunity ranges make no allowance for any underlying improvement in supply-side performance. They are consistent with a projected trend growth rate of 2 1 /4 per cent a year, in line with average growth over the post-war period. This assumption is transparent and cautious, and underpins the projections of the public finances. The upper ends of the opportunity ranges for GDP growth are based on the assumption that improved labour market performance leads to a 1 /2 percentage point decline in the sustainable rate of unemployment (or NAIRU) in both 1999 and 2000, and a further 1 /4 percentage point reduction in 2001. It is further assumed that these benefits are fully and immediately translated into higher employment and output, though in practice the effects would partly show up in lower wages and prices for a period. The projections for GDP growth within the opportunity ranges should be seen as illustrating the span of plausible outcomes offered by improved supply-side performance. Projections at the low end, meanwhile, constitute a more detailed consideration of prospects, though based on the particular assumption of no underlying supply-side improvement. As a result, a 'central view' for GDP growth cannot be found by taking the average of the projections at the lower and upper ends of the ranges. Actual outcomes will depend on both the success of Government policies and the actions of the private sector. In particular, responsible wage bargaining offers the opportunity to promote jobs. Irrespective of the precise path the economy takes over the shorter term, the opportunity ranges illustrate a substantive point. Very small improvements in trend economic growth, much smaller than those shown here, if sustained over the medium to long term, offer the prospect of very large improvements in UK economic welfare. Annex A of the EFSR illustrates how the long-term sustainability of the public finances could be strengthened, creating the potential for improved public services.

UK OVERVIEW

Recent economic developments

A3  Key indicators show that the Pre-Budget Report forecast is broadly on track. GDP grew by 0·2 per cent in the fourth quarter of 1998, in line with the Pre-Budget Report forecast, although manufacturing output fell by more than was expected, down 1·3 per cent. This was balanced by firmer than expected service sector output growth, up 0·6 per cent in the fourth quarter, and the continued buoyancy of labour market activity.

A4  Indeed, the labour market was surprisingly strong through the second half of 1998, with growth in employment showing a marked upturn compared to the first half of the year. Increased labour market participation has largely accounted for the flattening of the previously downward trend in unemployment to date, though both the ILO and claimant count measures show further modest falls on the latest readings.

A5  Total domestic demand has remained relatively firm, though this partly reflects strong inventory accumulation. Household consumption grew by 0·4 per cent in the fourth quarter of last year, despite weak December retail sales, and the latest monthly evidence signals continued expansion into 1999. The EC/GfK measure of consumer confidence moved further above normal levels in February, and retail sales volumes in the three months to January, spanning the Christmas and New Year sales trading periods, were up 0·4 per cent compared to the previous three months.

A6  Net trade was weaker than expected towards the end of last year, as was manufacturing output. Export volumes to non-EU countries have fallen sharply, reflecting the pattern of global growth. With growth in import volumes again outstripping that of exports, where the overall trend is flat to falling, net trade reduced GDP growth by more than 1 percentage point in the fourth quarter of last year.

A7  The more forward-looking business survey indicators have begun to rise from the lows recorded last autumn, as world economic turbulence has receded and interest rates have fallen. They suggest an easing in pressures in the manufacturing sector and continued growth in services, though below trend, as expected.

Box A2: Improving knowledge of the economy The national accounts provide an essential framework for monitoring the economy. To ensure that methodologies are as robust and relevant as possible, a number of developments are planned, including improvements to the quality and coherence of GDP estimates at constant prices: expanded data collection for capital expenditure, inventories, purchases by industry and a wider range of prices for deflation; the development of constant price input-output tables to ensure greater coherence between the expenditure and output measures of real GDP, progressively improving estimates of growth starting with the 2000 Blue Book; the development of a monthly index of service sector output, beginning with an index of distribution. This process should, in time, be aided by savings released as a result of the recently completed Efficiency Review. Nevertheless, official statistics will never give an entirely up-to-date and complete picture of the economy, not least because of time lags in data collection and processing. So the Treasury also makes extensive use of: a wide range of survey data compiled by private sector organisations. This information is typically more timely and provides certain indicators not otherwise available; information obtained through direct contact with regional and business organisations, both private and public. This includes a programme of regular regional visits undertaken by Treasury officials, regular participation in various business discussion groups, and ad-hoc business contacts. These additional sources are invaluable in forming assessments of economic developments and prospects.

