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ANNEX A: THE ECONOMY

Monetary and fiscal stability, together with improved underlying labour market performance, has created a foundation of steady growth and low inflation in the UK economy. The challenge ahead lies in maintaining economic stability, and improving productivity and employment opportunity for all, so delivering stronger sustained growth in output:

The UK economy has witnessed continued strong growth combined with low inflation in 2000. The number of people in work has risen by more than one million since spring 1997, and the employment rate is now close to its previous record high.

Underlying pay pressures have, nevertheless, remained subdued. This signals a fall in the sustainable rate of unemployment over recent years, boosting trend output growth and helping to keep interest rates historically low.

The Monetary Policy Committee has raised interest rates pre-emptively, noting that domestic demand growth needed to slow. As in Budget 2000, GDP is forecast to grow by 3 per cent in 2000, easing to its assumed sustainable rate of 21/4 to 23/4 per cent in 2001 and later years.

RPIX inflation is now expected to rise gradually back to 21/2 per cent by mid-2001, remaining at the Government's target thereafter. The short-term risk of excess growth in demand is balanced by the possibility of continued favourable developments in costs and margins.

There is considerable scope for stronger non-inflationary growth through seizing opportunities to step up the pace of productivity gains and further moves towards full employment.

Real oil prices remain significantly below late 1970s to mid-1980s levels, and global oil dependency has fallen significantly since then. But higher oil prices, if sustained, pose a clear risk to global inflation and growth.

Introduction

A1. This annex discusses economic developments since Budget 2000, and provides updated forecasts for the UK and world economies in the period to 2003. The overview section sets out the key points, summarising UK economic prospects in the light of the recent underlying improvement in labour market performance and its implications for trend output growth. More detailed forecast issues and risks are discussed in the second half of this annex, followed by a summary of the world economy outlook.

UK ECONOMY OVERVIEW

Table A1: Summary of forecast

Forecast
1999 2000 2001 2002 2003
GDP growth (per cent) 21/4 3 21/4 to 23/4 21/4 to 23/4 21/4 to 23/4
RPIX inflation (per cent, Q4) 21/4 21/4 21/2 21/2 21/2

The economy in 2000

A2. The UK economy has experienced continued strong growth in output and employment combined with low inflation since Budget 2000. The preliminary estimate of GDP showed total output rising by 0.7 per cent in the third quarter and by 2.9 per cent over the past year, exceeding its estimated trend rate. Growth had strengthened rapidly during the course of 1999, as buoyant domestic demand drove the economy out of a temporary slowing that was partly associated with the slowdown in global activity. Helped by low inflation, proactive policy responses, and a sharper than expected improvement in external demand, this was one of the most rapid recoveries in UK growth since the 1960s.

A3. The labour market remains buoyant, with activity further strengthening in the period since March. The Labour Force Survey (LFS) measure of employment has risen to a series of record highs, and in the three months to August was 330,000 higher than a year earlier. International Labour Organisation (ILO) and claimant count unemployment have fallen to their lowest rates since the 1970s. Underlying growth in average earnings has, nevertheless, edged below 41/2 per cent, and the headline measure eased significantly during the second quarter as the impact of bonuses and one-off millennium-related payments dissipated.

A4. Growth in unit labour costs has fallen following a strong cyclical recovery in whole economy productivity growth, and continued competitive pressures have contributed to a further compression of producer and retail margins. RPIX inflation therefore remained just over 2 per cent in the third quarter, despite stronger upward pressure from import prices, and has fluctuated in a very narrow range throughout 2000. On the Harmonised Index of Consumer Prices (HICP) measure, UK inflation was 1.0 per cent in September, remaining the lowest in the EU. Performance over recent years contrasts sharply with the UK's historical record as a relatively high and volatile inflation country.

A5. Latest data suggest that the softening in economic activity in the first quarter of 2000 was a temporary reaction to exceptional strength in demand in the run up to the new millennium. There was no run down of inventories as had been widely expected, but growth in final demand fell back. GDP rose by a modest 0.5 per cent overall, though partly reflecting an erratic decline in energy-related output. However, this pattern was quickly reversed with rapid growth in domestic demand driving a 0.9 per cent increase in GDP in the second quarter.

A6. Overall, GDP rose by 1.3 per cent in the first half of 2000 compared to the previous half year, closely in line with the Budget forecast, and with final domestic demand growth easing from the strong rates of expansion seen in 1999. Household consumption growth has shown some further moderation, though it still exceeds longer-term sustainable rates. Lower than expected growth in total domestic demand has largely reflected some temporary

weakness in government spending. This was broadly offset by surprisingly robust growth in goods export volumes, due to rapid growth in UK export markets. The contribution of net trade to GDP growth therefore has remained much more neutral than in previous years, continuing the clear improvement seen since mid-1999.

A7. Service sector activity remains strong, with output rising by 3.3 per cent in the year to the third quarter. Industrial production and construction output have also firmed and so divergence in performance between sectors has narrowed markedly over the past year. Manufacturing output rose by 0.6 per cent in the third quarter and was 0.9 per cent higher than a year earlier. While sterling's strength has had a disproportionate impact on manufacturing activity over recent years, variation in performance within the sector has been marked. A number of export-intensive businesses such as engineering and chemicals have recorded relatively strong gains in real output, as have some industries typically exposed to a high degree of foreign competition in the home market.

The labour market

A8. Strong and stable economic growth has led to a marked improvement in labour market performance over recent years. LFS employment has increased by more than one million in total since spring 1997, pushing the working-age employment rate to just below its previous 75 per cent peak reached in 1990. Unemployment has also fallen markedly, on the ILO measure from 7.2 per cent in spring 1997 to 5.3 per cent currently.

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A9. Growth in LFS employment looks to have strengthened in the period since Budget 2000, rising 80,000 in the three months to August compared to the previous three months. Growth in the alternative workforce jobs series has been more erratic, rising by 69,000 between June and March but showing little change in the first quarter. This may partly reflect sampling methods, but also continuing falls in the number of people with second jobs3. The proportion of temporary or part-time employees not able to find permanent or full-time employment has fallen significantly over the past year.

A10. Buoyant survey indicators and record numbers of vacancies suggest that labour demand will remain robust. With unemployment reaching new lows, it has become increasingly important that rising demand is matched by increased labour market participation. Working-age participation continues to rise modestly, though by less than in previous cycles, and so remains below the last peak recorded in 1990. In addition to the 1.6 million ILO unemployed, there are a further 2.3 million people of working age who are economically inactive but want a job. As set out in chapter 4, the challenge ahead lies with expanding the effective supply of labour, helping the economy to grow more rapidly without encountering skill shortages and excess cost pressures.

A11. The headline measure of whole economy earnings growth has fallen from a peak of 6.0 per cent in the three months to February to 3.9 per cent in the three months to August, driven by a deceleration in private service sector pay. This recent trend owes much to a sharp decline in the contribution of bonuses to overall pay growth, which turned sharply negative in the months after April. However, growth in underlying earnings (excluding bonuses) has also edged below 41/2 per cent during the course of 2000, with stronger first quarter outturns probably boosted by one-off payments associated with the millennium.

