The Home Economy
Britton, Andrew, National Institute Economic Review
The forecasts were prepared by Bob Anderton, Andrew Britton and Soterios Soteri, but they draw on the work of the whole team engaged in macroeconomic analysis and modelbuilding at the Institute. Part One of the chapter was written by Andrew Britton, Part Two by Bob Anderton.
The decision to join the exchange-rate mechanism had been expected, with increasing confidence, for several years. Nevertheless the actual announcement on 5th October came as something of a surprise. Up to that point the authorities, both the bank of England and the Treasury, had been encouraging the view that interest rates should be kept high for the foreseeable future so as to cut back the growth of domestic demand and to curb inflation. Joining the ERM implies that interest rates must be set mainly with a view to the foreign exchange market and are no longer fully available as an instrument to control the domestic economy. The decision to join the ERM in October, and the associated 1 percentage point cut in interest rates were probably the result of a reassessment of the state of the economy-as well as being a move in the complex game of European and domestic politics.
Over the past three months it has become increasingly clear that the UK economy has moved into recession. The signal has been most clear from the CBI Industrial Trends Survey, but it is confirmed by data on bankruptcies, retail sales, new car registrations, industrial output, vacancies, unemployment and the volume of imports. The scale of the fall in output will not be clear for some months yet, but the early indications are that it will be substantial. This would suggest a pattern unlike most other post-war cycles with the downturn phase lasting longer than usual, and intensifying in the later stages. it is already more than two years since the cyclical peak, identified by the CSO as August 1988.
The onset of this recession was unexpected. The same was true of the recession in 1979-80. Indeed, the onset of a recession may generally be unpredictable, rather like jumps' in the exchange rate. Decisions to cut investment spending, to reduce employment, to run down stocks all reflect the expectations of firms about the future demand for their products. When expectations change, real variables as well as prices can sometimes move abruptly, and these changes of sentiment are inherently unforecastable. After the event it may nevertheless be possible to guess what the new information was which caused the change of perception and behaviour.
The 'bad news' which has come to light since the summer includes the rise in world oil prices and the prospect of war in the Middle East, but also the continued rise in underlying inflation in this country despite two years of tight monetary policy. This will have been reinforced by the more cautious interpretation put on events in recent Government statements. Since the Budget Statement the expectation of a continuing succession of cuts in income tax in future years has evaporated. The Government's continuing political difficulties over the poll tax and especially over European integration seem to have contributed to the sombre mood of business in recent months-to judge by statements made at the CBI Annual Conference.
An alternative view would be that the recession is the predictable result of a sustained period of high interest rates-perhaps even its intended result. One difficulty with this interpretation is that neither the Government, nor the independent forecasters, ourselves included, actually foresaw that it would happen. Typically our models show the output response to higher interest rates building up gradually over a period of years, not intensifying suddenly after a long delay.
A third interpretation would be more worrying. It could be that the effects of tight monetary policy were delayed, perhaps because households were reluctant to sell their houses at a loss, or because firms went ahead with their investment plans using borrowed money. …