A8  RPI excluding mortgage interest payments (RPIX) inflation of 2½ per cent in the fourth quarter of 1998 was exactly as forecast. Earnings decelerated in the second half of last year, pay settlements have fallen back recently and producer output price inflation is historically low. This confirms the possibility of RPIX inflation dipping temporarily below 2½ per cent, before returning to its target level later this year, as forecast in the Pre-Budget Report.

Main features of the forecast

A9  The global downturn is having a significant impact on the UK economy. Lower exports to Asia have accounted for around half of the £2¼ billion widening of the UK trade in goods deficit in the year to the fourth quarter of 1998, and reduced demand from the major oil producing nations has also played a significant part. Overall, net trade reduced UK growth by 1¾ percentage points last year, and slower growth expected in 1999 is mainly due to weaker growth in UK export markets.

A10  Growth in UK export markets is now expected to fall to 5¾ per cent this year and 6 per cent in 2000, down from 7¼ per cent in 1998 and 10½ per cent in 1997. This represents a further downward revision since the Pre-Budget Report forecast, and around 1½ percentage points lower than expectations at the time of the March 1998 Budget in both years. This accounts for most of the downward revision to UK growth in 1999 compared to that projected a year ago. Domestic activity and spending has also been affected by the external shock to confidence following world financial turbulence last year.

A11  However, a combination of the timely policy loosening, underlying private sector financial strength, increased government capital spending, and an easing in trade conditions, is expected to underpin stronger growth, back towards trend rates, into 2000. Downside risks remain, including ongoing risks to the world economic outlook, though this is balanced by much firmer domestic consumer confidence.

Table A1:Summary of forecast

Chart A1: A temporary slowing of growth

A16  The projected GDP path would be a much better outcome for the UK economy than has been experienced in recent cycles. There are good reasons to expect this, despite adverse world developments.

A17  Although some evidence of excess labour market tightness remains, inflation is clearly less of a concern today compared to past cycles. The output gap, a key indicator of domestic price pressures, is estimated to have peaked at around ¾ per cent at the end of 1997, as opposed to more than 4 per cent in 1988. This was largely due to a more timely, and better coordinated, tightening of monetary and fiscal policy[3]. This means that only a relatively mild and necessary slowing of growth has been required in order to lock in economic stability for the years ahead, maintaining low inflation once the favourable impact of falling import prices unwinds (see Box A3).

A18  As a result, interest rates peaked at 7½ per cent, an historically low level compared to the cyclical peaks of 15 per cent or more seen over the previous 30 years. Furthermore, the subsequent easing of domestic monetary policy has been rapid. The Bank of England's Monetary Policy Committee has reduced interest rates by 2 percentage points since last October, rather faster than financial markets expected.

Box A3: The output gap: how large was the cyclical peak? As in the Pre-Budget Report forecast, the economy is judged to have moved above trend during the first half of 1997. The subsequent GDP path implies that the output gap peaked at around ¾ per cent of GDP at the end of the year, with the economy estimated to have moved back to around trend at the end of 1998. A two-year half cycle would be very short by historical standards and, as a result, the estimated cyclical peak is not very sensitive to the assumed trend rate for GDP growth. To infer a larger peak output gap, it is necessary to assume that the economy first moved above trend much earlier. The Pre-Budget Report set out why, on the basis of a range of indicators, this does not seem plausible. Moreover, a variety of key manufacturing indicators, for example, capacity utilisation and output prices, continue to suggest that the sector may already be operating with ample spare capacity. More generally, margins have come under pressure, skilled labour shortages have eased and earnings growth has fallen back. Such factors support the view that the economy as a whole may now have moved back close to potential, following a relatively small peak last year.

