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Chapter B, Part 2

Inflation

B54   Underlying inflation in the UK remains firmly in check. RPIX inflation, the Government's target measure, averaged 2.2 per cent last year. The average rate of UK HICP inflation over the past three years, at just 1.1 per cent, has been lower than in any other European Union country.

B55   RPIX inflation in February was slightly above target, at 3.0 per cent, whereas HICP inflation stood at 1.6 per cent. Strong house price gains in the second half of last year have temporarily lifted the contribution of housing costs to the 12-month RPIX inflation rate. Petrol prices have also contributed significantly to the recent uplift in inflation as the effects of sharply higher oil prices on a year earlier have fed through.

B56   Other temporary factors appear to have given an additional lift to inflation in February. In particular anecdotal evidence suggests that the New Year sales, especially for clothing and footwear, got underway earlier and ended sooner this season than last, when sales lingered into February, boosting the February inflation rate.

B57   Increases in oil prices have also been the main factor underpinning a pick-up in manufacturers' input costs in recent months, with material and fuel costs rising almost
6 per cent in the year to February, their fastest rate for over a year and a half. However, excluding erratic food, beverages, tobacco and petroleum prices, a still uncertain world outlook has kept underlying producer price inflation subdued, with input prices just 0.4 per cent higher in the year to February.

B58   House price inflation has moderated from its recent peaks in the second half of 2002, when annual price rises reached between 25 and 30 per cent. Monthly rates of growth have eased back, suggesting that the peak in the housing market has now passed. In the three months to March, the Nationwide House Price Index stood 4.4 per cent higher than in the previous three months, a significant moderation compared with its latest three month on three month peak of 7.7 per cent in August.

Media link

• Chart B6: RPIX

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B59   Although house prices themselves are not a direct element of the RPI, they influence it because they are used in the calculation of housing depreciation. This is expected to remain a significant factor in keeping RPIX inflation slightly above target over coming months. But with house price increases expected progressively to moderate this year, and as last year's gains fall out of the 12-month comparison, the positive influence of housing depreciation on RPIX inflation should wane as the year goes on. Likewise, oil prices are expected soon to contribute to some easing of RPIX inflation, although there is the risk of further volatility.

B60   Other key influences on inflation over the next two years are expected to be: upward pressure from rising import prices, as a result of the recent fall in the exchange rate and the forecast pick-up in the global economy; and the continuing negative, albeit narrowing, output gap, exerting downward pressure on domestically generated inflation.

B61   The combined effect of these factors is that over the next 12 months RPIX inflation is forecast to fall back to its 2¹/₂ per cent target, as the temporary housing depreciation and oil price effects unwind, and the upward import price effect slightly outweighs the downward output gap effect. Thereafter inflation is expected to remain at target.

Independent forecasts

B62   Independent forecasts for UK GDP growth have been reduced since the 2002 Pre-Budget Report. The latest independent average for growth in 2003 is 2.0 per cent, down from 2.4 per cent at the time of the 2002 Pre-Budget Report but consistent with the lower end of the Budget forecast range. For 2004, the average of independent forecasts for GDP growth is 2.4 per cent, down from 2.9 per cent at the time of the 2002 Pre-Budget Report. Independent forecasters continue to expect inflation to remain close to target this year and next.

Table B5: Budget and independent¹ forecasts

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UK FORECAST IN DETAIL

The household sector

B63   Underlying growth in household consumption - supported by high employment and low interest rates - has remained robust and continued to support UK GDP growth in the face of subdued global demand. Strong house price gains have contributed by shielding household total net wealth from the impact of declining equity prices. Although real income growth has moderated, homeowners' borrowing capacity has been enhanced by significant appreciation in housing wealth, and mortgage equity withdrawal in the fourth quarter of 2002, at 7.2 per cent of post-tax income, was at its highest level since its 1988 peak (see Box B8 for a fuller discussion). In 2002 as a whole, private consumption rose by 3³/₄ per cent.

