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 economic outlook is sometimes strongly influenced by what people expect to happen. In the late summer of last year, prospects for the British economy worsened partly because people had become more pessimistic about the world economic outlook. Among other things, it was feared that this would lead to postponement of investment projects and extra precautionary saving which would dampen demand, weaken output and so justify the greater pessimism.

At the time, we felt that the lack of confidence seen in business surveys pointed to a gloomier outlook than was warranted. To a large extent, we were relatively more optimistic because we felt that monetary policy could be eased substantially to ensure that demand did not collapse. In fact, the cuts in interest rates over the past six months have been much sharper than we had expected. Base rates in the UK and the rest of the world are now over I per cent lower than we had expected them to be. The swift easing of monetary policy has played a key role in preventing the loss of confidence causing a severe economic downturn.

Now that confidence is returning, it is likely that the UK will narrowly avoid an actual recession in the current downswing of the cycle. Latest estimates suggest that output growth remained positive around the turn of the year when the risks of a decline were greatest. While nothing is guaranteed, growth is likely to increase throughout the rest of this year and into 2000.

It is perhaps a sign of renewed confidence that commentators are now returning to their earlier theme of the 'two-speed' economy. While the overall economy appears to have avoided a recession, this is not true of the manufacturing sector. Manufacturing output in the first quarter appears to have fallen for the third quarter in succession. The most obvious cause of this weakness is the strong pound. This has reduced the profitability of domestic firms who compete with those overseas on the basis of price and reduced the attractiveness of those who attempt to maintain their profitability. Accepting an estimate of around ??1.30 as a fair value of sterling, then the exchange rate has been overvalued since the end of 1996.

It is possible to argue that the strength of sterling over the past two years or more has been caused partly by unnecessarily high interest rates in 1997 and the first part of 1998. But for the most part the slowdown in activity over this period has been close to that which was needed to meet the government's inflation target. In general, the Monetary Policy Committee (MPC) has not been sensitive to the needs of particular sectors or regions in setting interest rates and rightly has taken account only of the needs of the overall economy. In this case, it has been an imbalance in macroeconomic policy, with taxes not high enough to allow lower interest rates, that has caused problems for manufacturing industry, rather than the overall policy stance.

The weakness of the euro since its launch at the beginning of the year has meant that the value of sterling is putting further pressure on the traded sector of the economy. Towards the end of April, sterling is trading at around ??1.50, above its old central rate in the ERM. It is likely that further reductions in UK interest rates would weaken the pound and so relieve some of this pressure. But having been reduced so sharply, it is now possible that further cuts in interest rates would threaten the inflation target. This depends importantly on how further cuts in interest rates would be interpreted by the foreign exchange markets and how this would affect the value of the pound. Put simply, if the pound were to stay at its current high levels, then there is ample scope for further cuts in interest rates. But if the pound were to fall to a level at which the traded sector could more easily compete internationally, then further interest rate reductions would pose a threat to the inflation target by the end of next year. …

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