A19  In addition, the private sector remains in relatively sound financial health, with nothing approaching the deterioration which occurred prior to the 1990s' recession. Then, both households and companies moved into substantial financial deficit as spending boomed, leading to a significant worsening of the private sector balance sheet. This, combined with double digit interest rates for four years, led directly to sharp falls in private consumption in the early 1990s. For companies, the link between depressed financial health and falling investment spending most probably reflected weak liquidity and the associated tightening of credit conditions.

A20  Although there is no definitive measure of financial health, a number of relevant indicators are shown in Box A4. They suggest that the private sector is better placed to maintain moderate spending growth. Household consumption growth is expected to recover gradually during the course of this year, reaching trend rates in 2000. In addition, world trade growth is expected to strengthen modestly next year, as the Asian crisis economies begin to stabilise. The further drag on growth from net trade is expected fully to unwind through this year with the gradual easing in sterling. GDP is forecast to grow by 2¼ to 2¾ per cent in 2000.

A21  As in previous forecasts, stronger growth into next year and beyond is expected to be supported by the planned expansion in public sector capital expenditure, in line with the CSR commitments. General government investment is expected to contribute around ¼ percentage point to GDP growth in each of the next three years. In addition, Budget 99 continues to lock in the structural improvement in the public finances over the past two years while at the same time providing a boost to the economy of some £6 billion, thus supporting monetary policy while the economy is in its below trend phase.  

A22  On the basis of the slowing in growth to date, and lower growth in 1999, in line with the Pre-Budget Report forecast, output is now projected to fall to around 1 per cent below trend by the end of this year, with the gap narrowing in 2000. This allows stronger growth in 2001, when GDP growth is projected to grow by 2¾ to 3¼ per cent, consistent with achieving the Government's inflation target in the medium term.

A23  As in the Pre-Budget Report, RPIX inflation is expected to dip temporarily below the Government's 2½ per cent inflation target during the course of this year. Continuing negative imported inflation is expected to combine with an easing in domestic costs for a period. With the economy only returning to its trend level by the end of 2001, the easing in domestic pressures is likely to intensify, though this is expected to be broadly offset by a stabilisation and subsequent recovery in import prices, returning RPIX inflation close to target by the end of this year.

Box A4: Private sector financial position A range of indicators suggests that the financial position of the private sector is secure, relative to previous cycles. The household sector has been in financial surplus throughout the current upswing, remaining in balance despite the decline in the saving ratio over the past year. Non-financial corporations have recorded deficits since mid 1997 associated with strong growth in capital spending, but the deterioration is much less marked than 10 years ago. Private sector balance sheets, represented here by the ratio of total financial assets to loans outstanding, have strengthened over recent years, though household net wealth is sensitive to equity values. Improved company net worth has been mirrored by a continued decline in company gearing (loans relative to outstanding share capital). Company liquidity is particularly robust at present, providing a useful cushion against the weaker short-term profits outlook. Household liquidity has strengthened in recent years, though there has also been a structural shift towards lower holdings of liquid cash balances over time.

Chart A2: Avoiding a return to boom and bust

Forecast risks

A24  The Budget forecast is in line with the latest assessments of a number of leading organisations such as the Bank of England, the International Monetary Fund and the National Institute for Economic and Social Research. Of the independent forecasts surveyed each month by the Treasury, two thirds of the growth projections for 1999 and 2000 currently lie in a relatively narrow range of plus or minus ½ percentage point either side of the low end of the Budget opportunity range.

