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UK economy forecast: the production of this forecast is supported by the Institute's Corporate Members: Abbey plc, Bank of England, Barclays Bank plc, Ernst and Young LLP, Marks and Spencer plc, The National Grid Company plc, Nomura Research Institute Europe Ltd, Rio Tinto plc, Unilever plc and Watson Wyatt LLP.

Article Excerpt
Introduction

The economy continues to expand at a robust pace (figure 1). We now expect GDP to rise by 23/4 per cent in 2007 after similar growth in 2006. This is an upward revision to our forecast for economic growth in 2006 and 2007 of approximately 1/4 percentage point since October. Underlying these changes to the forecast for 2006 are upward revisions to the data for the first half of last year and stronger than expected growth for the third quarter of last year. The healthy pace of expansion forecast for this year is supported by a further acceleration in domestic demand growth after the weakness observed in 2005. This is led by a pick-up in consumer spending, supported by stronger growth in real disposable incomes and rapid accumulation of household wealth, and the continued strength of investment demand.

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The target measure of inflation rose to 3 per cent in December last year. Our forecast for inflation in the consumer prices index is shown in figure 2. This does not show inflation rising 1 percentage point above the target towards the end of last year since we report inflation for the quarter as a whole, rather than for individual months. Measured on a quarterly basis, inflation rises further at the start of this year. However, our central forecast does not show consumer price inflation accelerating by much and as such we expect the odds are a little less than even that the Governor of the Bank of England will have to send an explanatory letter to the Chancellor.

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As illustrated in figure 2, we expect inflation to fall back towards the target in the second half of this year. This occurs not only because commodity prices have stopped rising and the price of oil is expected to be reduced by $8 this year in comparison to last. The appreciation of the sterling effective exchange rate over the course of last year, which slows import price inflation in the forecast, has also helped.

Nevertheless, due to our projection of stronger growth and stronger than expected inflation outcomes for the final quarter of last year, we expect inflation to fall back to target less quickly than we anticipated three months ago at the time of our last forecast. With strong economic growth driven by a pick-up in domestic demand, we now think that the economy is operating above capacity, albeit only marginally. Figure 3 shows our estimate of the output gap, which suggests that the economic cycle that began in the final quarter of 2003 came to an end in the final quarter of last year. As illustrated there, we expect economic growth to be running a little ahead of trend this year.

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Despite the rise in output above capacity, wage inflation is likely to be restrained by rising unemployment, resulting from strong labour force growth. An upside risk to the inflation forecast is that the sharp acceleration in inflation in the retail prices index from 2.2 per cent in December 2005 to 4.4 per cent in December last year finds its way into pay settlements, due to be arranged in the coming months. It is likely that the Monetary Policy Committee raised interest rates in January to pre-empt this happening. We have revised up our forecast of wage inflation in light of the recent data. However, we assume that recent increases in interest rates, and the associated change in expectations of interest rates over the past year, are enough to maintain wage inflation at normal levels. Simulations using our model of the economy suggest that, in and of itself, the change in interest expectations over the past twelve months should reduce inflation by on average 1/2 percentage point over the next few years.

In 2008 we expect economic growth to slow to 2.4 per cent per annum. Both a fiscal and a monetary tightening dampen growth and inflation ahead. As we discuss later in this chapter, there is little room for anything but fiscal restraint in the near term. The slowdown in economic growth in the US over the forecast horizon also contributes to a moderation in growth in the UK. We can gauge the impacts of US growth and the risks to US growth on the UK economy using our model of the world economy. A fall in US house prices that slows US growth by 1/2 percentage point for two years would reduce UK GDP growth by 0.1 percentage point for two years and would reduce UK inflation by 1/4 percentage point over this period, as lower US interest rates would cause sterling to rise. A rise in the risk premium on US assets that reduces US growth by 1/2 percentage point for two years would also reduce UK GDP growth by 0.1 percentage point for two years and would reduce UK inflation by one third percentage point.