A12. Underlying pay settlements - which exclude so-called 'drift' elements of total earnings such as overtime payments and bonuses - have, nevertheless, been rising recently. The Industrial Relations Services (IRS) measure of 3-month median whole economy settlements has risen by around 1/2 percentage point to 3 per cent currently, with Confederation of British Industry (CBI) data showing a similar upturn. This may provide a clearer indication of underlying labour market tightness, though rising headline RPI inflation has probably also been a factor. This suggests that that real wage bargaining is still partly backward-looking despite some further decline in workers' expectations of future inflation in recent years. Greater credibility in the inflation target, nevertheless, will have helped to contain labour cost pressures, even with the economy operating just above trend.

A13. Whole economy productivity growth recovered to 2.4 per cent in the second quarter of 2000, driving a fall in unit wage cost growth to just 1.1 per cent. Although volatile shorter-term movements in productivity and unit costs can be misleading, underlying earnings growth of around 41/2 per cent recently appears sustainable given estimated trend productivity growth of 2 per cent a year. The absence of any upturn in wage inflation or trend unit wage costs growth4 since the first half of 1997 signals an underlying improvement in the trade-off between unemployment and inflation over recent years. Box A1 examines some possible explanations for this apparent fall in the non-accelerating inflation rate of unemployment (NAIRU). The implications for trend output growth are set out in the next section.

Box A1: The sustainable rate of unemployment

Higher levels of unemployment, indicating an excess supply of labour, can be thought of as exerting downward pressure on pay, resolving the competing real wage aspirations of workers and firms. Greater responsiveness of real wages to unemployment therefore allows stable inflation to be achieved with lower levels of unemployment and hence higher output. Similarly, a sustained reduction in unemployment can be achieved if external wage or price pressures fall, for example through enhanced product market competition or as a result of more intensive job search as returns to work relative to welfare are improved.

Much of the decline in unemployment during the late 1990s has been concentrated among the long-term unemployed. Long periods without employment can discourage individuals from actively searching for work and make them less attractive to potential employers due to loss of skills. As a result, the long-term unemployed may exert relatively little downward pressure on wages, perhaps explaining muted upward pressure on earnings growth as people in this group have returned to work. This fall in long-term unemployment will partly reflect a succession of labour market programmes, including a contribution from the New Deals in recent years.

This has been helped by a reduction in regional and skills mismatch compared to the first half of the 1990s. As set out in Budget 2000, divergence in unemployment rates between regions has fallen by roughly a third during the 1990s and regional dispersion in the number of unemployed per vacancy has also narrowed sharply. More efficient matching of workers and jobs may reflect improved job search on the part of the unemployed, again at least partly associated with the Welfare to Work initiative. In addition, there is some evidence of reduced skills mismatch during the late 1990s, with the CBI skilled labour shortage indicator remaining quite close to its long-run average despite strong economic growth over recent years.

Recent developments in product markets are also likely to have contributed to the fall in the NAIRU. Downward pressure on business margins boosts workers' real pay, helping contain nominal earnings growth at lower levels of unemployment. Evidence of sustained competitive pressure on margins remains widespread, with a trend towards outright deflation in a number of retail goods sectors. This partly reflects sterling's strength, but also structural changes including greater consumer price consciousness and enhanced potential for competition facilitated by new technology.

Any judgement on the NAIRU is subject to considerable uncertainty. While there are good grounds for thinking it has fallen to well below 6 per cent on the ILO measure in recent years, more pessimistic interpretations are possible. Sterling's earlier appreciation may have temporarily lowered wage pressures and hence the NAIRU, boosting the real 'consumption wage' though cheaper imports. This effect could unwind as has, decisively over the past year, the potential contribution from previously low oil prices. It will be some time before the contribution of such factors can be fully assessed.

Trend output growth and the output gap

A14. There have been significant revisions to key national accounts aggregates compared to the estimates available at the time of Budget 2000. In June, the Office for National Statistics (ONS) increased its average estimate of GDP growth in 1998 to 2.6 per cent from 2.2 per cent previously. This was more than accounted for by stronger household consumption growth and reinforced by a more modest upward revision to growth in 1999. The revisions were somewhat larger measured from the output side, leaving the level of gross value added at constant prices in the fourth quarter of 1999 some 1.2 percentage points higher than the estimate available in March.

A15. Conceivably, these upward revisions to GDP growth could be interpreted entirely as signalling greater cyclical strength in the economy, implying a correspondingly larger estimate of the output gap. Alternatively, stronger GDP growth might reflect higher trend output growth, with the cyclical position of the UK economy broadly unchanged. In practice, any assessment should be based on a range of evidence including measures of capacity utilisation, the apparent degree of domestic price pressures, and the fundamental drivers of trend output growth over recent years.

A16. Business survey indicators of capacity and labour utilisation are broadly consistent with the economy being at or close to trend around mid-1999. For manufacturing, both the CBI and British Chamber of Commerce (BCC) measures were close to their long-run averages at this point, as was the CBI indicator of skilled labour shortages. In services, the BCC capacity indicator exceeded its long-run average throughout the year, but remained close to its level during the first half of 1997 when the economy is previously estimated to have been on trend.

A17. Wage and price inflation have remained subdued over this period, though it is difficult to disentangle underlying domestic pressures from the downward impact of sterling's earlier appreciation. The upturn in underlying service sector inflation over recent years, for example, poses the risk that fairly significant pressures on capacity have emerged. However, the absence of any clear trend in domestic cost growth suggests that output has remained fairly close to productive potential throughout. Buoyant GDP growth over recent years - averaging just over 21/2 per cent a year between the first half of 1997 and mid-1999 - therefore appears to have been broadly matched by an equivalent expansion in trend output.

A18. Table A2 provides a simple5 decomposition of estimated trend output growth in recent years, together with a comparison with the earlier 1990s and the neutral assumptions underlying the GDP forecast ranges presented in this annex. Compared to the earlier 1990s, the most striking development in recent years has been the sharp increase in the employment rate. Allowing for employment responding to output with some lag, this is estimated to have risen by 0.5 per cent a year on a trend basis between 1997 and 1999. With the labour market inactivity rate having only edged down over this period, the employment rate trend corresponds to a fall in the NAIRU of similar magnitude. Thus over the past three years the NAIRU might have fallen by around 11/2 percentage points, to around 51/2 per cent, broadly in line with the fall in the actual unemployment rate.

