What they should have told the Chancellor
Monday 23 October 1995
Chancellor, the state of the economy is even harder to read than usual. Our preliminary forecast for the GDP figures out today shows a rise of 0.4-0.5 per cent in the third quarter. A significant deviation either way from the expected growth when the figures are published will have an important effect on market expectations of interest rates.
So will Tuesday's CBI survey. Usually, this follows the pattern of the Chambers of Commerce and Purchasing Managers surveys. Both have painted a picture of a slowing economy, though not yet a contracting one. The most worrying feature has been a sharp rise in the balance of companies that believe their holdings of inventories are excessive. This could well foreshadow a quarter or two of declining stocks, which would severely dent the manufacturing sector.
Exports slowed earlier in the year, and all the surveys indicate that growth in foreign orders is still cooling off. Furthermore,business surveys in continental Europe indicate that our main export markets are slowing. But in the US growth has bounced back quite strongly from the doldrums seen earlier this year. Overall, we expect export growth to improve, but probably not before the turn of the year.
Domestic demand is puzzling. The retail sector was weak in the first quarter, recovered strongly in the second, but has stagnated in the third. Special factors, including the weather, may have artifically depressed consumer spending in recent months. Investment, though, now seems to be growing quite strongly in the manufacturing sector, and surveys for capital spending in both services and manufacturing are encouraging.
The big question for policy is which way GDP growth will shift from its present rate, which is quite close to the 2.25 per cent per annum trend. Near term, it is quite likely to dip below this rate, because there is more inventory shedding to be done, both here and on the Continent.
This will be a rocky time politically. But the prospects for growth next year look good. Real disposable in-come will grow by 2.5-3 per cent in 1996, and companies are readily able to finance additional capital spending. If a serious recession should develop next year, we would be at a loss to explain why: monetary conditions are basically expansionary, and the private sector is not experiencing the balance-sheet strains that normally precede a recession. If there is a big shift away from trend GDP growth next year, it is more likely to be up than down.
A year ago, this prospect would have been quite alarming, since the economy was clearly exceeding the speed limits that lead to rising inflation. When interest rates were raised by 1.5 per cent about a year ago, many commentators said this was unnecessary. But subsequent inflation figures have proved them wrong. The underlying inflation rate is at a two-year high of 3.1 per cent, and will probably rise to 3.5 per cent in mid 1996, well above the 2.5 per cent target. Without last year's monetary tightening, it would almost certainly have moved above the 1-4 per cent range during 1996.
The great unknown is how much spare capacity still exists in the economy. It is easy to conclude that output is still some 2-3 per cent below trend, but this depends on a mechanical extrapolation of the long-term trend.This is too simplistic. Many of the direct measures of the economy's capacity suggest that strains on the system are already running at about the same levels as they were in 1987, just before the take-off in inflation at the end of the last cycle.
Less familiar is the fact that it is also now true of many important measures of slack in the labour market. As the graph shows, the combination of vacancies and unemployment relative to their trends is about to enter the danger territory seen in the 1987-89 period. Average earnings increases have admittedly been much more subdued than our equations have been predicting, but basic settlements themselves are now rising quite strongly.
Our conclusion is that the long-term trend in the economy may have temporarily been depressed by a lack of capital investment. Given the high rates of return on investment at present, there is every reason to believe the growth of the capital stock can be restored to previous trends, but it may take some time. We therefore see the current slowdown in demand growth as good news - a vindication of the policy stance pursued in the past 18 months. Our main expectation is that it will not go much further. Pressures for a base rate cut will probably intensify as the inventory shake-out develops in the next few months, but we would try to minimise any easing in monetary policy during this temporary weakness. Cuts now could spell the need for increases in base rates just before the election.
Finally, the Budget. The public sector borrowing requirement will be around 3.5 per cent of GDP this year, still much too high. As you, Chancellor, have been saying in public, it is not yet clear that tax cuts can be "afforded", in the sense that the public borrowing problem has been solved. Only if tough control over public spending can be maintained and if the economy can grow faster than trend for a couple more years will the Budget get anywhere near your balance in the medium term. Minor tax cuts might be just about acceptable if we can get the spending cuts we want. But that will result in a freeze in real spending in the year before the election - something the Tory party may not be prepared for.
Furthermore, we have not succeeded in hitting our real spending targets in any recent year, so the markets are questioning our resolve. If you come under too much pressure for tax cuts from your colleagues, tell them this : a financial crisis in the run-up to the election is just about the last thing the Government needs. - HM Treasury
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