3 The economy:
developments and prospects

Overview

Longer-term perspective

3.01 Despite the current position of above-trend growth and relatively modest inflationary pressures, the performance of the UK economy continues to suffer from a number of fundamental weaknesses:

Recent developments

3.02 Output began to grow in the first half of 1992, following two years of continuous decline. But recovery has not been evenly spread across sectors. While total output is now 11 per cent above its pre-recession peak, manufacturing output is just 3 1/4  per cent above its previous peak and only 8per cent above the level reached during 1974. Whole economy investment is still 2 1/4  per cent lower than when the recession began.

3.03 GDP grew at an annual rate of 2-2 1/2  per cent in the second half of 1995 and for much of 1996. But it accelerated sharply last autumn, since when it has been rising at an annualised rate of 3 1/2 -4 1/2  per cent, driven by strong consumer spending growth. Unemployment has continued to fall, and the rate of decline appears to have gathered pace since the autumn (although the fall in the claimant count has been amplified by the introduction of the Jobseeker's Allowance). Underlying retail price inflation (i.e. excluding mortgage interest payments) has fallen from around 3 per cent at the end of last year to 2.5per cent at present, reflecting the effects of sterling's appreciation.

Prospects

3.04 GDP is forecast to grow by 3 1/4  per cent in 1997. Consumer spending is likely to remain buoyant. Investment growth over the past two years or so has undershot expectations, although survey evidence of strong service sector investment intentions and rising capacity utilisation point to business investment accelerating further this year. But GDP growth is forecast to slow from the second half of the year as the appreciation of sterling affects net export growth, and domestic demand growth moderates, partly in lagged response to the tightening of monetary and fiscal policy. GDP is forecast to rise by 2 1/2  per cent in 1998.

3.05 As lower producer prices continue to feed through to retail prices, underlying retail price inflation is forecast to remain at around 2 1/2  per cent during the second half of this year. It is forecast to edge up temporarily next year.


Table 3.1 Summary of short-term forecast

Forecast
199619971998
Real GDP growth ( per cent)2 1/2 3 1/4 2 1/2
Inflation (RPI excluding MIPs, Q4)3 1/4 2 1/2 2 3/4

Risks

3.06 However, there are substantial risks to the forecast. On the upside, the risk of heavier than expected spending from windfall payments poses the prospect of very strong consumers' expenditure growth. On the downside, investment could once again turn out weaker than expected, especially if the high exchange rate hit exports hard. Were the economy to evolve unchecked along these lines, there would be further imbalance in the composition of growth. The Budget strategy has been designed to counter this risk. But given the chances of output already being above trend and consumer spending continuing to grow rapidly, there is a risk of growth remaining unbalanced.

Developments and short-term prospects

Output and demand - overview

Growth and productivity performance

3.07 Since 1973, UK GDP has grown at only about two thirds of the rate achieved during the earlier post-War years. GDP growth over the past 25 years has also been slower in the UK than in any of its major competitors. Annual growth has averaged around 1 3/4  per cent in the UK since 1973, compared with an average of around 2 1/2  per cent for the major (G7) industrial economies.

3.08 The level of GDP per head in the UK is below the OECD average and the level in all other G7 countries. Despite some relative improvement since 1992, reflecting a cyclical upswing from a deep trough, the UK has failed to narrow the gap with the OECD average since the 1970s.

3.09 As in all other industrial countries, the growth of productivity (output per worker) slowed sharply after 1973. Following growth of close to 3 per cent a year between 1960 and 1973, productivity growth has since averaged around 1 3/4  per cent a year - similar to the European Union and OECD averages.

3.10 However, the level of output per worker in the UK has been lower than that in other G7 economies since the early 1970s. After widening during the second half of the 1960s and the 1970s, this productivity gap has remained broadly constant during the 1980s and 1990s.

3.11 Productivity performance has been mixed across the sectors of the economy over the 1980s and 1990s. In manufacturing and the privatised utilities, productivity has grown strongly, partly associated with substantial labour shedding. But in much of the service sector (where productivity is less well-measured) productivity growth has been comparatively low, both relative to manufacturing and to growth in the 1960s and early 1970s. This has contributed to comparatively fast growth of employment in the service sector.

3.12 The UK economy has also suffered from a high degree of instability. Over the past 25 years, the UK has experienced the largest boom and the two deepest and longest recessions in the post-War period. In the early 1980s recession, output fell by 5 1/4  per cent from peak to trough, while there was a peak-to-trough fall in output of 3 3/4  per cent in the early 1990s. Since 1973, fluctuations in GDP growth have been larger in the UK than in any other G7 economy apart from Canada. This has been associated with a relatively high degree of inflation volatility.