A25  Although the average of outside forecasts for growth in 1999 and 2000 is around ¼ to ½ percentage point lower than the projections underpinning the public finances, outside views appear to have firmed lately, and there is a clear consensus that the economy is well placed for stronger growth into 2000. Half of the new forecasts show growth of 2 per cent or more in 2000, though there remain, as always, considerable risks to the outlook lying on both sides of the Budget projection

Table A2:Budget and independent¹ forecasts

Table A3:The world economy

Chart A3: The global downtown

A32  By contrast, the US economy has continued to expand at well above trend rates, with GDP up nearly 4 per cent in 1998. Last autumn's interest rate cuts, together with a recovery in equity prices, helped sustain consumer confidence at high levels. Growth is expected to slow in 1999, but forecasts have been revised upwards significantly.

Recent developments in developing countries

A33  The Brazilian real fell sharply after the government abandoned its US dollar currency peg on 15 January. Brazilian GDP is now likely to contract sharply this year, though the wider financial market contagion from the devaluation has been relatively limited. The spreads on Argentinian and Mexican bonds over US Treasury bonds remained well below levels reached immediately after the Russian crisis. Nevertheless, activity in Latin America as a whole is expected to slow significantly this year.

A34  GDP fell sharply in the Asian crisis countries in 1998, but there is now some evidence that the recessions are beginning to bottom out, notably in Korea. The weakness in commodity prices has adversely affected a number of developing country commodity producers in the Middle East and elsewhere.

World inflation and commodity prices

A35  Global inflationary pressures are very weak. Spare capacity at a global level has contributed to historically low G7 consumer price inflation, estimated at 1¼ per cent in 1998, and sharp falls in commodity prices. Oil prices fell by about 35 per cent during the course of 1998, at one stage reaching their lowest level for around 12 years, while non-oil commodity prices fell by 17 per cent. Non-oil commodity prices are expected to pick up gently through 1999. Moderate world activity and subdued commodity prices are expected to keep G7 consumer price inflation low, forecast at 1¼ per cent in the fourth quarter of 1999.

Chart A4: Commodity price deflation

World trade

A36  Growth of world trade in manufactures is estimated to have slowed sharply to 4½ per cent in 1998, partly a result of the collapse in intra-Asian trade. Trade growth should pick up this year as the Asian crisis economies begin to stabilise, although lower growth in Latin America will offset this to some extent. Growth in world trade is expected to recover to 5¼ per cent this year.  

A37  UK export markets are estimated to have grown more rapidly than world trade in 1998, at 7¼ per cent. However, with slower growth in the G7, and the weaker outlook for Europe in particular, UK export market growth is expected to slow to 5¾ per cent this year, slightly weaker than forecast in the November Pre-Budget Report.

FORECAST IN DETAIL

Trade and the balance of payments

A38  As widely expected, the UK's balance of trade in goods and services turned negative last year. From a position of near balance in 1997, a deficit of £7¼ billion was recorded for 1998 as a whole, more than accounted for by a widening of the deficit on trade in goods. As a result, the current account moved from a surplus of £6¼ billion in 1997 to an estimated deficit of £2¼ billion, or ¼ per cent of GDP, in 1998, despite the UK's surplus on trade in services rising to a record high of nearly £13½ billion. The current account deficit was about £½ billion larger than projected in the Pre-Budget Report, more than explained by stronger than expected import volumes.

A39  Although sterling has eased significantly since last spring, exchange rates tend to affect trade volumes with a lag, and so the effects of sterling's earlier appreciation continued to be felt through the year. The impact of the financial market turmoil in Asia also took its toll. Trade with Asia, and particularly lower exports, accounted for around half of the widening of the trade in goods deficit in the year to the fourth quarter of 1998. Although the value of UK imports from the region increased by much less, this probably masked a significant increase in import volumes, as the Asian economies became better placed to take advantage of their devaluations in 1997. UK exports may also have been displaced from third countries, some of which have been hit directly by world financial market turbulence, including other emerging markets and the major oil producing nations.

