The golden scenario of restrained inflation and high growth could play for three more years

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The Independent Online
TO A seasoned observer of the UK economy, accustomed to perennial crises and a generally lack-lustre performance, the picture painted in our latest forecast might seem too good to be true.

We expect growth of more than 3 per cent both this year and next to be accompanied by an inflation rate within the Government's target range. We also predict a striking improvement in our trading performance - the current account deficit is expected to be slightly better by 1997 than in 1993.

There will, of course, be some increase in inflationary pressures as the economic recovery progresses. But we anticipate that underlying inflation (excluding the impact of movements in mortgage interest rates) will be contained within the Government's target range by quite small increases in interest rates. We expect short rates to rise by 0.25 per cent next month, but two years from now it seems unlikely they will have breached 7 per cent.

However, as we explain below, it is by no means clear that even this outcome will be sufficiently rosy to give John Major a victory in the next general election, not least because the electorate may be hankering after more than can responsibly be delivered.

So far, most of the increase in GDP during the recovery has stemmed from growth in consumer spending. For example, in the year to the first quarter of 1994 consumption grew by 3.5 per cent, but GDP excluding oil and gas production grew by only 2.25 per cent. Over the same period, post-tax disposable incomes in real terms grew by only 1.5 per cent - in other words, people financed increases in consumption to a large extent by saving less of their incomes.

For the recovery to continue it is important that consumer spending continues to grow, but over-dependence on this source of growth could provoke inflation and balance of payments problems. We do not, anyhow, expect much faster growth in consumption, what with the stuttering housing market, very high levels of consumer debt relative both to past UK experience and to the position in competitor countries (see chart) and accumulated tax increases.

What is required is more balanced growth in the economy, and for this we need a stronger performance by fixed investment and exports.

We do, in fact, expect a strong recovery in exports, which look set to grow by 9 per cent and 7 per cent in 1995 and 1996. Many will view these growth rates as optimistic, especially since exports grew by just over 3 per cent in 1993 despite the big devaluation of sterling in the autumn of 1992. However, it is important to remember that the benefits of devaluation can take some time to come through and that the rest of Europe was mired in recession throughout most of last year. Thus in 1993 exports to the European Union rose by some 5 per cent to pounds 63.5bn, while exports to other countries rose by 23 per cent to pounds 57.3bn. Exports to those countries outside the EU have continued to rise strongly in 1994, and in the second quarter they were 10 per cent higher than in the same quarter a year ago. Exports to EU countries are, however, now starting to sparkle. Because of the new Intrasat system we have data only to April 1994. But in that month, exports to the EU were nearly 17 per cent up on a year earlier. We expect the European recovery to gather pace over the coming months and, since the UK is still very competitive (see chart), we expect export growth to stay healthy for some time.

We are less confident about investment, partly because it has grown only modestly so far, despite rises in demand and low interest rates. In particular, investment by companies appears to be growing more slowly than during previous upturns. To an extent, this must reflect continued doubts on the part of firms about the durability of the recovery and fears about rises in interest rates. Moreover, the Confederation of British Industry and the Bank of England have also highlighted the high returns companies require in order to justify more investment. For example, the CBI survey shows firms looking for an average rate of return of 17 per cent on capital spending, with 43 per cent wanting more than 20 per cent. Firms that assess investment in terms of payback period are also very demanding. The average payback is less than three years, with 66 per cent expecting investment projects to pay for themselves in between two and three years. The Bank of England carried out a survey of 250 companies in March. It found 70 per cent of businesses had not reduced their target rates of return to take account of low inflation.

Both the studies are worrying, but do not necessarily indicate that investment will not grow sharply in 1994-95. The financial position of companies has now improved dramatically - industrial and commercial companies (ICCs) were in record surplus in the first quarter of 1994. Furthermore, ICCs are much more profitable now than they were at equivalent stages in previous recoveries. The pretax return on capital in the non-North Sea sector was 9.5 per cent in the first quarter of this year, almost double that at the same stage in 1982-84.

Since demand is expected to continue to grow and interest rates to stay relatively low, we believe that companies will soon decide to spend the surplus. At least in part, some of this spending will be on productive investment. Even so, we expect manufacturing investment in 1995 to be below the levels of 1988-90.