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Recent developments

3.13 The UK economy started a cyclical upswing in the first half of 1992, following a deep trough in output. GDP grew at an annualised rate of around 2 per cent between mid-1992 and mid-1993. But growth then picked up sharply to 4 1/2  per cent in 1994, as exports grew strongly in response to rapid world trade growth.

3.14 The growth of both domestic demand and exports slowed during 1995, the former reflecting a tightening of monetary policy and the latter a slackening of world trade growth. However, the impact on GDP was cushioned by higher stockbuilding, which was probably largely involuntary, and GDP rose by 2 per cent in the year to the fourth quarter of 1995.

3.15 Domestic demand has been strengthening again since the beginning of 1996, but lower stockbuilding at first held back GDP growth, which remained at an annual rate of 2-2 1/2  per cent over the first three quarters of the year. However, GDP accelerated sharply towards the end of the year, rising at an annualised rate of almost 4 1/2  per cent in the fourth quarter of 1996 and 3 1/2  per cent in the first quarter of 1997. On balance, it seems likely that the output gap is currently close to zero, though there is a significant risk that output could already be above its trend level (see box).

3.16 Over the past year, growth has been led by the service sector, where output increased at an annualised rate of 5 1/4  per cent in the first quarter, and by 4 1/4  per cent on a year earlier. Growth has been particularly strong in the financial and business services and transport and communication sectors. After showing little change for almost a year, construction output has been rising strongly since the middle of 1996, and in the first quarter of 1997 was 3 3/4  per cent higher than a year earlier. Manufacturing output remained broadly flat between late 1994 and mid-1996, but has picked up since last summer and in the three months to April was almost 2 per cent higher than a year earlier.

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Prospects

3.17 Consumers' expenditure should continue to expand quite strongly in response to rising incomes and wealth and increasing consumer confidence, with scope for very strong growth in the event of heavier than expected spending out of windfall payments. Business investment is expected to pick up further this year, though manufacturing investment is expected to remain weak. But whole economy investment has been sluggish in recent years, and forecasts of strong growth over the past two years or so have failed to materialise. Moreover, investment prospects could be adversely affected if the high exchange rate hit exports hard. So the investment forecast is particularly uncertain. The drag on growth from stock adjustment now appears to have passed, and stockbuilding is expected to make little contribution to growth over the next 18months. Total domestic demand is forecast to grow by 3 3/4  per cent this year.

3.18 However, export growth is expected to be slower from the second half of the year as the impact of the exchange rate appreciation begins to build up. Towards the end of the year and into next year domestic demand is also expected to decelerate, partly in lagged response to the tightening of monetary and fiscal policy, and as the effect of spending out of windfalls on growth recedes. GDP is forecast to grow by 3 1/4 per cent in 1997 as a whole, with growth slowing through the year. Growth of 2 1/2  per cent is forecast for 1998. Lower domestic demand growth and net trade are expected to contribute roughly equally to this slowdown.


SPARE CAPACITY AND THE OUTPUT GAP

The output gap is the difference between actual output and a measure of "potential" or "trend" output. It can be used as a measure of demand pressure - i.e. the degree of under or over-heating in the economy. If actual output were above trend - a positive output gap - for a sustained time, experience suggests there would tend to be upward pressure on inflation.

It is impossible to measure the output gap with any degree of certainty. Business surveys of capacity utilisation provide an indication of short-term capacity pressures in product markets. And surveys of skilled labour shortages, together with other labour market indicators - unemployment, vacancies and average earnings - can be used to estimate the degree of slack in the labour market.

Capacity utilisation

The most quoted measure of capacity utilisation, from the CBI survey of manufacturing, has been just above its long-run average since mid-1994. But it is unlikely that the economy as a whole was above trend in 1994, so soon after the early 1990s recession.

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Other surveys suggest that capacity utilisation may be tighter in the service sector. The British Chambers of Commerce (BCC) survey shows that it has continued to rise in services in recent quarters and is now above itslevel in 1989, when demand pressure was certainly high. The Building Employers' Confederation (BEC) survey indicates that capacity utilisation is also slightly above its long-run average in construction.

