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

Most of the economic news since our last forecast in May points to an earlier reduction in the rate of economic growth in the UK than we had been expecting at that time. At the aggregate level, GDP growth for the first quarter of the year was revised downwards slightly to 0.7 per cent and growth in the second quarter is estimated to have fallen to 0.6 per cent. Recent business surveys indicate less optimism than was apparent in the earlier part of the year. Other recent figures are indicative of a lack of optimism among households: the weakness of retail sales has continued, house prices have fallen again and the decline in the level of unemployment has abated. A similar pattern is being observed outside of the UK with growth falling more quickly than expected in most of the G7 countries.

This reduction in the growth of activity is one factor behind our changed assumption as to the likely stance of monetary policy. In May, it appeared obvious to most observers, including the Governor of the Bank of England but not the Chancellor, that interest rates needed to be raised for the government to have a good chance of meeting its inflation target. We argued that interest rates would need to be raised to 8 per cent by the end of this year in order to offset the effects of a weak exchange rate and to influence expectations by demonstrating the commitment of the authorities to monetary stringency.

Events have caused us to revise this view. We are now forecasting that inflation will rise later this year, but it will then slow down again and will be around 2 1/2 per cent at the end of next year with interest rates unchanged from current levels. There are a number of factors underlying this assessment. First and foremost, the slowdown in activity in the domestic and overseas economies will relieve much of the pressure on prices and wages that would have threatened the target. Second, the change in the world outlook has led to a lowering of actual and prospective interest rates in other countries and this will have strengthened sterling relative to what it would otherwise have been thus dissipating some of the inflationary pressure. Third, the markets have revised downwards their view of future interest rates especially over the short term. In previous months when interest rates had been expected by the markets to rise, it could be argued that not to raise rates would threaten the credibility of the authorities. This consideration no longer appears to apply.

Our forecast of inflation is very similar to that of the Bank of England's projection that if interest rates are not changed annual inflation will be marginally higher than 2 1/2 per cent in the middle of 1997. Our forecast for the third quarter of 1997 is that inflation will be 2.6 per cent. The Bank's call for higher interest rates is based on an assessment of the risks associated with their projection: in effect there is a more than even chance that inflation will be above 2 1/2 per cent. This suggests to them a need to raise interest rates and, because of the lags in the operation of monetary policy and its effect on credibility, a need to act immediately.

The latest Treasury forecast is for inflation of 2 1/2 per cent at the end of 1996. This is consistent with the view of the Bank although the Treasury does not say whether it believes that interest rates need to be raised to achieve this target. Despite the similarity of the assessment, the Chancellor appears much more relaxed about the need to raise interest rates and this probably reflects a political judgement that it is not worth risking the opprobrium of business leaders, Conservative backbenchers, the housing lobby and a large proportion of the electorate by raising interest rates for the sake of a forecast that inflation is likely to be within a quarter of a percentage point of its target. This view will have been reinforced by statements from the Prime Minister that the government's main priority in relation to the housing market was to keep interest rates as low as possible. …

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