The figures have also frightened the Government. The interest rate cut last Tuesday was both unexpected and costly to the financial markets (which had to spend an extra pounds 25m in Wednesday's gilt auction). It also smacked of political desperation. With interest rates at their lowest levels for 15 years, a weak exchange rate and a burgeoning fiscal deficit, the Government seems willing to try anything to kick-start recovery.
Whatever the political rationale behind such an approach, the economic case reflects concerns about a lingering recession turning into a slump. Recent sharp rises in unemployment and continuing falls in house prices appear to point in that direction. But there have also been a number of more promising economic indicators. This month's CBI Industrial Trends survey indicated a substantial upturn in business confidence in the last quarter of 1992. This was matched by significant growth in exports and manufacturing productivity.
Thus, although the economy remains weak, conditions do not appear to warrant the radically loose policy stance that is now in place. Nevertheless, after last week's interest rate cut it is now clear that the Government will take any action to get the economy growing. We thus expect GDP to grow by 1.2 per cent in 1993 and by 3.1 per cent in 1994. The real debate should now be over the consequences of the recovery for the trade balance and inflation.
Despite stagnant demand during 1992, import volumes grew by almost 8 per cent. Consequently, the visible trade deficit grew to pounds 13.9bn (compared with pounds 9.9bn in 1991) and import penetration as a share of total spending increased by 1.3 per cent. In fact, if imports had grown in line with their long-run trend in relation to domestic demand, the UK's GDP would have been little changed in 1992, instead of falling by 0.9 per cent.
However, such import growth did not necessarily reflect a supply side that was unable to produce sufficient goods. Import growth partly occurred due to restocking ahead of an anticipated recovery that failed to get under way, and partly due to an influx of capital goods (for instance, the tooling-up of Japanese car plants in Britain) that will soon add to the UK's productive capacity.
Furthermore, export volumes rose through 1992, and appear to have been particularly strong at the end of the year. This would not have occurred in the face of across-the-board supply constraints. Looking ahead, the gain to competitiveness arising from sterling's depreciation will also support a rise in the UK's share of world trade. This view is reflected in our forecast of the current account deficit: it remains at about 2 per cent of GDP throughout the recovery phase. The current account will also benefit from higher net property income from overseas, due to a stronger dollar.
This outlook for the current account is more optimistic than that of the latest Treasury forecast. This is because, in contrast to the Treasury, we do not expect the recovery to be consumer-led. The personal sector will remain subdued until 1994, notwithstanding the sharp cuts in interest rates that have occurred. Those who have gained from lower borrowing costs are, of course, largely balanced by the worsened position of savers, who are now earning less interest income.
We do not expect the savings ratio (as a percentage of personal disposable income) to fall below 10.5 per cent over the forecast period, given rising unemployment and the logjam in the housing market.
We, therefore, expect growth in consumer spending of only 0.7 per cent in 1993.
A consumer-led recovery is not desirable anyway. If, by further cuts in interest rates, the Government did engineer a significant decline in the savings ratio, and an upturn led by the consumer, the balance of payments would sink further into deficit. And a much-needed transfer of resources in favour of manufacturing and the tradable goods sector, set in train by devaluation, would be less likely to occur. Although our forecast of the balance of payments is worrying, the inflation risks following such a substantial easing in monetary and fiscal policy are immense. Recent evidence of inflationary pressure, since sterling left the ERM in September, is unclear.
Earnings growth has slowed, reaching 5 per cent on an underlying basis in the year to November. Settlements are also down, and a number of employers have announced pay freezes or wage cuts.
However, there have been a number of large price increases linked to the lower exchange rate - electrical goods, glass, steel and cars.
These are early days, though. Average earnings growth in the UK is still well above that of many of our competitors. And any moderation that has occurred over the last two years of ERM membership could dissipate rapidly.
Experience has also shown that UK earnings growth is not restrained by high unemployment itself. Nevertheless, earnings growth may well be subdued because of low rates of 'headline' inflation, resulting from reduced mortgage rates. The outlook thereafter will depend critically on the policy response. Only by reimposing a credible counter-inflationary framework can the gains to competitiveness from a lower exchange rate be made to stick. In our forecast, this occurs through re-entry to the ERM in mid-1994; without that assumption the outlook for inflation would be markedly more pessimistic. A credible counter-inflationary policy is not, in our view, consistent with further cuts in interest rates unless this is combined with substantial fiscal tightening.
The case for fiscal tightening rests upon the ballooning of government borrowing. However, the scale of any such moves will depend on signs of recovery between now and the Budget on 16 March. The more of these signs there are, the more fiscal tightening we would expect.
Further fiscal loosening is unlikely, given the scale of the financing requirement that already faces the Government. Much more likely is that, if the recovery remains elusive, the Chancellor will opt for fiscal neutrality but announce indirect tax increases well in advance, hoping to stimulate spending in the interim.
The justification for further reductions in interest rates below 6 per cent is limited. Treasury mandarins (quite rightly) are keen to wait and observe the results of easing of policy to date. But the Government may not heed these words of caution. And as a result they may well come to regret the consequences of their current actions in future years.
The authors are economists at Oxford Economic Forecasting
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