A40  In the short term, prospects for the traded goods sector remain quite weak. Asian demand for UK goods and services is likely to remain muted which, together with the deterioration in European growth prospects and recent events in Latin America, will act to restrain export growth in 1999. As a result, despite the projected pick up in world trade growth, UK export markets growth is likely to fall further this year. In addition, there may be some further delayed, albeit more moderate, adjustment to the rise in sterling since 1996.

A41  However, key business survey readings relating to manufacturing export orders and confidence have shown some stabilisation and recovery in recent months. They suggest some easing in trade conditions, implying a gradual strengthening in exports growth into 2000, as UK export markets growth picks up and the benefits of the decline in sterling since last spring feed through. Import volume growth is expected to slacken further in 1999, with domestic demand subdued, recovering thereafter as UK activity strengthens. Overall, net trade is forecast to exert a broadly neutral influence on GDP growth through this year and beyond, though this implies a negative impact on growth in 1999 as a whole, with net exports well down on levels recorded last year.

Table A4: Trade in goods and services

	Percentage changes on previous year					£ billion
	Volumes		Prices1			Goods and
	Exports	Imports	Exports	Imports	Terms of trade	services balance
1998	2¾	7¾	-4¼	-6	1¾	-7¼
Forecast
1999	¼ to ¾	3¾ to 4¼	-½	-1½	1	-13¼
2000	4½ to 5	4½ to 5	2¼	2¼	0	-13½
2001	6 to 6½	5½ to 6	3	3	0	-13¾
1 Average value indices.
2 Ratio of export to import prices.

A42  The exchange rate and the Asian crisis have been important factors in putting downward pressure on trade prices. Import prices fell by 6 per cent last year, rather more than the fall in export prices. However, import prices are likely to gradually recover later this year as the easing of the exchange rate feeds through and combines with the effects of firmer world activity. This implies continued, but moderating, downward pressure on domestic inflation for a period, but with import price inflation turning positive and then gradually moving back into line with domestic inflation in the first half of 2000.

A43  The deficit in trade in goods and services is forecast to widen to around £13¼ billion in 1999, stabilising around this level as growth in both exports and imports move closer together. The investment income surplus is also expected to fall back as a result of reduced profitability of UK subsidiaries overseas. Overall, the current account deficit is forecast to widen to £10 billion, or 1¼ per cent of GDP, in 1999, remaining around this level through the forecast period. This is a relatively modest deficit by historical standards.

Chart A5: Modest external deficit despite global turbulence

The household sector

A44  Household consumption rose by 2¾ per cent in 1998, down from rates of 3¾ to 4 per cent in the previous two years. While the quarterly profile of consumption has been somewhat erratic, the broad picture, based on a variety of indicators, has been of an underlying slowing in demand through the year. Quarterly growth averaged just under ½ per cent in 1998. Expenditure on goods has been weaker, perhaps reflecting a discrete adjustment to the strength in purchases of durables last year, in turn partly associated with the 'windfall payments'. Spending on non-durable goods has also eased, but consumption of services has remained much more buoyant.

A45  Growth in consumer spending would have been weaker, were it not for the cyclical fall in saving. Real household disposable income is estimated to have risen by ½ per cent in 1998, with the effect on spending cushioned by a fall in the saving ratio to 7 per cent, down from rates of over 9 per cent in preceding years. Growth in nominal disposable income was below estimated growth of nearly 7 per cent in wages and salaries. This reflected an increase in income tax payments related to the implementation of self-assessment, and a rise in net interest payments. As a proportion of gross disposable income, household net interest payments are estimated to have risen from 2·9 per cent in 1997 to 3·9 per cent last year, despite households' holdings of interest bearing deposits almost matching their loan liabilities.

A46  The increase in self-assessment tax payments in 1998 probably represented a permanent increase in the tax base. However, this does not imply that the impact on disposable income growth last year will be repeated. Indeed, the evidence on self-assessment receipts in January suggests that growth in overall taxes on income has fallen back to more normal rates.