Table B6: Household sector¹ expenditure and income

B64   Nonetheless, growth in private consumption has continued to moderate gradually from its most recent peak in 2000, when growth reached over 5 per cent. Retail sales growth fell back in the latter stages of 2002, with growth between the first and second halves at its slowest rate for over two years. While monthly sales growth picked up strongly in December, rising 1 per cent on November, this reflected the particularly late Christmas trading period in 2002. Thus, as widely anticipated, January saw a corresponding fallback in sales volumes; and another, albeit fractional, easing in February provided further confirmation that retail sales growth has slackened. In the year to February retail sales were 3.3 per cent up, around half the rate of growth seen in the year to February 2002. Moreover, excluding December, retail sales have remained virtually flat since October.

B65   Although retail sales account for only 35 per cent of household consumption, other evidence suggests that the slowdown in household expenditure is proving broad based. New car registrations have fallen back from record highs. Consumer confidence has also eased back in recent months; although consumers remain more positive over the outlook for their own finances, sentiment regarding prospects for the general economy has weakened considerably. The composite European Commission/GfK measure of consumer confidence has trended downwards since last summer and in March was at its lowest level since December 1995, albeit only just below its past long-run average. This possibly reflects a partially delayed reaction to last year's stock market turbulence, and renewed equity price weakness this year risks a further unravelling of confidence. However, shifts in confidence also suggest that volatility on financial markets in recent months have begun to have some adverse bearing on households' perceptions of economic prospects, while the recent moderation of underlying house price inflation may have further dampened consumer sentiment. Ongoing concerns over potential terrorist attacks in both the UK and US may also have played a role in reducing confidence.

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B66   Lower income growth in 2002 is likely to prompt a continued moderation of private consumption growth through this year. Further recent declines on world equity markets, compounding already sharply reduced valuations in 2000 and 2001, are also expected to feed through to consumption as households adjust spending patterns to reductions in net financial wealth. Moreover, with house price inflation showing signs of having peaked, more moderate growth in valuations can be expected to reduce some of the recent momentum in household consumption too. With household debt having risen rapidly in recent years, increasing by over 40 per cent since 1998, consumers' appetite for further borrowing is likely to wane.

B67   Nonetheless, the strong fundamentals that have militated against any abrupt reversal in the strength of private consumption growth remain in place. Household consumption is therefore expected to continue slowing gradually through this year, growing by 2³/₄ to 3 per cent in 2003 as a whole. Thereafter growth is forecast to remain at sustainable rates, and significantly below the average of 4¹/₄ per cent a year seen between 1996 and 2002.

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Investment

B68   Estimates of business investment from the beginning of 2001 have recently been revised up. As a result, business investment expenditure for last year as a whole is now estimated to have fallen by less, and to have been around 3¹/₂ per cent higher, than expected in the Pre-Budget Report.

B69   Nonetheless, these revisions have not significantly changed the recent pattern of business investment expenditure. Although there have been signs of business investment bottoming out, the subdued nature of the global recovery in 2002, together with ongoing international uncertainties, have continued to discourage firms from undertaking new investment. The CBI Industrial Trends Survey for the first quarter of 2003 showed that the importance of political and economic uncertainty as a constraint on investment intentions was at its highest since in the immediate aftermath of 11 September 2001, and similar to the levels witnessed at the height of the late 1990s' Asian crisis.

B70   The sharpest quarterly falls in business investment were concentrated over the second half of 2001 and into the first quarter of 2002, amidst significantly heightened uncertainty in the wake of 11 September. Business investment remained broadly flat between the first and second halves of last year, although it ended the year 5¹/₂ per cent lower than in late 2001. Ongoing international uncertainty and sharp falls on global equity markets through last year and into early 2003 have continued to blunt the incentive to invest.