Table 1 illustrates the uncertainty around our projections for CPI inflation and GDP growth this year and next. The root mean square errors of the forecasts are calculated from past forecast errors over the period 1993-2005 for inflation and 1989-2005 for GDP growth. We exclude forecast errors made in the 1980s. The shift to the low inflation regime in the 1990s implies that the magnitude of inflation forecast errors before then is likely to exaggerate the uncertainty surrounding the central forecast. Indeed, examining the accuracy of density forecasts of inflation, Mitchell (2003) finds this to be the case. The shift to a more stable macroeconomic environment in the 1990s provides a similar justification for excluding errors for real GDP growth from the 1980s, but we include the recession of the early 1990s so as not to underestimate the uncertainty of our forecast. The probability distributions of our growth and inflation forecasts, shown in table 1, give the probability that actual outcomes will fall within certain bands and are calculated under the assumption that the future forecast errors are normally distributed and unbiased.

On these assumptions there is a 15 per cent chance that inflation, measured on average over the quarter, will rise above 3 per cent towards the end of this year and next. In comparison, our forecast made one year ago, in January 2006, attached a similar probability to the event that inflation would rise above 3 per cent in the final quarter of last year. As things turned out, inflation rose to 2.7 per cent in the fourth quarter of 2006. At the time, we attached a likelihood of i in 4 to the event that inflation would be at least 2.7 per cent at the end of 2006, based on a central forecast for inflation of 2.2 per cent, only marginally above target and the forecast consensus at the time. Thus, although CPI inflation has risen quite substantially in the past year, it would be difficult to describe events as unusual. Our forecast shows GDP growth rising to 2.8 per cent per annum this year and weakening to 2.4 per cent per annum next year. Based on past experience, there is a 2 in 5 chance that growth will be at least 3 per cent this year.

Interest rates, exchange rates and prices

To the surprise of many analysts and commentators the Bank of England's Monetary Policy Committee raised interest rates from 5 to 5.25 per cent at their January meeting. This is the third time the base rate has been increased in the past six months. Prior to this period of monetary tightening the base rate had been maintained at 4.5 per cent for a year. At the time of our October forecast money markets anticipated an interest rate rise in the first quarter of 2007. However, for many the assumption was that the rise would arrive with the publication of the Bank's Inflation Report in February. The tightening in the month before the Bank of England's forecast is likely to have added significance to its impact on expectations. It is now the case that expectations for short-term interest rates this year are 1/2 percentage point higher than at the time of our October forecast (see figure 4). Compared to a year ago, the government liability yield curve suggests that short-term interest rates this year are 1.4 percentage points higher.

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The increase in the short-term interest rate since our last forecast has not been matched by a rise in inflation expectations. Expectations of inflation two years hence have remained stable since October. This suggests financial markets expect the projected monetary tightening, which shows interest rates rising by at least another 1/4 point, to be enough to keep inflation on target. The latest data from the Bank of England/GfK NOP Inflation Attitudes Survey in November suggest that inflation expectations for the year ahead increased by 0.2 percentage point from August. The perception of current inflation in November 2006 was just above the official estimate for the fourth quarter of 2.7 per cent. The current expectation of 2.7 per cent in twelve months time could be interpreted as an expectation that price increases will not moderate much over the coming year. The Inflation Attitudes Survey in February is likely to be influential in helping to shape monetary policy over the near term, especially if there is a sharp movement in inflation expectations after January's figures.

It is possible that the Bank Governor may have to explain why inflation outturns are more than 1 percentage point above target. The single largest upward effect on inflation at the end of last year comes from the rise in prices of fuels and lubricants, which is partly due to the increase in fuel duty which came into effect on 6 December, with the publication of the Pre-Budget Report. Policies announced in the Pre-Budget Report, such as the increase in Air Passenger Duty, help to keep CPI inflation above target this year. Any further increases to 'environmental' taxes in this year's Budget will cause inflation to be higher than we currently anticipate. It is clear from the data that indirect taxes have contributed an extra 0.1 percentage point to the inflation rate in December. However, it is also clear from figure 5 that indirect taxes have had little to do with inflationary pressure over the past eighteen months.

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The second half of 2006 has seen input price inflation moderate from the double digit figures of 2005 and the first half of 2006. Our forecast is for the oil price to remain at around $55 a barrel this year and next. This is below what our projection showed in October 2006 and will help to moderate input price inflation in coming years. The recovery in productivity last year suggests that unit labour cost growth has slowed from 3.6 per cent in 2005 to 2.5 per cent in 2006 and this should help to dampen inflation. We expect average...