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Skilled labour shortages

Indicators of skilled labour shortages are more conflicting. The CBI survey suggests that they may still be slightly below average in manufacturing. However, the BCC survey suggests that skill shortages are back to their 1989 levels in both manufacturing and services.

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Labour market indicators

Other indicators suggest that the labour market has tightened in recent months and may now have little or no slack remaining. (If this were correct, the scope for further falls in unemployment, without putting upward pressure on inflation, would depend solely on structural reforms.) Unemployment has continued to fall, although part of the sharp decline in the claimant count since last autumn can be attributed to distortionary effects from the introduction of the Jobseeker's Allowance (JSA). Vacancies in early 1996, even before JSA had distortionary effects, were already back to the levels seen in the late 1980s. There has also been a pick-up in average earnings growth since mid-1995, with a steady rise in manufacturing and a sharper rise in service sector earnings growth.

Speed limits

It is possible that if the economy is growing fast enough, inflation could still rise even when the economy is operating below its supply potential, i.e. with a negative output gap. This is the so-called "speed limit" effect.

High levels of capacity utilisation, which may reflect the weakness of investment in recent years, began to show in the manufacturing sector as early as 1994. Since then manufacturing growth has slowed, but service sector output has accelerated, and this has been reflected in the acceleration in service sector earnings.

The output gap

These modest inflationary pressures probably reflect the economy running into speed limits in first the manufacturing and then the service sector, though they do not necessarily imply that the output gap in the economy as a whole has turned positive.

The evidence overall suggests that the output gap is now close to zero. But there is a significant risk that output could already be above its trend level (a positive output gap).

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3.19 The composition of demand growth over the next two years is likely to continue to be relatively favourable to the service sector. Manufacturing output is forecast to grow by just 1 1/2  per cent this year and 3/4  per cent in 1998.

3.20 Were the possible upside risk to consumer spending from windfalls and the downside risks to investment and exports from the high exchange rate to materialise, there would be further imbalance in the composition of growth. The Budget strategy has been designed to reduce the risks of growth remaining unbalanced.

Personal sector and the housing market

Longer-term perspective

3.21 The personal saving ratio (saving as a percentage of disposable income) was very low in the immediate post-War period. But it rose progressively during the 1960s and 1970s: higher rates of inflation required people to save more simply to maintain the real value of their savings, while it is likely that increasing unemployment led to greater job insecurity and higher precautionary saving. The saving ratio peaked in 1980 at 13 1/2  per cent.

3.22 However, fuelled by the expansionary impact of financial liberalisation, lower oil prices, and a relaxation of both fiscal and monetary policy, consumers' expenditure accelerated unsustainably in the second half of the 1980s and the saving ratio fell sharply. Between 1986 and 1988, consumer spending increased at an average rate of 6 1/2  per cent a year, and the saving ratio fell to 6 per cent in 1988. The housing market boomed - prices increased by around 90 per cent between 1986 and 1989 - and many homeowners borrowed for consumption on the back of rising house prices. With falling saving and a sharp increase in housing investment, the personal sector moved into financial deficit in the late 1980s for the first sustained period since the 1950s.

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3.23 The subsequent recession and housing market downturn left the personal sector with a high debt burden and many homeowners with negative equity (the value of the mortgage outstanding exceeding the market value of the property). Consumers' expenditure fell by 3 1/2  per cent from peak to trough and house prices fell on average by almost 13 per cent. The saving ratio peaked at almost 13 per cent during 1992 and, despite relatively low inflation, has remained at a high level since, partly reflecting increased consumer caution after the experience of the late 1980s.

Consumption, income and saving

3.24 Consumer spending is by far the largest expenditure component of GDP, accounting for over 60 per cent of the total. Having increased by 1 3/4 -2 3/4  per cent a year between 1993 and 1995, it grew by 3 1/2  per cent last year, with the annual growth rate picking up to 4 1/4  per cent in the final quarter. Spending on durable goods was particularly strong.

3.25 Strong growth continued in the first quarter of 1997. Recent monthly indicators also point to strong consumer demand. Retail sales (which account for about 40 per cent of total consumption) were 4.9 per cent higher in the three months to May than a year earlier. New car registrations in the three months to May were 4.1 per cent up on a year earlier. Consumer credit continues to grow strongly (up by 17.0 per cent in the year to May) and consumer confidence is now back to levels last seen in mid-1988.