Table A2: Contributions to trend output growth

Estimated trend rates of growth1, per cent per annum
Trend labour productivity2 Trend employment rate4 Population of working age5 Trend output
Underlying3 Actual
(1) (2) (3) (4) (5)
1990Q4 to 1997H1 2.06 2.1 -0.2 0.3 21/4
1997H1 to mid-1999 1.95 1.6 0.5 0.5 21/2
Forecast7 2.05 1.9 0.1 0.5 21/2

1 Treasury analysis based on the judgement that 1990Q4, 1997H1 and mid-1999 were on-trend points of the output cycle, and allowing for employment lagging output in order to estimate trend growth rates for employment and labour productivity. Figures independently rounded.
Columns (2) + (3) + (4) = (5)
2 Output per workforce job.
3 Adjusted for effect of changes in employment rate, i.e. assuming the employment rate had remained constant.
Column (1) - column (2) = (1-a). column (3), where a is the ratio of new to average worker productivity levels. The figuring is consistent with this ratio being of the order of 50 per cent, as suggested by data on relative entry wages.
4 Ratio of workforce jobs to working-age household population.
5 UK household basis.
6 Estimated from a regression of productivity growth on employment rate growth and the output gap over a complete output cycle from 1986Q2 to 1997H1.
7 Neutral case assumptions underlying the mid-points of the GDP growth ranges from 2001Q1.



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A19. This judgement is, of course, subject to considerable uncertainty. The main risk is that unemployment has fallen significantly below its sustainable rate, and hence that the economy is much further above trend than estimated. This would imply reduced scope for non-inflationary growth in the period ahead and, from a fiscal policy perspective, a weaker structural starting position for the projections of the public finances. This risk is analysed in Chapter 2, demonstrating that the Government would remain on track to meet its fiscal rules even on less favourable assumptions concerning the current cyclical position of the UK economy - the cautious case.

A20. Strong employment gains in recent years have been accompanied by subdued productivity growth, which has been below its long-run rate since 1995. This mainly reflects the temporary impact of bringing large numbers of people back into employment, as those entering work tend to have lower than average productivity levels. Adjusting for this transitory impact on productivity growth, Table A2 shows that in underlying terms the expansion in trend productivity over recent years has been close to the average for the earlier 1990s.

A21. The recent trend is still puzzling, nevertheless, given strong business investment growth and the rapid increase in Information and Communications Technology (ICT) usage. It contrasts sharply with recent US experience, where rising ICT intensity has been credited with contributing to a significant acceleration in trend productivity (see Box A2). However, such comparisons with the US also raise some important statistical issues, including the difficulty of measuring real output gains for new technology products where prices and quality are changing rapidly. The ONS is actively engaged in examining 'new economy' measurement issues6.

A22. As in Budget 2000, the mid-point of the Pre-Budget Report GDP forecast ranges are anchored on a neutral assumption of 21/2 per cent a year trend output growth. This assumes trend productivity growth of 2 per cent in underlying terms, as estimated for the pre-1997 cycle, and only a very modest trend increase in the employment rate compared to the recent past. Revised projections from the Government Actuary's Department now show 0.5 per cent a year medium-term growth in the population of working age, 0.1 percentage points higher than previously expected. This small revision has not changed the neutral assumption for trend output growth itself. Projections for the public finances continue to be based on the cautious 21/4 per cent a year trend growth assumption, as they will be in Budget 2001.

A23. Downside risks to trend output growth are at least balanced by the possibility of continued underlying improvements in supply performance, illustrated by the upper ends of the GDP forecast ranges. Indeed, recent evidence from the US points to considerable opportunities for accelerated productivity performance based on capital deepening through ICT investment and associated diffusion of know-how across the economy. Herein lies part of the productivity challenge which, together with the Government's aim to secure further progress towards full employment, opens up the potential for sustainable growth beyond the upper ends of the GDP forecast ranges (see Box A2).

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Output and demand

A24. GDP is expected to grow at an annualised rate of 3 per cent during the second half of 2000, reflecting some near-term firming in final demand. GfK consumer confidence remains above long-run levels, with household expectations of their own future financial position at a record level in October. Strong household spending will be reinforced by a pick up in government consumption from a relatively weak first half, partly reflecting the carry forward of underspends from the previous financial year.

A25. These developments will sustain rapid service sector growth. Manufacturing activity is likely to remain more muted for a period, though latest data show that the deterioration in business survey indicators following sterling's temporary peak in May overstated the potential impact on output. GDP is forecast to grow by 3 per cent in 2000 as a whole, unchanged from the Budget 2000 forecast. This does not include any explicit allowance for the effects of the disruption of fuel supplies in September, which appear to have been modest at the whole economy level.

A26. Based on the re-assessment of trend output growth over recent years, the economy is judged to be operating just above its supply potential at present. The output gap is estimated to have risen gradually to around 1/2 per cent currently, with most survey measures of capacity utilisation moving just above their long-run averages since mid-1999. Strong output growth, nevertheless, can be accommodated for a period, with upward short-term pressures on domestic costs helping push RPIX inflation back up towards its target rate. However, as the Bank of England's Monetary Policy Committee (MPC) has made clear, it is important that growth in aggregate demand does not out-pace potential output growth for long.

Box A2: Sustaining stronger growth with low inflation - supply side opportunities

The Pre-Budget Report projects a modest slowing in GDP growth in order to prevent inflation from rising above target in the medium term, so preserving long-term economic stability. However, despite a clear short-term risk that growth in domestic demand may not fall back as expected, the inflation outlook remains very finely balanced.

At the producer level, underlying growth in output prices has been relatively restrained despite much stronger upward pressures on input prices, particularly due to dearer oil. For retailers, competitive pressures remain intense and margins are still being squeezed in a number of sectors. The MPC regularly considers a range of plausible alternative assumptions for the future trend in margins, with significant implications for the inflation outlook1. Even in the event of stronger than expected domestic or external cost pressures, there is a clear possibility that this could be offset by continued favourable developments in prices relative to costs.

The trade-off between output growth and inflation might be more permanently improved through stronger medium-term growth in productivity. The manufacturing sector in particular will be looking to build on recent productivity improvements in order to restore profitability. Currently low levels of unemployment will encourage firms more generally to meet increases in demand through higher productivity. According to some independent forecasters, notably the National Institute for Economic and Social Research, such factors might underpin a period of 'catch-up' over the coming years, with average productivity growth rising well above the 1990s' trend2.

Moreover, the Pre-Budget Report forecast does not assume any underlying improvements in supply performance associated with the adoption of 'new economy' technologies and related diffusion of know-how. In the US, however, the strength and longevity of the growth upswing has prompted re-assessment of the evidence. While earlier studies had concluded that most of the improvements in US productivity could be explained by more efficient production as opposed to use of ICT equipment, there is now more support for the view that economy-wide capital deepening is paying dividends (see also Box 3.1). With strong UK private investment spending in the late 1990s apparently focused on ICT and other specialist equipment, there is a good chance that firms here may be able to emulate US performance to some degree.

Therefore businesses, individuals and the Government are faced with the challenge to secure a significantly stronger productivity performance than the 2 per cent a year trend assumption that underlies the mid-points of the Pre-Budget Report forecast ranges. Despite very favourable labour market developments in recent years, the neutral assessment of trend output growth also assumes only a 0.1 percentage points a year reduction in the sustainable rate of unemployment, mainly reflecting the long-term increase in female participation. Government policies to extend employment opportunity to all open up the possibility of much stronger improvements in underlying labour market performance. So there are considerable opportunities which, if taken, could sustain stronger GDP growth at or beyond the upper ends of the Pre-Budget Report forecast ranges.
1Bank of England Inflation Report, August 2000.
2National Institute Economic Review, No. 173, July 2000.