A47  The outlook for household saving reflects a balance of factors. On the one hand, precautionary motives for saving have risen, given the slowing in the wider economy. On the other, inflation is low, protecting the real value of existing household wealth. Moreover, a variety of indicators do suggest that households are well placed to maintain spending growth in the period ahead. Box A4 showed that households are not over-borrowed and net financial wealth remains at historically high levels, consistent with the strength of household confidence in their own financial situation.

Table A5:Household sector¹ expenditure and income

Table A6:Gross fixed capital formation

Chart A6: Securing higher investment

A52  Whole economy investment is expected to rise faster than business investment as the Government's CSR commitment to raise public investment takes effect. General government investment is expected to grow at double-digit rates from now on, reversing the sharp falls of recent years. This boost to investment is well timed to support stronger economic growth. Sustaining improved investment performance and fostering a higher ratio of investment to GDP is a key factor in closing the productivity gap with other industrialised countries.

A53  Inventory accumulation averaged ½ per cent of GDP per quarter last year, well above its average over the last cycle. Although these data are less reliable than other national accounts series, the build up was mirrored in business survey evidence. It is likely that firms will run down excess inventories in the coming period, providing a temporary restraint on growth during 1999. While there is a risk that the correction could be larger than expected, it is important not to over-emphasise the influence of inventory accumulation on overall activity. Inventory accumulation has tended to coincide with the growth cycle in the past, as opposed to driving it.

The labour market

A54  A variety of indicators, including high vacancies and relatively low unemployment inflows, show that labour market activity has remained surprisingly robust. The key feature has been the strong upturn in employment growth during the second half of 1998. In the fourth quarter, LFS employment was up 122,000 on the previous quarter and around 250,000 on the second quarter, close to the rapid gains recorded in early 1997.

A55  A recent switch to part-time working has meant that the continued, though more moderate, economic expansion has remained relatively jobs-rich. This partly reflects still firm service sector growth. However, although part-time employment accounted for around two thirds of the total employment growth in the fourth quarter of 1998, a 175,000 expansion in full-time jobs accounted for the larger part of employment gains through the year as a whole. Total hours worked have risen more than ½ per cent over the past year.

A56  The counterpart has been a cyclical slowing in productivity growth which, on a non-oil basis, is estimated to have fallen from around 2 per cent in the second half of 1997 to under 1¼ per cent in the fourth quarter of 1998. Productivity growth tends to fall in downswings as companies hold onto some excess labour due to the costs of changing employment levels. With company finances in relatively good shape and unemployment low, firms are likely to continue to hoard trained employees through the temporary period of slower growth. Survey measures of employment expectations remain relatively optimistic in the service sector, and less pessimistic for manufacturing than in past downturns. Government policies to move people from welfare into work and make work pay, as described in Chapter 4 of the Economic and Fiscal Strategy Report, will help minimise dislocations associated with lower growth.

Chart A7: More jobs than ever before

A57  Recent increases in labour market participation have been significant. In the fourth quarter of 1998, the economic inactivity rate among people of working age was ½ percentage point down on six months earlier, though this looks to have been from an erratically high level. Overall, the decline in working age inactivity added around 70,000 to the labour force through the course of 1998, almost halting the downward trend in unemployment in the second half. This was a key change from the previous year when rising inactivity had reinforced the downward trend in unemployment.

A58  Indeed, with the population of working age continuing to rise, it is the recent acceleration in employment that has prevented unemployment from rising. Both unemployment measures continue to show modest declines on the latest readings and the ILO unemployment rate now stands at around 6¼ per cent, down from about 8 per cent two years ago and 10½ per cent in early 1993. However, in addition to 1·8 million currently ILO unemployed, there are a further 2·3 million working age people who want a job but are either not seeking or unavailable for work, evidence of the need for the Government's policies to make work pay. So despite apparent labour market tightness, amongst working age people there are still over 4 million, equivalent to 11½ per cent, who are without work and want a job.

