Conditions now appear ripe for a robust recovery of domestic demand, both consumer spending and business investment. The policy stance is very loose: interest rates are at their lowest levels for 16 years, sterling has fallen by 13 per cent compared with a year ago, and the PSBR is running at around pounds lbn per week. Fears that high levels of indebtedness would reduce consumers' willingness to open their wallets appear to have been overstated.
Indeed, recent evidence suggests demand is already gaining speed. Retail sales volumes rose by 4.1 per cent in the year to March, car registrations in the first four months of 1993 were well up on that period in 1992, and the housing market is showing signs of improvement.
After falling by 2.1 per cent in 1991 and stabilising last year, consumer spending is expected to rise by 2.6 per cent in 1993. The turnaround in investment spending is even more pronounced. Excluding public sector investment, this category of demand fell by 10.4 per cent in 1991 and by 2.8 per cent in 1992 but is expected to grow by about that amount this year.
Overall GDP will expand by 1.7 per cent, taking 1993 as a whole, with the pace picking up through the year. For 1994, GDP growth is expected to be close to 3 per cent. This is somewhat faster than the trend rate of growth of productive potential, implying that unemployment will come down (although it is likely to rise above the three million mark in months ahead).
Following two years of negative growth there is now considerable spare capacity in the economy. The level of productive potential may be some 5 per cent higher than the current level of output. High unemployment is one symptom of this; another is the deceleration of inflation. Consumer prices (excluding mortgage interest payments) are rising at their slowest rate since 1986. And earnings growth - for so long the Achilles' heel of the British economy - has fallen to levels last seen in 1967.
Retail price inflation will begin to rise over the remainder of 1993. One factor is sharply higher import prices in the wake of sterling's decline following its exit from the ERM. Firms will also take the opportunity provided by strengthening demand to raise profit margins. Nonetheless the underlying rate of inflation is expected to remain just inside the Government's 1 per cent to 4 per cent target range during 1993 and 1994, reflecting relatively subdued wage growth. Over a longer perspective, doubts remain about the UK's tendency to inflate during periods of growth.
Such doubts are addressed in this forecast by assuming that sterling re-enters the ERM during 1994. By stabilising the exchange rate and reinforcing the credibility of the Government's counter-inflation strategy, this permits a better trade-off between growth and inflation than achieved in the 1970s and 1980s.
The current account deficit is certain to widen over the near term. One reason for this is the rise in import prices arising from sterling's fall (this is the so-called J-curve impact of depreciation). But another, more important, reason is the divergence between the UK and the rest of Europe.
The UK will be the only EC country to register growth in 1993, and will also register the fastest rate of expansion in 1994. Recession in Germany and elsewhere means lower demand for UK exports, while stronger domestic demand will partly be met by higher imports, despite the fact that the UK's competitiveness in international trade will be some 20 per cent better in 1993 than in 1992.
This de-coupling of the UK from continental Europe has important policy implications. In the first place, it is a barrier to sterling rejoining the ERM, which is not a feasible option until a reasonable amount of convergence of economic performance has been achieved. In this forecast, convergence arises through recovery in the rest of Europe during 1994. Secondly, the UK's relatively rapid growth is likely to lead to upward pressure on sterling (despite the growing trade imbalance). This is because continental interest rates will fall sharply over the next 12 months as the severity of the downturn outweighs the Bundesbank's concerns over the inflationary consequences of German re-unification.
It is therefore possible over this period that UK authorities will face a re-run of 1987, when there was a conflict between upward pressure on UK interest rates needed to curb domestic demand, and downward pressure on interest rates needed to prevent sterling rising against the D-mark. At that time, Chancellor Nigel Lawson erred too far towards the latter course. After six years of growth, falling interest rates led to overheating of demand. But cutting interest rates would be the right thing to do if similar conditions emerge in 1993-94, when the fledgling recovery could be stopped in its tracks by too rapid an appreciation of sterling.
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