Media link

• Chart B7: Business and non-residential investment ratios

B71   After the sharp downturn in ICT spending in 2001, high-technology investment declined further throughout 2002, accounting for over a quarter of the overall decline in current price business investment for the year as a whole. One factor that may have compounded the global investment downturn in keeping ICT spending subdued in recent years is an extension in the effective lives of many high-technology assets. While ICT equipment is subject to rapid obsolescence as new technologies come onto the market, machines bought around the end of the 1990s and in 2000 were massively more powerful than ones acquired a decade earlier, reflecting the marked increase in computer processor speed. As a result, firms may have been able to continue deriving service streams from ICT equipment for longer, diminishing the need for regular replacement and upgrading of computing systems and other high-technology assets.

B72   Nonetheless, there have been some early encouraging signs that the foundations necessary for a turnaround in business investment are beginning to emerge. Investment expenditure on software and hardware rose by almost 15 per cent in the third quarter and by a further 5³/₄ per cent in the final quarter of 2002. Moreover, both imports and production of capital equipment have shown some signs of having flattened out in recent months.

B73   Company profitability has shown encouraging signs of having stabilised. Rates of return in manufacturing have picked up from lows seen in 2001, while service sector rates remained broadly flat over last year as a whole. Moreover, private non-financial corporations have aggressively tackled debts accumulated during the investment boom of the late 1990s, and ran significant financial surpluses throughout last year.

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Table B7: Gross fixed capital formation

B74   Overall, these tentatively encouraging signs are consistent with private sector capital expenditure being at or close to its trough. Nonetheless, the main catalyst for a rebound in business investment in the second half of 2003 is still expected to be a strengthening of the global recovery.

B75   Mirroring the outlook for world growth, the Budget forecast shows business investment remaining subdued in early 2003, as the international environment continues to encourage a cautious approach to capital spending, but picking up from around the middle of the year and growing in the second half. In 2003 as a whole, business investment is forecast to decline by 1 to 1¹/₂ per cent, which masks growth of over 1¹/₄ per cent between the first and second halves of this year.

B76   As the global recovery gathers further momentum into 2004, and international uncertainties recede, postponed investment projects are expected to come back on stream as the outlook for demand improves. With firms having largely adjusted to the overhang from the investment boom of the late 1990s, a step-up in new ICT expenditure is expected to emerge over the course of the forecast horizon as a stronger world economy gives firms more confidence to upgrade and expand productive potential. Business investment is therefore forecast to grow by 4³/₄ to 5¹/₂ per cent next year and by 5¹/₄ to 6 per cent in 2005, accounting for a marked increase in its ratio to GDP.

Trade and the balance of payments

B77   A tentative recovery in world trade in the first half of 2002 temporarily boosted UK exports in the second quarter. However, faltering world trade growth in the second half was reflected in a sharp fall back in UK goods export volumes, which contracted by 5³/₄ per cent between the third and fourth quarters. So despite the spurt of growth earlier in the year, goods export volumes declined by nearly 2 per cent in 2002 as a whole, standing at their lowest level for three years in the final quarter. Services export volumes meanwhile increased marginally compared with 2001.

B78   The UK has recently seen a bigger decline in goods export volumes to non-EU markets than to the EU. Indeed, by value, a third of the decline in UK exports last year was attributable to the US alone. To some extent, this appears at odds with the pattern of global growth given GDP growth in the US outstripped that in the Euro-area last year. Moreover, although US imports were relatively weak in the third quarter of 2002, latest data show a sharp pick-up in the fourth quarter still coincided with a further weakening in UK exports to the US.

B79   Sterling has fallen by around 7 per cent against the euro since the 2002 Pre-Budget Report, and presently stands some 11 per cent lower than its most recent peak in February 2002. This should offer a spur to UK exports to the Euro-area. Although a corresponding increase of the sterling-dollar exchange rate over the past year is likely partially to offset any increase in UK market share at the global level, the composite Sterling Exchange Rate Index (ERI) has still eased back by around 7 per cent since early 2002, reflecting the far greater weight of the Euro-area in UK trade. Nonetheless, the lags typically judged to exist between exchange rate movements and trade flows mean that it is too early for these developments to have played a significant role in relative export trends in the course of 2002.