A27. Household consumption growth is forecast to slow further in the period ahead. Pro-active monetary policy tightening from September 1999 has already had a substantial impact, with the full effects likely to build further into 2001. Household responsiveness to interest rate changes now appears stronger than in the past, perhaps reflecting increased policy credibility as well as greater household caution following the experience of the early 1990s. In addition, support to consumer spending from past gains in household wealth is declining rapidly. Equity prices have shown no underlying growth for a year and house prices have recently been decelerating. These factors should contribute to a gradual recovery in the household saving ratio, which has recently fallen to low levels (see Box A4).

A28. Business investment growth has slowed broadly in line with the Budget 2000 forecast, though this is likely to be temporary. Manufacturing investment has begun to pick up with stronger external demand boosting output prospects, and service sector spending rebounded in the second quarter. A gradual strengthening in investment growth is therefore expected, keeping the business investment to GDP ratio close to record levels, but with already significant company deficits preventing a more rapid expansion. Net trade performance is also improving, despite the persistent weakness of the euro and rapid growth in import volumes. UK exporters' market share may be stabilising, particularly in non-EU markets, and net exports are expected to exert only a modest drag on GDP growth from now on.

A29. Government spending on key priorities, including health and education, is set to increase over the next three years, as set out in Budget 2000 and the 2000 Spending Review. The implications for aggregate demand and inflation, however, will depend on the overall fiscal position, which will remain historically tight over the next few years. Growth in private demand has remained rapid despite the significant fiscal tightening since 1996-97. This may reflect long adjustment lags and also some clear tendency for private saving rates to adjust to offset reductions in government borrowing. In either case, this suggests that the overall impact on aggregate demand of future movements in the fiscal stance is likely to be relatively modest, helping to explain still benign financial market expectations of interest rates in the period since Budget 2000.

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A30. Domestic demand growth is forecast to slow to 21/2 to 3 per cent in 2001, with GDP rising by 21/4 to 23/4 per cent overall. However, the pace of expansion in demand and output is expected to fall just below trend rates during the year. This appears necessary to eliminate the output gap gradually and so prevent RPIX inflation moving above the Government's target in the medium term. This is reflected in some further decline in annual domestic demand growth to 21/4 to 23/4 per cent in 2002, with continued moderation in household consumption offsetting stronger business investment growth. Combined with a still modest negative contribution from net trade, GDP is forecast to grow by 21/4 to 23/4 per cent in 2002, remaining at this rate in 2003.

A31. Forecast risks are discussed in the second half of this annex. In particular, there remains a clear possibility of more rapid growth in consumption and investment. While this would tend to boost wage pressures, the short-term inflation outlook remains very finely balanced. Following some evidence of improved underlying economic performance over recent years, Box A2 examines the possibilities for stronger growth combined with low inflation. Upside risks are still balanced principally by the possibility of weaker growth in net exports. Global demand remains susceptible to revaluations in equity prices, and now also the possibility of persistent strength in oil prices (see Box A3).

Inflation

A32. RPIX inflation was 2.1 per cent in the third quarter of 2000, in line with the Budget 2000 forecast. The deflationary trend in retail goods prices has more than accounted for the modest undershoot of RPIX inflation relative to target, driven by a 16 per cent decline in import prices of goods and services between spring 1996 and late 1999. Assessing the degree of underlying domestic price pressures is not straightforward. The Bank of England's RPIX excluding import prices measure of domestically-generated inflation has fallen over recent years, to around 21/2 per cent currently. However, the full impact of sterling's earlier appreciation goes well beyond direct movements in import price inflation, and is also likely to have been more drawn out.

A33. Inflation in the service sector, which is relatively sheltered from international competition and hence movements in the exchange rate, provides another guide. Excluding rent and utilities, it has risen by more than 1 percentage point since the first half of 1997 to around 51/2 per cent currently, and is now above the 1990s' average. According to simple analysis of the past short-run trade-off between output and inflation, this would point to a larger output gap currently than is embodied in the Pre-Budget Report forecast (chart A2). This upside risk is balanced by the absence of any upward trend in domestic cost growth over the same period, suggesting that output has remained close to trend throughout.

A34. Import prices rose gradually in the first half of 2000. Growth in world non-oil commodity prices remains relatively restrained, but has been boosted for UK importers due to sterling's recent decline against the dollar. Rising cost pressures overall have been dominated by the sharp increase in crude oil prices to more than $30 per barrel recently, up from $27 per barrel at Budget time and a low of $10 per barrel in early 1999. Producer input price inflation has risen to double-digit rates, driving a significant upturn in total manufacturing cost growth to around 41/2 per cent. Service sector firms, by contrast, are likely to have seen profits improve as a result of the recent decline in average earnings growth.

A35. For many manufacturers, it has been difficult to pass on cost increases. Producer output price inflation has been running at around 21/2 per cent in recent months, and remains significantly lower on an underlying basis. Margins have also been squeezed at the retail level, with around half of goods sectors now showing year-on-year reductions in prices. Evidence from the CBI's Industrial Trends and Distributive Trades surveys suggests that competitive pressures are likely to remain intense in the shorter term. Beyond that, the forecast assumes that margins cannot continue to be squeezed at their current rate. This judgement is subject to downside risk, not least reflecting on going technological changes such as the growth of e-commerce.

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A36. RPIX inflation is now expected to rise gradually back to its 21/2 per cent target in mid-2001, a little later than anticipated in the Budget 2000 forecast. Direct pressures from higher oil prices have so far been offset by a deeper compression in margins. Although oil prices are assumed to fall back towards the middle of the $22-28 per barrel OPEC target band by end- 2001, the wider inflationary impact could be more drawn out (see Box A3). Import price inflation has now turned positive, boosting total cost growth. Combined with a declining negative contribution from falling business margins, this accounts for the anticipated rise in RPIX inflation. Further moderation in domestic demand should help to keep growth in average earnings within sustainable limits, though there remain some clear upside risks.

A37. GDP deflator inflation is forecast to be 2 per cent in 2000-01, down from 2.5 per cent in 1999-2000. This reflects currently low consumers' expenditure deflator (CED) inflation and the unwinding of the previously positive contribution from the terms of trade. It is expected to return to 21/2 per cent in 2001-02, as CED inflation moves back in line with RPIX.

Box A3: The economic impact of higher oil prices

Oil prices have risen sharply since their trough of $10 per barrel in early 1999, to more than $30 per barrel in September 2000 as world demand strengthened against a background of weaker than expected OPEC supply (chart A8). Prices eased temporarily following OPEC's announcement of a modest increase in supply and the US government's decision to release 30 million barrels from its strategic stockpile. However, recent tension in the Middle East drove prices to a 10-year high of $35 per barrel in mid-October.