A59  Moreover, the recently re-instated Average Earnings Index points to an easing in labour market pressures, with whole economy earnings growth slowing from around 5¾ per cent in the second quarter of 1998 to 4½ per cent in the fourth quarter. Private sector earnings growth has eased to a similar degree, though in both cases this has been partly a result of lower bonuses. This suggests that earnings growth has fallen back in response to the slowing of the economy, despite output remaining above potential and evidence of labour market tightness. Additional factors that may have contributed include the fall in headline RPI inflation, increased uncertainties following the shock to confidence last autumn, and the concentration of recent employment growth in part-time jobs (which is likely to have depressed overall average earnings).

A60  Firm evidence of a fall back in wage settlements is also emerging. For example, CBI data show that manufacturing settlements in the three months to January averaged 3 per cent, down ½ percentage point on the previous three months. Service sector settlements were down 0·7 percentage points over the same period, to around 3¾ per cent. The decline in average earnings growth and settlements is encouraging. Economic stability depends on wage responsibility across the public and private sectors.

Inflation

A61  RPIX inflation averaged 2·6 per cent in 1998 as a whole and was exactly at its 2½ per cent target between August and November last year. This favourable inflation outturn benefited from sharp falls in import prices, masking stronger growth in UK labour costs and an expansion in domestic retail margins. This was reflected in services price inflation (excluding rent and utilities) of 4¾ per cent, more than double the rate of goods price inflation, despite some recent signs of easing.

A62  Import prices have fallen for ten consecutive quarters, primarily the result of sterling's previous appreciation, but with additional pressure from the sharp falls in the prices of raw materials. Brent oil prices reached a 12 year low in late 1998. But despite lower import costs, producer profits have been squeezed by strong competition from cheap imports, particularly from Asia, and the build up of inventories last year. As a result, producer output prices (excluding excise duties) of manufactures fell by 0·8 per cent in the year to January and survey price expectations are also at historically low levels.

A63  As in the Pre-Budget Report forecast, RPIX inflation is expected to dip temporarily below target during 1999. In the short term, import prices are likely to remain weak, forcing domestic manufacturers to cut prices further. For a period, this is expected to combine with moderating domestically-generated inflation to reduce RPIX inflation. This domestic easing is likely to intensify with the output gap projected to turn negative in early 1999, and output remaining below trend until late 2001. Growth in earnings has already fallen back since last spring, accompanied by a significant easing in wage settlements in recent months.

A64  Retail margins are also likely to be squeezed as those factors that boosted them in recent years unwind. Retailers have benefited from strong consumer demand, enabling them to pass on only part of the drop in import prices. However, import prices are expected first to stabilise and then gradually recover later this year, as the easing in sterling begins to feed through. Non-oil commodity prices are also expected to pick up gently through 1999, as the Asian crisis economies stabilise. This is likely to offset the decline in domestically-generated inflation, bringing RPIX inflation back to target by the end of this year.

A65  Inflation, as measured by the GDP deflator, is likely to be similar to RPIX inflation in 1998-99. The rise in the terms of trade over the past two years, with import prices falling more sharply than export prices, has tended to boost the GDP deflator relative to RPIX inflation. However, this effect has been offset by abnormally low consumers' expenditure deflator (CED) inflation relative to RPIX, reflecting coverage differences. CED inflation is assumed to move broadly back in line with RPIX inflation during 1999, and the terms of trade effect should diminish as the effect of the previous exchange rate appreciation unwinds. So GDP deflator inflation is expected to remain close to 2½ per cent in financial year 1999-2000.

A66  The Harmonised Index of Consumer Prices (HICP) is the inflation measure adopted by the European Central Bank for assessing its price stability objective. UK HICP inflation has recently been running at around 1½ per cent, 1 percentage point or more below RPIX inflation. Half of this differential can be explained by coverage differences, primarily the exclusion of some housing components from the HICP; the remainder is due to the different formulae by which the two indices aggregate individual prices. This formula effect will persist, but the differential due to coverage differences is expected to narrow overthe forecast period.

Chart A8: Locking in low inflation