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Table B8: Trade in goods and services

B80   Imports appeared to resume growing in early 2002, having contracted over most of 2001 as weak manufacturing output and declining business investment reduced demand for both intermediate and capital goods. Nonetheless, any underlying turnaround in imports remains sluggish. Growth appears to have been inflated by a surge in imports of consumer goods through much of 2002, reflecting robust demand for new cars as well as the underlying strength of private consumption. However, with imports of non-car consumer goods having fallen back since the second quarter, goods import volumes in 2002 as a whole were less than 1 per cent up on 2001, and the underlying trend in import volumes in recent months now appears approximately flat.

B81   As a result of some recovery in imports and faltering exports, the deficit on trade in goods and services has widened since the first half of 2002. However, in 2002 as a whole it still narrowed as an increased surplus on services trade more than offset a widening in the goods deficit. This partly reflected a recovery in net exports of insurance services, following substantial insurance losses in 2001 arising from the 11 September tragedies. Moreover, in contrast to goods, underlying services export growth appears to have resumed in the second half of last year.

B82   As in the 2002 Pre-Budget Report, exports are expected to recover over the course of 2003 as world trade growth begins to gather increased momentum. Goods and services export volumes are forecast to rise by 1¹/₄ to 1¹/₂ per cent this year, slightly below the 2002 Pre-Budget Report projection as a result of a less pronounced pick-up in UK export market growth in the first half of the year, mainly reflecting a subdued near-term outlook for the Euro-area economies. Thereafter, exports are expected to strengthen considerably as the global recovery becomes more firmly entrenched and as the effects of increased UK price competitiveness from the recent weakening of sterling feed through. The volume of exports of goods and services is forecast to increase by 8¹/₄ to 8³/₄ per cent in 2004 and by 7 to 7¹/₂ per cent in 2005.

Media link

• Chart B8: Balance of payments current account

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B83   At the same time, a sustained recovery in manufacturing output and renewed growth of UK business investment are expected to feed through to a strengthening of import growth over the forecast horizon. Overall, export and import volumes are expected to grow at broadly comparable rates for the foreseeable future, with the goods and services trade deficit levelling off, at around 2¹/₄ per cent of GDP, by 2005.

B84   Partly as a result of recent revisions to Balance of Payments data, the current account deficit for 2002, at under £9 billion, was less than half the level forecast in the 2002 Pre-Budget Report. The main reason for this is a stronger position on investment income, with 2002 registering another record surplus. This surplus is expected to moderate over the forecast period as stronger domestic GDP growth raises the relative profitability of overseas businesses operating in the UK and hence investment income debits, especially amongst financial service companies who appear to have been particularly affected by the recent period of weak global growth. Although a strengthening external environment should also give a lift to UK earnings from overseas, the investment income surplus has been unusually high for the past two years or so, and the forecast assumes a return to a position more in line with historical experience. Together with a gradual widening of the deficit on trade in goods and services, this is expected to underpin a higher current account deficit in coming years. However, relative to GDP, the current deficit is expected to remain modest at around 2 per cent.

Table B9: Summary of economic prospects¹

¹The UK forecast is consistent with national accounts and balance of payments statistics to the fourth quarter of 2002, released by the Office for National Statistics on 27 March 2003. A detailed set of charts and tables relating to the economic forecast is available on the Treasury's internet site (http://www.hm-treasury.gov.uk), and copies can be obtained on request from the Treasury's Public Enquiry Unit (020 7270 4558).
²The forecast is based on the assumption that the exchange rate moves in line with an uncovered interest parity condition, consistent with the interest rates underlying the economic forecast.
³Consensus Forecasts, Consensus Economics Inc.

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Table B10: Gross domestic product and its components

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Budget Report 2003 index