The Pre-Budget Report audited assumption is that prices fall back towards the middle of the $22-28 per barrel OPEC target band by end-2001, as both OPEC and non-OPEC production is stepped up and oil product stocks are rebuilt. However, the near-term outlook is subject to a number of upside risks, not least from continued speculative activity. In the US - the world's biggest consumer of oil - economic activity has outstripped expectations and crude oil stocks have fallen to their lowest level since the mid-1970s.

By raising production costs and so constraining supply, higher oil prices tend to depress GDP growth, simultaneously pushing up inflation and unemployment. As an illustration, the International Monetary Fund (IMF) estimates that a $10 per barrel increase in oil prices lasting for 1 year may reduce OECD growth by around 0.4 percentage points, at the same time raising price levels by 0.4 to 0.8 percentage points1. In practice, the overall economic effects will depend largely on second round impacts on wages and other prices, as well as movements in business and consumer confidence.

Currently high stock market valuations and significant global current account imbalances heighten the threat posed to the world economy by a prolonged hike in oil prices. Nevertheless, there are a number of reasons for believing that it is now better placed to deal with such a shock. Global oil dependency has fallen sharply, following a doubling of oil efficiency in the US and Europe since the early 1970s. Moreover, real oil prices are well below half their peak in late 1979, and more than 40 per cent lower than their average from then through to 1985. Greater anti-inflation policy credibility should help contain second round impacts on wages and prices, as will the perceived temporary nature of the current increase in oil prices.

The UK differs from most other major industrialised economies in that it is a small net exporter of oil. Potential output losses therefore may be partly offset by increased North Sea production and gains to UK incomes due to the improvement in the terms of trade. While UK exports more generally will be affected by any reduction in global activity due to dearer oil, the overall outlook for world trade growth is buoyant. Higher oil prices impact directly on the RPI mainly through increased motoring costs, with increased petrol prices on average contributing 0.6 percentage points to inflation in 2000. Wider impacts have so far been relatively muted, with producers able to pass on only a small part of the sharp increase in input prices. However, this compression in producer margins might not be sustainable in the longer term, should oil prices stay at high levels.
1 World Economic Outlook, IMF, October 2000.

A38. The independent consensus for GDP growth in 2000 is currently 3.0 per cent, just below its April peak. On average, growth is expected to ease to 2.7 per cent in 2001, mainly reflecting slower growth in household consumption. The average of medium-term forecasts regularly monitored by the Treasury shows growth of around 21/2 per cent during the period 2002 to 2004, consistent with the Pre-Budget Report neutral assessment of trend growth.

A39. RPIX inflation is expected to remain below target in the short-term, though the average independent projection for the fourth quarter of 2000 has edged up to 2.1 per cent. It is expected to rise gradually to 2.4 per cent by the fourth quarter of 2001. Independent forecasts for the balance of payments current account have changed little since Budget 2000, with deficits of around 13/4 per cent of GDP projected in both 2000 and 2001.

Table A3: Pre-Budget Report and independent1 forecasts

 Percentage changes on a year earlier unless otherwise stated
2000 2001
Independent Independent
Pre- Budget Report Average Range Pre- Budget Report Average Range
Gross domestic product 3 3.0 2.7 to 3.3 21/4 to 23/4 2.7 1.5 to 3.3
RPIX (Q4) 21/4 2.1 1.5 to 2.4 21/2 2.4 1.3 to 3.7
Current account (£ billion) -141/4 -15.9 -27.5 to -9.0 -15 -18.2 -28.2 to -7.2
1 'Forecasts for the UK Economy: A Comparison of Independent Forecasts', October 2000.



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UK FORECAST IN DETAIL

The household sector

A40. Household consumption rose by 0.7 and 0.8 per cent in the first and second quarters of 2000 respectively, a considerable moderation from the very rapid rates of expansion seen through much of 1999. Services expenditure has accounted for the bulk of this slowing, reinforced by lower growth in durables spending in the second quarter as housing market activity cooled. Non-durables expenditure has remained more robust, driven by strong underlying growth in retail sales volumes throughout 2000. Lower general economy optimism has caused measures of consumer confidence to decline, though household perceptions of their own financial position remain historically high. Growth in consumer credit has eased from high levels, but the Bank of England estimates that mortgage equity withdrawal rebounded quite sharply in the second quarter.

A41. House prices have decelerated sharply in 2000, with annual inflation falling from a peak of more than 15 per cent at the turn of the year to 10 per cent on the Nationwide measure and lower according to the Halifax. Housing transactions have also declined, falling below their long-run average in recent months. Recent developments reflect increases in interest rates and the abolition of MIRAS, and followed a decline in measures of housing affordability during the second half of 1999. Further moderation in house price inflation is likely during the course of 2001, though there is a clear chance of renewed housing market vigour should the economy fail to slow as expected. The recent trend may have been exaggerated by the unusual strength of housing market activity ahead of Budget 2000, and the level of mortgage loan approvals remains high.

Box A4: Household saving and borrowing

The household saving ratio fell from rates of around 10 per cent in the mid-1990s to 5 per cent in 1999. Some fall was to be expected compared to previous cycles, with sustained low inflation and greater economic stability reducing the need for precautionary saving. The further fall in the saving ratio to 3 per cent in the second quarter of 2000 has, nevertheless, prompted some commentators to make comparisons with the late 1980s. However, this masks marked divergences in the pattern of gross saving and borrowing between then and now, reflecting different structural and cyclical influences on household behaviour.

Gross borrowing rose to record rates of around 15 per cent of incomes in the late 1980s, significantly higher than today. Gross household saving increased to a lesser extent and almost exclusively in the form of liquid spendable balances. Increased long-term secured borrowing in particular helped fund the housing investment boom, but was also used to finance everyday consumption - a process known as equity withdrawal. This peaked at over 6 per cent of disposable income in 1988, facilitated by financial liberalisation and rapid house price inflation. The failure of monetary policy to react to clear signs of overheating had encouraged a sharp, though ultimately unrealistic, upward revision to household expectations of future income growth.

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The eventual doubling of interest rates to 15 per cent in late 1989 prompted a prolonged period of household retrenchment to restore balance sheets. With debt having risen to record levels in relation to incomes, households were faced by soaring debt service costs, sharp falls in nominal house prices, and the erosion of real financial wealth due to higher inflation in the early 1990s. Total wealth fell sharply relative to incomes, and the saving ratio rose to 12 per cent in 1992. Continued perceptions of job insecurity and widespread negative housing equity subsequently helped keep the saving ratio well above normal levels until 1996. Households showed little appetite for new debt as the economy strengthened, with gross borrowing rising only gradually from its 1993 trough.

Strong growth in asset prices has since driven household wealth to record levels relative to incomes. This has helped sustain consumer confidence at high levels contributing to the sharp reduction in net saving in the late 1990s. However, gross saving as a proportion of income has remained robust, with long-term saving in particular still close to its 1990s average last year. Household investment has increased gradually, but with the flow of funds into housing assets limited by enhanced policy credibility and lower inflation expectations. Similarly, the recent increase in equity withdrawal has been relatively restrained.

