Academic journal article National Institute Economic Review

The UK Economy

Academic journal article National Institute Economic Review

The UK Economy

Article excerpt

Section I. Recent Developments and Summary of the Forecast

The UK economy will soon be completing the third year of recovery from the low point of the business cycle reached in the second quarter of 1992. Since that time output has risen by close to 8 per cent and now stands at 4 per cent above its previous peak. Over the recovery phase of the cycle, output in the onshore economy has grown at an average rate of 2.7 per cent per annum, with the annual rate of expansion accelerating to reach 3.7 per cent in the last quarter of 1994. This rate of growth is certainly in excess of that which the economy can sustain in the long term. Unsustainable growth eventually leads to inflationary pressure as firms, faced with strong product demand, push up their prices. Depending on the attitude of the monetary authorities, this leads either to a period of higher inflation or to tighter policy and higher interest rates to prevent inflation speeding up.

The key question at the current conjuncture is whether the economy has in fact reached the point where the unsustainable growth that is typically associated with economic recovery needs to be choked off by a more restrictive policy stance. A common means of addressing this issue is to construct estimates of the 'output gap': a measure of the actual level of output relative to the trend level of output that could be produced with available factors of production. Chart 1 plots a measure of the output gap and the annual rate of inflation. This estimate of the output gap has been constructed by assuming that trend output grows at 2 per cent per annum and that output was at trend at the mid point of the most recent complete cycle in the first quarter of 1987. (See the note on p. 65 for further discusion of methods of estimating the output gap.) The chart shows that, on this measure, the output gap is now almost closed: the above trend rates of growth seen since the recession have brought output back to where it would have been without the recession. The chart also lends some support to the view that inflation tends to rise when output is above trend levels.

Because of the rather inexact nature of output gap calculations, it is of some importance to consider other evidence on the extent of spare capacity. The CBI Industrial Trends survey provides evidence which supports the view that there is now relatively little spare capacity: only 49 per cent of all firms in manufacturing claim that their present level of output is below capacity. This represents a level typically associated with above trend levels of output. Similarly, the British Chambers of Commerce (BCC) survey indicates that capacity utilisation in the service sector has returned to levels last seen at the end of 1989. Further survey evidence from the Royal Institution of Chartered Surveyors suggests that demand is exceeding supply for at least some parts of the construction industry.

One factor which tells against some of the other evidence on the extent of capacity utilisation is the low level of investment spending that is currently taking place. Firms typically respond to a decline in spare capacity by expanding their capital investment. So far in the recovery investment has been lower than might be expected especially when some account is taken of the low level of the cost of capital. For example, investment in manufacturing reached a low point in the third quarter of 1993 and has grown by only 2 per cent since then. Clearly there are delays between investment orders and the installation of capital goods, but the recent survey evidence shows some weakening of investment intentions from the levels observed at the end of last year.

Apart from these concerns about the relatively low level of investment, the evidence from surveys of companies is consistent with the view that the UK economy is close to a normal, mid-cycle, level of operation. It is therefore likely that any restraining effect on price inflation that has come from excess industrial capacity is now abating. …

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