UK Economy Forecast: The Production of This Forecast Is Supported by the Institute's Corporate Members: Abbey Plc, Bank of England, Barclays Bank Plc, Ernst and Young LLP, Marks and Spencer Plc, the National Grid Company Plc, Nomura Research Institute Europe Ltd, Rio Tinto Plc, Unilever PLC and Watson Wyatt LLP

By Kirby, Simon; Riley, Rebecca | National Institute Economic Review, January 2007 | Go to article overview

UK Economy Forecast: The Production of This Forecast Is Supported by the Institute's Corporate Members: Abbey Plc, Bank of England, Barclays Bank Plc, Ernst and Young LLP, Marks and Spencer Plc, the National Grid Company Plc, Nomura Research Institute Europe Ltd, Rio Tinto Plc, Unilever PLC and Watson Wyatt LLP


Kirby, Simon, Riley, Rebecca, National Institute Economic Review


Introduction

The economy continues to expand at a robust pace (figure 1). We now expect GDP to rise by 23/4 per cent in 2007 after similar growth in 2006. This is an upward revision to our forecast for economic growth in 2006 and 2007 of approximately 1/4 percentage point since October. Underlying these changes to the forecast for 2006 are upward revisions to the data for the first half of last year and stronger than expected growth for the third quarter of last year. The healthy pace of expansion forecast for this year is supported by a further acceleration in domestic demand growth after the weakness observed in 2005. This is led by a pick-up in consumer spending, supported by stronger growth in real disposable incomes and rapid accumulation of household wealth, and the continued strength of investment demand.

[FIGURE 1 OMITTED]

The target measure of inflation rose to 3 per cent in December last year. Our forecast for inflation in the consumer prices index is shown in figure 2. This does not show inflation rising 1 percentage point above the target towards the end of last year since we report inflation for the quarter as a whole, rather than for individual months. Measured on a quarterly basis, inflation rises further at the start of this year. However, our central forecast does not show consumer price inflation accelerating by much and as such we expect the odds are a little less than even that the Governor of the Bank of England will have to send an explanatory letter to the Chancellor.

[FIGURE 2 OMITTED]

As illustrated in figure 2, we expect inflation to fall back towards the target in the second half of this year. This occurs not only because commodity prices have stopped rising and the price of oil is expected to be reduced by $8 this year in comparison to last. The appreciation of the sterling effective exchange rate over the course of last year, which slows import price inflation in the forecast, has also helped.

Nevertheless, due to our projection of stronger growth and stronger than expected inflation outcomes for the final quarter of last year, we expect inflation to fall back to target less quickly than we anticipated three months ago at the time of our last forecast. With strong economic growth driven by a pick-up in domestic demand, we now think that the economy is operating above capacity, albeit only marginally. Figure 3 shows our estimate of the output gap, which suggests that the economic cycle that began in the final quarter of 2003 came to an end in the final quarter of last year. As illustrated there, we expect economic growth to be running a little ahead of trend this year.

[FIGURE 3 OMITTED]

Despite the rise in output above capacity, wage inflation is likely to be restrained by rising unemployment, resulting from strong labour force growth. An upside risk to the inflation forecast is that the sharp acceleration in inflation in the retail prices index from 2.2 per cent in December 2005 to 4.4 per cent in December last year finds its way into pay settlements, due to be arranged in the coming months. It is likely that the Monetary Policy Committee raised interest rates in January to pre-empt this happening. We have revised up our forecast of wage inflation in light of the recent data. However, we assume that recent increases in interest rates, and the associated change in expectations of interest rates over the past year, are enough to maintain wage inflation at normal levels. Simulations using our model of the economy suggest that, in and of itself, the change in interest expectations over the past twelve months should reduce inflation by on average 1/2 percentage point over the next few years.

In 2008 we expect economic growth to slow to 2.4 per cent per annum. Both a fiscal and a monetary tightening dampen growth and inflation ahead. As we discuss later in this chapter, there is little room for anything but fiscal restraint in the near term.

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UK Economy Forecast: The Production of This Forecast Is Supported by the Institute's Corporate Members: Abbey Plc, Bank of England, Barclays Bank Plc, Ernst and Young LLP, Marks and Spencer Plc, the National Grid Company Plc, Nomura Research Institute Europe Ltd, Rio Tinto Plc, Unilever PLC and Watson Wyatt LLP
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