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B31 On the HICP measure, which was developed to facilitate comparisons between EU countries, the UK now has the lowest inflation rate in the EU. In February UK HICP inflation was just 1 per cent, following a record low of 0.8 per cent in January. This provides a further reflection of weak price pressures in the UK goods sector. In the Eurozone, by contrast, goods inflation has been pushed up by the euro's depreciation and related stronger impact from rising oil prices. As in the Pre-Budget Report forecast, the current 1.2 percentage point divergence between UK HICP and RPIX inflation is expected to narrow over the next few years.
B32 The main upside risk to the inflation outlook is that domestic cost pressures could turn out to be stronger than expected. An examination of previous cycles shows that current inflation outturns are a poor guide to prospects (Box B3). With the economy estimated to be above its trend level and, as yet, few signs that the pace of domestic demand has slowed to more sustainable rates, there is a risk that domestically-generated inflationary pressures could pick up rather than ease. Combined with rising import price inflation, this could lead to stronger than forecast RPIX inflation later this year and into 2001.
B33 The December national accounts release included major upward revisions to GDP deflator inflation over the past two years, with implied inflation rates for both private and government consumption now higher. However, GDP deflator inflation is still forecast to fall from 3.3 per cent in 1998-99 to around 21/2 per cent in 1999-2000 overall. This reflects a smaller contribution from the terms of trade and lower consumers' expenditure deflator (CED) inflation, subsequently pushing GDP deflator inflation down further to 21/4 per cent in 2000-01. GDP deflator inflation is forecast to return to 21/2 per cent in 2001-02.
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Box B3: Inflation and the economic cycle
Output gap analysis suggests that inflation tends to rise when output is above its trend level and fall when output is below potential. This relationship is far from precise: it depends on changes in inflation being unanticipated, and also on external price pressures and hence exchange rate movements. Moreover, the output gap is difficult to measure. Nevertheless, the deviation of output from its trend level typically appears to offer a fairly reliable gauge of domestically-generated inflationary pressures.
This model conforms with the familiar view that upward or downward pressures on inflation take time to build following either an upturn or slowing in output growth. However, its conclusions are in fact much stronger than this, particularly if cycles are fairly symmetric. GDP growth is likely to be at its strongest around the point at which the economy approaches trend from below, and yet downward inflationary pressures will persist until the output gap is fully closed. Conversely, inflation is likely to peak just around the point where growth hits a low point as the economy returns to trend from above.
These stylised predictions seem to fit the facts of recent cycles. Following the recession of the early 1980s, stronger growth gradually returned the economy to its trend level by the middle of the decade. Inflation fell sharply over this period, and did not bottom out until mid-1986 (albeit helped by the oil price). Broadly as the output gap model predicts, this coincided with the onset of the strongest output growth, with GDP growth averaging more than 41/2 per cent from 1986 to 1988.
As the economy moved above trend after 1986, inflation began to turn upwards. But, at around 4 per cent in the first half of 1988, it appeared still subdued even three years into the boom in domestic demand and despite the preceding sharp depreciation in sterling. Partly in response to these subdued inflation outturns, monetary policy failed to act early enough to prevent the substantial boom of the late 1980s, notwithstanding clear warning signals from rising capacity utilisation, house prices and the current account deficit. From mid-1988 prices accelerated sharply, with inflation approaching double-digits during 1990. This led to a sharp policy tightening, and by October 1989 interest rates had doubled to 15 per cent, eventually tipping the economy into recession. Inflation meanwhile peaked in autumn 1990, just as the sharpest output losses took output back to trend, thus marking the end of a turbulent 11-year cycle.
Direct parallels with previous cycles must be treated with great caution. Consistent with the Government's commitment to delivering economic stability, the economy has remained much closer to its sustainable position over the past three years. This limits the usefulness of the output gap approach, given the substantial margins of error. However, one of the key lessons of the 1980s was that surprisingly benign inflation outturns can persist alongside a peak in output growth. Under the output gap framework, they should be expected to. This underlines the importance of setting monetary policy in a forward-looking context.
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Independent forecasts
B34 Independent forecasts for the UK economy have strengthened further since the publication of the Pre-Budget Report. The independent consensus for GDP growth is 3.1 per cent for 2000, an increase of 1/2 percentage point since the autumn. For 2001, the average independent forecast is for GDP to grow by 2.6 per cent, a modest easing to a more sustainable rate of growth. The Budget 2000 growth forecasts, following the small upward revision in 2000, are almost exactly in line with the independent consensus both this year and next.