But can all this be achieved without unacceptably high inflation? The performance here has been better than many commentators expected. But there is now cause for concern, with capacity utilisation rising, narrow money (M0) above its target range, commodity prices perking up, and signs that average earnings may be about to increase. Many commentators are worried that inflation is set to rise sharply, reaching 5 per cent or more over the next year or so. This in turn would undermine our optimism about growth as high inflation and consequential higher interest rates would weaken investment and exports (because of poor competitiveness).

We accept that such an outcome was more than likely during similar recovery periods of previous cycles. However, we believe it is less likely this time for a number of reasons. Firstly, because the depth of recession, unemployment levels and output gaps all indicate an amount of spare capacity that must exert substantial downward pressure on inflation.

Secondly, while the recovery we are projecting shows growth rising somewhat faster than trend and thus unemployment falling, we do not expect a boom. It is therefore still the case that some capacity should be available even in 1996.

Thirdly, international competitive pressures will help limit price increases.

Finally, and perhaps more controversially, labour market reforms may well mean that wage pressures will be a little more subdued during this recovery than in the 1970s. (To some extent, this appeared to be the case even in the boom of the late 1980s.)

None of the above is sufficient justification for expecting no rise in inflation over the next year or so. Profit margins are likely to rise a little as the recovery continues. Partly as a result, the balance of companies intending to raise prices in the coming months as revealed in the CBI survey increased from -1 in the April survey to +12 in June-July. Oil and commodity prices are now rising rather than falling (and may rise quite rapidly over the next 12 months). Furthermore, wage settlements are set to pick up from the very low levels seen during recent years. These factors will push price inflation up to 3.5-4 per cent over the next year or so, as earnings increases move to the 5-6 per cent range. Only if earnings increases rose to 7-8 per cent or more, or if there were commodity or oil price explosions, would inflation rise to over 5 per cent.

What does all this mean for the next election, due by June 1997 at the latest? Our forecast suggests that in the six to nine months before this, unemployment will be just under 7 per cent, consumer spending growth will be 2.75-3 per cent and inflation around 3 per cent - a rosy scenario for John Major to contemplate on his holidays this summer.

However, this may not be sufficient for him to feel optimistic about winning that election. Part of the problem may be the desire of the electorate for change after 17 years of Tory rule. Another may be the attraction of Tony Blair, the new Labour leader. Our economic scenario may not, in any case, be rosy enough for the electorate. In the late 1980s, people became used to consumer spending growth of 7 per cent and big rises in house prices that made them feel wealthy. It could well be that they feel entitled to more of the same - an outcome that would be bad for the economy, and which the Chancellor, Kenneth Clarke, says he is determined to prevent.

But the political cost of this caution may ultimately seem too high and the temptation to cut taxes sharply may be difficult to resist. Will the Governor of the Bank of England then have the last word?

----------------------------------------------------------------- THE OXFORD UK FORECAST ----------------------------------------------------------------- Annual percentage changes, 1993 1994 1995 1996 1997 1998 unless otherwise specified GDP AND ITS COMPONENTS GDP (average measure) 1.9 3.2 3.2 2.7 2.1 1.8 Consumer expenditure 2.5 2.9 3.0 2.9 2.8 2.4 Government consumption 0.2 1.1 0.5 0.5 0.6 0.6 Investment 0.4 6.4 5.8 4.5 2.8 -0.2 Stockbuilding (% of GDP) 0.1 0.1 0.4 0.5 0.4 0.1 Exports of goods and services 3.1 6.9 8.6 6.8 5.5 6.2 Imports of goods and services 2.8 6.4 7.9 6.7 5.4 4.3 MEMORANDUM ITEMS Unemployment (000s Q4) 2771 2371 2136 1980 1933 1977 Current account (pounds bn) -10.9 -7.2 -10.0 -10.9 -9.8 -6.9 Retail price index 1.6 2.5 3.6 3.4 3.4 3.6 FINANCIAL ITEMS 3-month interbank (Q4) 5.6 5.5 6.3 6.4 6.4 6.3 DM/pounds (Q4) 2.51 2.49 2.49 2.54 2.59 2.52 -----------------------------------------------------------------

The authors are with Oxford Economic Forecasting

(Graphs omitted)

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