Therefore a key feature that distinguishes current household behaviour from the late 1980s is that gross household borrowing has remained much lower, despite rising to around 10 per cent of income in 1999. The proactive monetary policy tightening since the second half of 1999 is expected to restrain gross borrowing, as will the significant deceleration in asset prices over the past year. Gross saving is likely to be underpinned by the new framework for economic stability and Government measures to encourage long-term saving (see Chapter 5). Thus the household saving ratio is expected to recover gradually. Any further weakening would pose risks to the economic outlook.

A42. Household income growth is set to remain robust given labour market tightness, with consumers' real purchasing power further boosted by competitive retail pricing. Consumption growth, nevertheless, is expected to fall just below trend rates of expansion in the period ahead. It is forecast to fall to 21/4 to 21/2 per cent in 2001 and 13/4 to 21/4 per cent in 2002, consistent with a gradual recovery in the household saving ratio to around 6 per cent by 2003. The contribution of past gains in household wealth to consumption growth has eased considerably during 2000, with a further deceleration in prospect next year. The impact of previous proactive monetary policy tightening is also likely to build. Box A4 contrasts the recent trend in saving and borrowing with the late 1980s, though still high levels of consumer confidence pose some clear short-term risks.

Table A4: Household sector1 expenditure and income

Percentage changes on previous year
Forecast
1999 2000 2001 2002 2003
Household consumption2 41/4 31/2 21/4 to 21/2 13/4 to 21/4 2 to 21/2
Real household disposable income 31/2 4 3 to 31/4 23/4 to 31/4 21/4 to 23/4
Saving ratio (level, per cent) 51/4 41/2 43/4 53/4 6
1 Including non-profit institutions serving households.
2 At constant prices.

Companies and investment

A43. As expected in Budget 2000 and earlier forecasts, business investment has decelerated significantly since early 1999, though remains at an historically high level in relation to GDP (see Chart A5). It rose by 0.5 per cent in the second quarter, contributing to growth of just 1.5 per cent over the past year. Service sector capital spending in particular has decelerated significantly, following a sharp increase in the ratio of services business investment to output during the late 1990s. Rising capital intensity in services has partly reflected new technological requirements, including millennium preparations, installation of euro compliant systems, and rapid advances in telecommunications infrastructure. Manufacturing business investment, by contrast, fell sharply in the year to mid-1999, reflecting weaker output growth and declining profitability. These falls have subsequently been partly reversed, bringing annual growth in manufacturing investment back in line with services at around 3 per cent in the second quarter.

A44. Private non-financial corporations (PNFC) gross saving fell markedly to 8.8 per cent of nominal GDP in 1999, largely reflecting a sharp increase in dividend payments with profits unchanged on the previous year. But investment only partly depends on availability of internal company finance, and PNFC fixed capital formation has remained close to its recent peak of around 11 per cent of GDP, despite the recent slowdown. The strong stock market and historically low interest rates have reduced the real cost of capital, and there has been a sharp increase in company borrowing to bridge the financing gap. PNFC net borrowing was just under 2 per cent of GDP in 1999, though it has eased in 2000 as profits and company saving firmed. Increased company indebtedness has been matched by strong growth in company assets: traditional measures of capital gearing therefore remain relatively benign, but company balance sheets have become more vulnerable to changes in market asset valuations.

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A45. The forecast assumes that firms will wish to curtail borrowing further in the period ahead, preventing a return to rapid rates of expansion in capital spending. Survey evidence of rising capacity utilisation and increased profit expectations in 1999, nevertheless, points to a gradual strengthening in investment growth. BCC investment intentions have risen, though CBI survey evidence still paints a weaker picture. Business investment growth is expected to rise to 21/4 to 23/4 per cent by 2002, with spending as a proportion of GDP remaining very close to its recent record high across the forecast horizon. There is, however, a clear possibility of further increases in economy-wide ICT capital intensity due to technological change, for example due to increased spending associated with e-commerce strategies.

Table A5: Gross fixed capital formation

Percentage changes on previous year
Forecast
1999 2000 2001 2002 2003
Whole economy1 6 21/2 41/4 to 41/2 33/4 to 41/4 31/4 to 33/4
of which:
Business2,3 71/2 13/4 11/2 to 2 21/4 to 23/4 21/2 to 3
Private dwellings3 23/4 1 11/2 to 13/4 2 to 21/2 2 to 21/2
General government3,4 11/2 11 313/4 161/4 101/2
1 Includes costs associated with the transfer of ownership of land and existing buildings.
2 Private sector and public corporations' (except National Health Service Trusts) non-residential investment. Includes investment under the Private Finance Initiative.
3 Excludes purchases less sales of land and existing buildings.
4 Includes National Health Service Trusts.

A46. Growth in private residential investment has fallen to low levels recently, despite increased housebuilders' profitability due to strong gains in prices. However, private housing starts so far in 2000 are well above levels last year and so private residential investment growth is expected to strengthen gradually in the period ahead, reaching 2 to 21/2 per cent by 2002. Total fixed investment growth is forecast to rise more sharply, from 21/2 per cent in 2000 to an average of 33/4 to 41/4 per cent over the next three years, mainly due to the sharp programmed increase in general government investment. Budget 2000 set out the Government's commitment to raise public sector net investment to 1.8 per cent of GDP by 2003-04.

Trade and the balance of payments

A47. The widening of the UK balance of payments deficit since 1997 has levelled out significantly over the past year. The non-oil trade deficit was 2.5 per cent of GDP in the first half of 2000, rising only modestly compared to the previous half year and somewhat lower than forecast in Budget 2000. This turnaround has been due to the sharp acceleration in external demand, with UK export markets now expected to grow by over 9 per cent in 2000 as a whole. Total export volumes rose at a similar rate in the year to the second quarter of 2000, with latest monthly data showing continued strength into the second half of the year. Competitive import prices combined with buoyant domestic demand has, nevertheless, led to slightly stronger growth in import volumes. Net exports therefore have continued to restrain UK growth in 2000, but much more modestly than in previous years.

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A48. Firms have responded to sterling's strength by cutting export prices significantly since late 1996, helping to contain the overall deterioration in price competitiveness and loss of export market share. The share fell markedly in the period to early 1999, but has since shown clear signs of stabilisation, particularly in non-EU markets. At the same time, strong growth in manufacturing productivity over the past year has helped to restore domestic cost competitiveness, permitting a modest upturn in export prices during 2000. Export volumes are now expected to grow by 8 per cent in 2000 overall, gradually easing to 51/2 to 6 per cent by 2003 as growth in UK export markets falls back to more normal rates. The trade forecast assumes no further loss of export market share, though this judgement is subject to downside risk due to the persistent weakness of the euro.