Table B2: Budget and independent1 forecasts
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Percentage changes on a year earlier unless otherwise stated
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|
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2000
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2001
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|
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Independent
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Independent
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March Budget
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Average
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Range
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March Budget
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Average
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Range
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Gross domestic product
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23/4 to 31/4
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3.1
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2.0 to 3.7
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21/4 to 23/4
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2·6
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1·6 to 3·8
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RPIX (Q4)
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21/4
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2·1
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1·3 to 2·8
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21/2
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2·4
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1·5 to 2.8
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Current account (£ billion)
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-201/2
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-15.6
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-28.0 to -9.3
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-21
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-16.4
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-39.0 to -5·0
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1 'Forecasts for the UK Economy: A Comparison of Independent Forecasts', March 2000.
B35 Like the Budget 2000 forecast, independent forecasters expect the current combination of strong growth and subdued retail price pressures to persist for a period. The average independent forecast for RPIX inflation in the fourth quarter of 2000 is now 2.1 per cent, down around 1/4 percentage point since November. It is expected to return gradually to the Government's 21/2 per cent target by the end of next year.
B36 Independent forecasts for the balance of payments current account have changed little over recent months, and deficits equivalent to between 11/2 and 13/4 per cent of GDP are expected in both 2000 and 2001. However, there exists a considerable range of views around these average forecasts. Larger than expected current account deficits would provide a warning signal of stronger than expected demand, borrowing and inflationary pressures.
FORECAST ISSUES AND RISKS
The household sector
B37 Household consumption rose by 4 per cent in 1999, in line with the Pre-Budget Report forecast, and readily explicable in terms of the fundamental drivers of consumer demand. Growth in real household disposable incomes was somewhat weaker than forecast, despite a sharp rise to 31/4 per cent, which reflected a continued robust expansion in employment incomes and a significant decline in growth in taxes on income as the impact of self-assessment worked through. Stronger underlying growth in spending therefore led to an unexpected fall in the saving ratio, with rapid gains in household wealth perhaps boosting spending by more than 1 percentage point relative to incomes last year. In particular, house prices accelerated unexpectedly sharply from mid-1999. Falling interest rates in the year to June 1999 also supported above trend consumption growth during the first half of the year.
B38 While growth in total spending is reported to have eased during the course of 1999, latest indicators are very strong. Slower recorded growth in vehicles spending is uncertain due to the change in the system of vehicle registrations, and reported easing in purchases of non-durable goods and services contrasts with the sharp acceleration in retail sales volumes and still strong services output growth. Household consumption is now forecast to grow by 31/2 to 33/4 per cent in 2000 as a whole, 1 percentage point higher than in the Pre-Budget Report, reflecting both stronger growth in employment incomes and lower than previously expected saving. Precautionary motives for saving have fallen sharply with enhanced macroeconomic and job prospects: the proportion of households expecting higher unemployment has fallen sharply over the past year and consumers' confidence in their future financial situation has stabilised around record levels.
Table B3: Household sector1 expenditure and income
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Percentage changes on previous year
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|
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Forecast
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1999
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2000
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2001
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2002
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Household consumption2
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4
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31/2 to 33/4
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2 to 21/2
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13/4 to 21/4
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Real household disposable income
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31/4
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33/4 to 4
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23/4 to 31/4
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21/2 to 3
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Saving ratio (level, per cent)
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53/4
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51/2
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6
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63/4
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1 Including non-profit institutions serving households.
2 At constant prices.
B39 Consumption growth is, however, expected to ease later in 2000, subsequently falling just below trend rates during 2001 with the saving ratio rising to 6 per cent. This slowing will partly reflect the direct impact of recent increases in interest rates. Rising mortgage interest payments, together with the abolition of MIRAS and increased stamp duty, are likely to dampen growth in housing demand and prices. This should indirectly restrain growth in consumer spending into 2001 via the effects on household wealth and borrowing. Household consumption growth is forecast to fall to 2 to 21/2 per cent in 2001, broadly in line with independent forecasts, and to ease a little further in 2002.
B40 There are clear upside risks to the outlook. The tight labour market poses a direct upside risk to growth in earnings and hence consumer spending, at least in the short term. Moreover, there remains a strong possibility that households may choose to react more positively to rapid gains in wealth over recent years. As a proportion of household income, total household wealth is estimated to have risen to a record level in the fourth quarter of 1999. One way of releasing such gains to boost spending is through secured borrowing above that needed for house purchase or improvements, known as mortgage equity withdrawal. Although still substantially lower than in the 1980s, the Bank of England estimates that equity withdrawal rose quite sharply in the second half of 1999, bolstering already strong growth in consumer credit. Box B4 discusses the housing market outlook and risks in more detail.