3.26 Real personal disposable income grew by 3 3/4  per cent last year - well above its long-term trend rate of around 2 1/2  per cent - reflecting income tax cuts, rising employment, higher real average earnings growth and further strong growth of dividend receipts. Dividend receipts are unlikely to grow as quickly this year as last, but with lower inflation, real average earnings growth is likely to be higher. Real personal disposable income is therefore forecast to grow strongly again this year, by 3 per cent. It is forecast to increase by 1 3/4  per cent in 1998.

3.27 Net personal financial wealth has grown by 30 per cent over the past two years, as a result of high personal sector saving (particularly in pensions) and rapid increases in equity prices. The FT-SE All-Share index rose by around 30 per cent between the beginning of 1995 and the end of 1996, and has risen by a further 10 per cent so far this year. Rising house prices have also been boosting total wealth since mid-1995.

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3.28 Personal wealth is being further increased by "windfall payments". People have already received around £25 billion this year from the flotation of building societies and insurance companies, and this is likely to rise to over £30billion in the year as a whole. There is a further £5 billion from maturing TESSA accounts, which does not increase total wealth but makes existing wealth more liquid.

3.29 The forecast assumes that most of this money will be saved, and hence the effect on consumer spending will be relatively small - adding around 3/4 -1 per cent to consumption this year. Evidence from previous flotations and consumer surveys tends to support the view of relatively modest spending from these windfalls. However, it could be much larger, and this represents a significant upside risk to the forecast. For example, if a quarter of the windfalls were to be spent (compared with a central assumption of around 15 per cent), this would add a further 1/2 - 3/4  per cent to consumers' expenditure this year.

3.30 With consumption growth matching that of personal disposable income, the personal sector saving ratio remained at around 11 1/2 -12 per cent for most of last year. However, high levels of consumer confidence (at least partly associated with falling unemployment and rising house prices), high wealth and spending out of windfalls will all be tending to reduce the saving ratio. The forecast assumes that it falls to 8 3/4  per cent next year.


Table 3.2 Personal expenditure and income

Percentage changes on a year earlier
Forecast
199619971998
Consumers' expenditure3 1/2 4 1/2 4
Real personal disposable income3 3/4 31 3/4
Saving ratio (level,  per cent)1210 1/2 8 3/4

3.31 Reflecting the rise in real incomes and the fall in the saving ratio, consumer spending is forecast to grow by 4 1/2  per cent in 1997. But, as already noted, heavier than expected spending from windfalls could lead to much stronger consumption growth in 1997. In any case, as a matter of arithmetic, the effect of windfalls on the growth of consumer spending is likely to recede during the course of next year. Moreover, towards the end of this year consumer spending is expected to start decelerating under the influence of the tightening of monetary and fiscal policy. Growth in consumers' expenditure is therefore forecast to slow to 4per cent in 1998.

Housing market

3.32 House prices have been rising strongly since late 1995. The Halifax index shows prices in May 6.6 per cent higher than a year earlier, while the Nationwide index puts the increase in the year to June at 11.0 per cent. A shortage of properties on the market appears to be contributing to the upward pressure on prices. The May survey from the Royal Institute of Chartered Surveyors reported that the number of properties for sale was down 28 per cent on a year earlier. This now appears to be having an effect on turnover. The number of particulars delivered at the Land Registry has flattened off in the past few months, having risen sharply since early last year.

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3.33 In real terms, house prices remain well below their previous peak. With the house price-earnings ratio still low, housing remains very affordable. Higher demand and limited increases in supply are therefore likely to combine to put upward pressure on house price inflation for a time. However, thereafter the rate of increase in house prices should begin to moderate, damped by the reduction in mortgage interest tax relief, and with slower growth in real incomes in 1998 acting as a restraint on housing demand. On the supply side, the supply of new houses should increase as the rise in private sector housing starts over the past year feeds through into completions.

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Private housing investment

3.34 Private housing investment includes both new housebuilding and improvements to existing properties. It was virtually unchanged in 1996 as a whole, but picked up through the year, mainly led by higher investment in existing dwellings. However, investment in new dwellings also began to pick up in the second half of last year, and should increase further in 1997 as housing completions pick up. Investment in existing dwellings should grow quite quickly too: personal incomes are forecast to grow strongly and some of the windfalls are likely to be spent on home improvements.

Financial position

3.35 With little change in either saving or investment, the personal sector financial surplus remained at around 6 per cent of disposable income last year, well above its long-run average of around 3 1/2 per cent. But with a fall in the saving ratio and a pick-up in housing investment, this surplus is projected to decline to around 2 per cent of income in 1998.

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Prepared 2 July 1997