A49. Import penetration has risen significantly over recent years, reflecting the protracted fall in import prices since spring 1996. It has stepped up markedly since mid-1999, following some earlier signs of stabilisation, more than offsetting the recent moderation in domestic demand growth. Total import volumes therefore rose by nearly 11 per cent in the year to the second quarter of 2000, with growth in goods imports from non-EU countries in particular remaining very strong in the third quarter. Import volumes are now expected to grow by

71/4 to 71/2 per cent in 2001, a significant upward revision from the Budget 2000 forecast, but lower than in 2000 and easing further in later years as domestic demand growth falls back to trend rates and import price inflation picks up further.

A50. Net export volumes overall are forecast to reduce UK GDP growth by 0.7 percentage points in 2000, down from 1.6 percentage points in 1999, and a little less than expected in March. This is reflected in a 0.3 percentage point downward revision to the trade in goods and services deficit, which is now forecast at around 2 per cent of GDP in 2000. Although growth in import volumes is broadly expected to match export volumes in later years, the deficit is forecast to rise to around 21/2 per cent of GDP due to a modest deterioration in the terms of trade.

A51. The current account deficit is now expected to be 11/2 per cent of GDP in 2000,

3/4 percentage points lower that forecast in Budget 2000, partly reflecting a stronger than expected combined surplus on investment income and transfers during the first half of the year. This surplus is likely to be sustained, with the current account deficit overall peaking at 13/4 per cent of GDP in 2002 before falling back in 2003. Such deficits appear readily financeable given the strength of private sector balance sheets, though national saving may need to rise to secure further sustained improvements in the UK investment ratio.

Table A6: Trade in goods and services

 Percentage changes on previous year £ billion
Volumes Prices £ billion
Exports Imports Exports Imports Terms of trade2 Goods and services balance
1999 31/4 73/4 -11/4 -21/2 11/4 -151/4
Forecast
2000 8 9 2 2 0 -191/2
2001 7 to 71/2 71/4 to 71/2 3 33/4 -1/2 -231/2
2002 6 to 61/2 6 to 61/2 23/4 3 0 -26
2003 51/2 to 6 51/2 to 6 21/2 21/2 0 -281/4
1 Average value indices.
2 Ratio of export to import prices.



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Table A7: Summary of economic prospects1

Percentage changes on a year earlier unless otherwise stated
Forecast2
1999 2000 2001 2002 2003 Average errors from past forecasts3
Output at constant market prices
Gross domestic product (GDP) 21/4 3 21/4 to 23/4 21/4 to 23/4 21/4 to 23/4 1
Manufacturing output 0 11/4 2 to 21/4 13/4 to 21/4 13/4 to 21/4 2
Expenditure components of GDP at constant market prices4
Domestic demand 33/4 31/2 21/2 to 3 21/4 to 23/4 21/4 to 23/4 11/4
Household consumption5 41/4 31/2 21/4 to 21/2 13/4 to 21/4 2 to 21/2 11/4
General government consumption 31/4 21/4 4 4 31/2 11/2
Fixed investment 6 21/2 41/4 to 41/2 33/4 to 41/4 31/4 to 33/4 23/4
Change in inventories6 -3/4 1/2 -1/4 -1/4 to 0 -1/4 1/4
Export of goods and services 31/4 8 7 to 71/2 6 to 61/2 51/2 to 6 2
Imports of goods and services 73/4 9 71/4 to 71/2 6 to 61/2 51/2 to 6 2
Balance of payments current account
£ billion -11 -141/4 -15 ­171/2 -163/4 61/2
per cent of GDP -11/4 -11/2 ­11/2 -13/4 -11/2 3/4
Inflation
RPIX (Q4) 21/4 21/4 21/2 21/2 21/2 1
Producer output prices (Q4)7 11/4 2 2 2 21/4 11/4
GDP deflator at market prices (financial year) 21/2 2 21/2 21/2 21/2 1
Money GDP at market prices (financial year)
£ billion 904 950 995 to 999 1042 to 1051 1091 to 1106 12
percentage change 5 5 43/4 to 51/4 43/4 to 51/4 43/4 to 51/4 11/4



1 The forecast is consistent with the national accounts and balance of payments statistics to the second quarter of 2000, released by the Office for National Statistics on 27 September 2000, and the preliminary GDP estimate for the third quarter released on 20 October.
2 The size of the growth ranges for GDP components may differ from those for total GDP growth because of rounding and the assumed invariance of the levels of public spending within the forecast ranges.
3 Average absolute errors for year-ahead projections made in autumn forecasts over the past ten years. The average errors for the current account are calculated as a per cent of GDP, with £ billion figures calculated by scaling the errors by forecast money GDP in 2001.
4 Further detail on the expenditure components of GDP is given in Table A8.
5 Includes households and non-profit institutions serving households.
6 Contribution to GDP growth, percentage points.
7 Excluding excise duties.

Table A8: Gross domestic product and its components

£ billion at 1995 prices, seasonally adjusted
Household consumption1 General government consumption Fixed investment Change in inventories Domestic demand2 Exports of goods and services Total final expenditure Lessimports of goods and services Plus statistical discrepancy3 GDP at market prices
1999 531.4 147.8 153.3 -1.4 831.5 250.4 1081.9 286.6 -0.6 794.7
2000 550.2 151.0 157.0 2.4 860.6 270.3 1130.9 312.2 -0.4 818.3
2001 562.1 to 563.8 157.0 163.6 to 164.1 0.4 to 0.9 883.2 to 885.9 289.4 to 290.3 1172.6 to 1176.2 334.7 to 335.7 -0.4 837.5 to 840.1
2002 571.5 to 576.1 163.3 169.7 to 171.0 -0.6 to 0.7 903.9 to 911.1 306.5 to 309.0 1210.4 to 1220.1 354.7 to 357.5 -0.4 855.4 to 862.2
2003 582.9 to 590.5 169.1 175.4 to 177.6 -2.6 to -0.4 924.8 to 936.8 323.5 to 327.6 1248.3 to 1264.4 374.1 to 379.0 -0.4 873.8 to 885.1
1999 1st half 263.1 73.9 76.0 -1.2 411.9 121.4 533.3 139.1 -0.3 393.9
2nd half 268.3 74.0 77.3 -0.2 419.6 129.0 548.6 147.5 -0.3 400.8
2000 1st half 273.2 74.3 77.5 1.4 426.3 132.4 558.8 152.4 -0.2 406.1
2nd half 277.1 76.7 79.5 1.0 434.3 137.8 572.1 159.8 -0.2 412.1
2001 1st half 279.9 to 280.4 77.9 81.2 to 81.4 0.1 to 0.2 439.1 to 439.9 142.5 to 142.8 581.7 to 582.7 164.8 to 165.1 -0.2 416.7 to 417.4
2nd half 282.1 to 283.3 79.2 82.4 to 82.8 0.3 to 0.7 444.0 to 445.9 146.9 to 147.5 590.9 to 593.4 169.9 to 170.6 -0.2 420.8 to 422.6
2002 1st half 284.5 to 286.4 80.8 84.0 to 84.6 -0.1 to 0.5 449.3 to 452.3 151.1 to 152.1 600.4 to 604.5 174.9 to 176.0 -0.2 425.3 to 428.2
2nd half 287.0 to 289.7 82.5 85.6 to 86.4 -0.5 to 0.2 454.6 to 458.8 155.4 to 156.8 610.0 to 615.6 179.8 to 181.5 -0.2 430.0 to 434.0
2003 1st half 289.9 to 293.3 84.1 87.1 to 88.1 -1.3 to -0.4 459.8 to 465.2 159.6 to 161.4 619.4 to 626.6 184.6 to 186.8 -0.2 434.6 to 439.7
2nd half 293.0 to 297.1 85.0 88.2 to 89.5 -1.2 to -0.1 465.0 to 471.6 163.9 to 166.2 628.9 to 637.8 189.5 to 192.2 -0.2 439.2 to 445.4
Percentage changes on previous year4, 5
1999 41/4 31/4 6 -3/4 33/4 31/4 31/2 73/4 0 21/4
2000 31/2 21/4 2 1/2 1/2 31/2 8 41/2 9 0 3
2001 21/4 to 21/2 4 41/4 to 41/2 -1/4 21/2 to 3 7 to 71/2 33/4 to 4 71/4 to 71/2 0 21/4 to 23/4
2002 13/4 to 21/4 4 33/4 to 41/4 -1/4 to 0 21/4 to 23/4 6 to 61/2 31/4 to 33/4 6 to 61/2 0 21/4 to 23/4
2003 2 to 21/2 31/2 31/4 to 33/4 -1/4 21/4 to 23/4 51/2 to 6 31/4 to 33/4 51/2 to 6 0 21/4 to 23/4