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Box B4: Housing and the wider economy - outlook and risks
House price inflation rose sharply from mid-1999, recently reaching around 15 per cent. Housing transactions also stepped up markedly, rising 9 per cent during the year as a whole, while secured borrowing grew by over 8 per cent in the year to January 2000 compared to under 6 per cent a year earlier.
Box A4 of the Pre-Budget Report discussed the potential links between the housing market and wider economic performance. Direct impacts, such as the boost to spending associated with higher levels of housing transactions, are uncontroversial, and non-vehicle durables spending has been very strong. But indirect effects on spending are not straightforward. While recent growth in housing values, lending and equity withdrawal has been rapid, this may be more a symptom of the underlying strength in consumer demand rather than an explanation or cause. The strong past association between changes in household wealth and consumer confidence does, however, raise the risk of much stronger growth in household consumption in 2000. This depends on whether current housing market signals add to existing knowledge of the underlying momentum in consumer demand.
Annual growth in real household disposable incomes is estimated to have recently risen to around 5 per cent. Given a fairly fixed supply of housing in the short run, this is probably sufficient to explain house price inflation close to double digit rates in the context of conventional models of housing demand. Current house price gains have moved beyond this reflecting, among other things, the still relatively low mortgage interest payments burden, although the level of prices does not appear out of line with fundamentals.
The regional dimension of recent housing market performance is also a concern. While less marked than in previous economic cycles, house price gains have been most rapid in London and the South East. This is likely to reflect the relatively fixed supply of land and housing, and perhaps greater cyclicality in local incomes and demand. Unchecked, it would raise the possibility of stronger house price inflation elsewhere.
The risk that housing market developments could encourage wider macroeconomic instability highlights the importance of the Government's monetary framework. The new arrangements are designed to promote forward-looking policy setting taking full account of all available economic indicators. Despite currently subdued retail price pressures, interest rates have risen by 1 percentage point since their low of 5 per cent in June last year. The removal of MIRAS from April 2000 and increased stamp duty will also contribute to greater sustainability in housing and consumer demand.
House price inflation and transactions are expected to remain high for a while, given strong near-term economic growth and the significant stock of approved mortgage lending. However, pressures are likely to ease later in 2000 and into 2001 as higher house prices, increased post-tax interest rates and some slowing in income growth dampen housing demand. Nevertheless, past housing cycles have been characterised by stronger and more persistent overshooting in activity and prices relative to longer-term sustainable levels. While the new macroeconomic framework provides a more credible guard against speculative behaviour, policy will need to remain alert to the risks.
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Companies and investment
B41 Business investment growth eased further in the second half of 1999, as slower private service sector spending combined with continuing weakness in manufacturing. A temporary retrenchment was anticipated in the Pre-Budget Report and earlier forecasts, in lagged response to the earlier deterioration in business optimism, profit and output expectations. These factors were subsequently reflected in an estimated 3/4 percentage point reduction in private non-financial companies (NFCs) profits as a per cent of GDP in 1999. Fears of potential millennium bug related problems may also have contributed to the slowdown, with major ICT projects increasingly held off as the date change drew near.
B42 Most indicators suggest that the climate for investment has improved significantly over the past year. With stronger economic growth, NFC profits have begun to recover, rising an estimated 4 per cent by the fourth quarter of 1999 from their trough in the first quarter, though partly reflecting buoyant North-Sea incomes. Rising capacity utilisation and buoyant output expectations have prompted continued improvements in investment intentions overall. BCC survey evidence shows that plant and machinery investment intentions have risen back to their strong 1995-97 average in the service sector. In manufacturing they are also above the longer-run average, though CBI survey evidence paints a weaker picture. These cyclical improvements have reinforced existing incentives to invest. Company rates of return are high relative to the cost of capital, the buoyant stock market has tended to lower the cost of equity finance, and corporate income gearing (the ratio of debt service costs to corporate income) remains low.
B43 However, NFC's net borrowing is estimated at around 2 per cent of GDP in 1999 and is forecast to rise to around 3 per cent of GDP in 2000. While larger deficits were recorded in the late 1980s, the forecast cautiously assumes that companies will aim to curtail borrowing gradually in the period ahead, implying more modest rates of expansion in capital spending compared to recent years. Overall business investment is forecast to grow by 21/4 to 23/4 per cent in 2000, strengthening fairly gradually from its dip last autumn in lagged response to stronger output growth. It is forecast to rise by 2 to 21/2 per cent in 2001, reflecting the general easing in economic growth, remaining within this range in 2002.
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