Economic Prospects and Policy Recommendations
Economic conditions continue to improve, with growth at a satisfactory rate and inflation subdued, whether one considers the UK in particular or the world economy in aggregate. This cheerful prospect may be threatened however by financial developments, with some turbulence in foreign exchange markets and uncertainty about the future of monetary policy. In the UK this uncertainty is particularly acute following the surprise decision not to raise short-term interest rates in May.
The World Economy
The main issue for world economy forecasters at present is the significance of the recent exchange-rate movements; the substantial rise in the yen as well as the fall in the dollar. We attribute these movements primarily to a shift of sentiment in Japan against the holding of most kinds of foreign currency assets. The result is a pattern of exchange rates which may appear to be misaligned, but which will not be quickly reversed. Thus we show a fall of about 7 per cent in the effective rate of the dollar this year, with little change thereafter. The immediate response to the currency movements has been to reduce interest rates in the countries experiencing appreciation, without any corresponding increase in America. By next year however we expect short-term world interest rates generally to be increasing slightly, as suggested by the present term structure of rates in the markets.
Our world forecasts show growth in the OECD economies as a whole continuing at close to 3 per cent a year this year and next. It would be consistent with that view for the growth of world trade to slow down significantly next year from the exceptionally rapid rate which has been experienced since 1994 as a result of various special factors, including trade liberalisation.
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We continue to forecast acceleration in inflation in America, reaching about 4 per cent in the medium-term. The evidence excess demand for labour in the US remains sparse, but the fall in the dollar will obviously be adding to cost pressure. In an economy the size of the US it may take many years for this effect to work through in full to the domestic price level. For the OECD area as a whole we expect inflation to reach 3 1/2 per cent in the medium-term, with little increase in prices in Japan and Germany but no sign of any abatement in countries such as Italy still unable to break the spiral of depreciation and cost increases.
Policy Assumptions for the UK
On fiscal policy we assume cuts in income tax worth about [pounds]5 billion in this year's Budget. Public spending is kept under tight control in the short term with no increase at all in the volume of current expenditure on goods and services. Public sector fixed investment is assumed to fall in volume this year as indicated by published plans. Expenditure on current grants will be rising less than the increase in consumer prices. These projections are consistent with a fall in the public sector borrowing requirement to just 2 1/2 per cent of GDP by the latter half of next year, and subsequently to about 1 per cent in 1999.
On monetary policy we assume that interest rates are set mainly with a view to achieving a rate of inflation well within the present 1 to 4 per cent target range, with the hope of being in the lower half of that range by 1997. Our forecasts imply that further increases in interest rates will be signalled by this approach during the course of this year. For short-term rates we expect an increase to about 8 1/2 per cent by the early part of next year. After that it should be possible to hold rates broadly constant with the prospect of reductions at some stage in the medium-term.
We have made no explicit assumptions about the timing or the result of the next general election, which must obviously influence the outcome in the medium-term. Within the short-term period anticipation (whether correct or not) of a possible change of government could well affect financial markets. …