1 Includes households and non-profit institutions serving households.
2 Also includes acquisitions less disposals of valuables.
3 Expenditure adjustment.
4 For change in inventories and the statistical discrepancy, changes are expressed as a per cent of GDP.
5 Growth ranges for GDP components do not necessarily sum to the 1/2 percentage point ranges for GDP growth because of rounding and the assumed invariance of the levels of public spending within the forecast ranges.

THE WORLD ECONOMY

Overview

A52. The world economic outlook has strengthened considerably since the Budget. Growth in all major regions has surpassed expectations, and a more balanced pattern of economic activity is emerging in the G7. World trade has also picked up, driven by buoyant US demand. Better policymaking has helped to strengthen economic fundamentals in many developing countries, leading to improved access to capital markets. But high oil prices, if sustained, could impede the current expansion and trigger higher inflation. Significant current account imbalances, high equity valuations, and recent movements in the major exchange rates also pose risks for the world economy.

Percentage change on a year earlier
Forecast
19991 2000 2001 2002 2003
Major 7 countries2
Real GDP 23/4 4 3 23/4 23/4
Consumer price inflation3 13/4 21/2 21/4 21/4 21/4
World trade in goods 53/4 11 73/4 63/4 61/4
UK export markets4 7 91/4 7 6 53/4




1 Estimates, except consumer price inflation.
2 G7: US, Japan, Germany, France, UK, Italy and Canada.
3 Final quarter of each period. For UK, RPIX.
4 Other countries' imports of manufactures weighted according to their importance in UK exports.

G7 activity

A53. The balance of G7 output and demand is expected to improve gradually next year as Japan's recovery becomes established, European growth continues and the US economy begins to slow. G7 growth is expected to peak at 4 per cent this year before falling back to

3 per cent in 2001 and 23/4 per cent in 2002. Japan is the only economy where activity is expected to strengthen next year, as improvements in industrial output and exports boost incomes and confidence.

A54. Euro area activity is now stronger than expected, boosted by the global recovery and currency weakness. High levels of consumer and business confidence have been accompanied by a significant decline in unemployment. The weak euro and higher oil prices have prompted the European Central Bank to raise interest rates by 13/4 percentage points during 2000, which seems likely to stabilise growth at healthy levels.

A55. The US expansion continues to exceed expectations, and there is increasing evidence that the economy can sustain stronger growth than previously without triggering inflation. Strong labour productivity growth, buoyant consumer confidence and robust investment spending should underpin still solid growth into 2001. However, sluggish equity prices, dearer oil and monetary tightening are expected to dampen the pace of expansion further ahead. The current account deficit continues to widen, increasing the risk of financial market instability if financing were to become a problem.

Rest of the world

A56. The recovery from the 1997-98 crises has taken firmer hold, aided by rapid export market growth, stronger domestic confidence and improving investor sentiment. The IMF expects all regions of the world to grow faster this year than they did in 1999, with particularly rapid growth in large economies such as Mexico and Russia. Some countries, including Brazil, are benefiting from structural reform and fiscal consolidation, which should improve their medium-term prospects. However, a number of countries, particularly in Latin America, still have large external financing requirements. Turbulence in global financial markets would pose a risk to financial flows and growth prospects.

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World trade

A57. World trade is expected to grow by 11 per cent this year, nearly double last year's rate of 53/4 per cent. The rapid recovery in European exports and improving prospects in Latin America and Asia explain much of this improvement. World trade growth is expected to fall back to a healthy 73/4 per cent in 2001, as the global economy slows. Strong domestic demand in the US, Europe and parts of Asia is projected to boost UK export market growth to 91/4 per cent in 2000, much stronger than expected at the time of the Budget. Although prospects remain good, UK export market growth is expected to fall back in the next few years, in particular reflecting the US slowdown.

G7 inflation

A58. The sharp rise in oil prices this year has helped to push up headline inflation in the major economies. However, core inflation remains relatively subdued and there has been little upward pressure from wages so far. Inflation expectations do not appear to have risen during the year and there is still spare capacity in some major economies, notably Japan. These factors suggest that G7 inflation will fall back next year as oil prices decline. However, the unexpected extent and persistence of the rise in headline consumer prices in both the US and the Euro Area means that there could be some secondary pressures on wages and prices in 2001. This risk will increase if oil prices remain high (see Box A3).

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Non-oil commodity prices

A59. The risk to inflation from non-oil commodity prices is low. Prices are only slightly higher than a year ago, and significantly below pre-Asian crisis levels. Metals continue to be the main source of price growth, whilst agricultural prices have yet to show clear signs of recovery. Relatively slow growth in non-oil commodity prices has been surprising, given the rapid strengthening in world demand. Prices are expected to remain stagnant in 2001, as increasing supply and high stock levels keep price pressures in check.

1The forecast is consistent with national accounts and balance of payments statistics to the second quarter of 2000 released by the Office for National Statistics on 27 September, and the preliminary GDP estimate for the third quarter released on 20 October. 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.
3The LFS series is based on a rolling household survey and measures the number of people in employment. The workforce jobs series is an employer-based survey providing a snapshot of the number of jobs on one particular day in the final month of each quarter.
4Average earnings divided by estimated trend productivity.
5In this framework, the contributions of the capital stock per worker and total factor productivity to trend output are subsumed in estimated labour productivity (output per worker).
6See Productivity in the UK: The evidence and the Government's approach, HM Treasury, November 2000.

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