The latest picture of economic activity is encouraging: retail sales rose at an annual rate of 3.5 per cent in the first quarter; car registrations are strong; manufacturing output is up; unemployment fell again in March. These figures were reflected in the CSO's preliminary estimate of GDP, which showed the non-oil economy expanding by 0.6 per cent in the first quarter of 1994 to a level 2.6 per cent higher than a year earlier. Though it may not feel like it, the recovery is now two years old and longer than the recession that preceded it. Including the buoyant oil and gas sector, total output has risen to its pre-recession peak of nearly four years ago.
But with April's tax increases now upon us, and more to come, the durability of the UK upswing is in question. The likely reaction of consumers to VAT on fuel, reduced allowances for mortgage interest relief and married couples, plus increased national insurance contributions, is uncertain. But that reaction is critical, since it is consumer spending that has contributed so much to the recovery to date: total consumption rose nearly 5 per cent from the bottom of the cycle to the end of last year, around 1 1/2 percentage points more than GDP over the same period.
A dampening effect seems inevitable, but will it be enough to derail recovery? The additional personal sector taxes of the two Budgets last year amount to almost pounds 6.5bn, or around 1 1/4 per cent of personal disposable income. Pessimists point to the fragile state of consumer confidence and high levels of household debt. The last comparable fiscal tightening came in the spring Budget of 1981 and, at the time, it appeared to have an immediate negative impact on retail spending, which slowed recovery. But the effects were not permanent, with the trend in sales positive by the year end.
Our expectation that consumers' expenditure growth will be maintained at 2.7 per cent this year and next depends on a further fall in the savings ratio. It is certainly possible that the recent downward drift in personal savings could tail off or even go into reverse. But a further decline in the savings ratio seems more likely in an environment of falling unemployment and low inflation.
This adjustment would be reinforced if consumers expect looser policy in future: pre-election tax cuts, for example.
But not all the risks are on the downside. Although we do not disagree with the current consensus for a modest housing market recovery this year, the fundamentals are in place for a much stronger performance. House price-to-income and mortgage-gearing ratios are low, and the significant shift to fixed-rate mortgages has eliminated a large part of the risk associated with borrowing for home purchase.
Prospects are also improving for other components of demand, in particular investment. Total capital spending rose by 2.5 per cent in the final quarter of 1993. We expect investment to rise by nearly 6 per cent this year and 4.5 per cent in 1995. Driving this is the improvement in company finances in the past year, and growth in profits anticipated in the period ahead.
Other positive factors include low interest rates and the competitiveness of the UK trading sector at current exchange rates. We also expect a pick-up in export growth. Despite more subdued first-quarter figures, the US will continue to expand rapidly, while the main European economies should all see positive growth this year after declines in output in 1993.
Our overall forecast is for GDP growth of 2.8 per cent this year and 2.7 per cent in 1995, very close to the consensus among forecasters. Where we differ is in our assessment of inflation prospects. We do not see growth on the scale envisaged in our latest forecast posing any significant threat to inflation over the next 18 months. Though the full impact of Budget measures and other temporary factors may push up inflation during the rest of this year, we expect the underlying rate to be back around its current level, at 2.7 per cent in the fourth quarter of 1995. By contrast, the majority of other forecasters see the underlying rate rising much closer to the 4 per cent upper limit of the Government's target range by that stage. Despite the downbeat tone of the Bank of England's latest inflation report, we remain encouraged by the latest price signals. These included a sharp fall in the underlying rate of inflation to 2.4 per cent in March, the lowest since this series began in 1975. Underlying growth in producer prices is also very subdued. Our long-term view is that domestic prices will be kept in check by the significant gap between actual and potential output. Our own estimate of this 'output gap' is in the region of 4 per cent, assuming trend growth of 2 1/4 per cent per annum in the non-oil economy. Though somewhat lower estimates are plausible, the implication is that growth could be 1 per cent above trend for at least the next two years before whole economy supply bottlenecks begin to bite.
Even so, domestic prices could be disturbed via some other shock. Doubts are beginning to build as to whether the UK labour market can continue to turn in the excellent cost performance of the past year. Recent large-scale revisions to the employment figures have pushed up estimated growth of unit labour costs in manufacturing in the second half of 1993. Growth of average earnings meanwhile has ticked up 0.5 percentage points in the early months of 1994. With unemployment set to continue downward, there are clear dangers ahead. However, our view is that the degree of labour market tightening implied by the headline statistics is overstated. Falling unemployment remains as much a result of depressed labour market participation as rising employment and, where the latter, is more than accounted for by rising part-time employment, which will exert less upward wage pressure.
We said three months ago that the absence of a significant inflation risk and the temptation for the Government to crank up the pace of recovery would lead to a further loosening of monetary policy, with interest rates falling to 4 per cent by mid-1995. However, sterling financial markets have been adversely affected in the wake of interest rate increases by the US Federal Reserve. Yields on long-dated gilts have risen by about 1 1/2 percentage points, rather greater than the adjustment in comparable US and German bonds. This move has partly reflected a deterioration in inflation expectations as shown by the widening gap between yields on conventional and index-linked gilts.
This clearly limits the Government's room for manoeuvre, as does the decision to publish minutes of the monthly meetings between the Chancellor and the Governor of the Bank of England. It may be Mr Clarke agreed to publish because he believes interest rates have bottomed and wants to divert the blame for subsequent increases on to the Bank. So a consensus is emerging among forecasters that UK rates will not fall further unless recovery starts to falter or sterling appreciates to an uncomfortable extent. Even the CBI has broken with tradition by expressing no strong desire for further cuts.
Our judgement is that the markets may be overstating the upside risk on inflation both in the UK and Europe. We expect German rates to fall further, creating room for a quarter-point cut in UK base rates, while permitting the re-emergence of a positive interest differential in the UK's favour. This should underpin sterling, as will the gathering momentum of economic recovery, despite the political uncertainties.
The authors are with Oxford Economic Forecasting
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