NIESR predicts pre-election boom for jobs and growth

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Economic growth will hit a peak in the run-up to a 2001 general election while unemployment will continue to fall for the rest of the decade, according to a golden scenario forecast today by one of the UK's most respected analysts.

Economic growth will hit a peak in the run-up to a 2001 general election while unemployment will continue to fall for the rest of the decade, according to a golden scenario forecast today by one of the UK's most respected analysts.

In its optimistic outlook, the National Institute for Economic and Social Research says that the economy will grow 3.2 per cent this year and 3.6 per cent in 2001, well above the economy's long-term trend and delivering the Government a handy pre-election boom.

It also forecasts above-trend growth until at least 2009 - although its long-range forecast assumes the UK joins the euro in 2005.

Despite the bullish outlook the institute predicts that inflation will stay marginally above the Government's target for most of the decade, with interest rates hitting a peak of 6.5 per cent - much lower than many analysts believe would be needed to tackle such strong growth.

"The sharp rise in government spending will undoubtedly boost the economy in the second half of the year and in 2001," said Garry Young, a National Institute economist.

"The increase in spending is awkwardly timed since the outlook for growth has improved."

This echoes the warning from National Institute director Martin Wheale to MPslast week. He said domestic demand would have to slow sharply to prevent the £43bn hike in state spending triggering an inflationary boom.

The forecast puts the National Institute well above even the most bullish of the City analysts, whose 2001 GDP estimates are within a range of 1.8 and 3.2 per cent, according to the latest survey carried out by the Treasury.

Mr Young admitted it represented a sharp upward revision to its forecast three months ago but said it was based on the fall in the exchange rate and the outlook for strong global growth. "I think [the City] has been waiting for someone to step out of line. I think you will now see the City consensus change," he said.

Mr Young said the economy would be driven by a surge in exports to meet booming world demand. Until recently, the UK's net trade deficit has wiped up to 2 per cent off GDP growth as the strength of the pound has depressed exports.

"Inflationary pressures will start to build up because the economy will be growing faster than its potential trend rate of growth at a time when there is little spare capacity," Mr Young said. "This will spur two further quarter-point rises in interest rates by the first quarter of next year."

Despite the bullish growth forecast, the underlying measure of inflation, which excludes housing costs, is forecast to stay below the Government's 2.5 per cent target this year and next.

But inflation will accelerate sharply, staying just above 3 per cent between 2005 and 2009. The National Institute warned there was a one-in-three chance that inflation would hit 3.5 per cent - the point at which the Bank of England has to write an open letter of explanation - in two years' time.

It said it was relying on two key factors - a decline in household spending and demand, and an improvement in productivity - to hold back inflation. Productivity of the British workforce since the start of the 1990s' recovery has stayed stubbornly around the long-term average of 2 per cent - poor compared with its main rivals.

The report forecasts a sharp pick-up in productivity to 2.9 per cent next year and 2002, allowing GDP to accelerate without triggering massive wage inflation. But it acknowledges that continued poor productivity would force firms to take on extra workers, which would in turn lead to a pick-up in wages.

Without productivity improvements, average earnings growth would peak at an unsustainable 7.2 per cent in 2002. Mr Young said: "There will definitely be strong demand growth over the next year but the question is whether we can do that without inflation picking up. Clearly there's an upside risk to inflation that might materialise without a pick-up in productivity growth."

Its forecast also assumes the UK joins the European single currency in five years' time at a historically high exchange rate against its European partners.

The National Institute assumes the UK joins the euro in 2005 at a rate of around 1.55 euros to the £1, equivalent to DM3.03 against the German currency, based on financial markets' expectations.

This is considerably above the range of DM2.70 to DM2.80 that groups such as the Confederation of British Industry would see as the rate that business could cope with.

"Many would regard this rate as being too high and it certainly implies a higher real exchange rate than the UK has been able to sustain historically," Mr Young said. But he said the economy had learned to adapt to a higher exchange rate and said industry would be able to adjust to the DM3.03 rate once the decision to join had been taken.