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Economic outlook

By Paul Convery

Working Brief 113, April 2000

The economies of Britain, Europe and the USA are all growing - but at a differing pace - according to a clutch of economic data and reliable forecasts released in the first 3 months of this year. Authoritative - but relatively cautious - City estimates now predict that the UK economy will grow by 3%, the USA by 4% and Germany by 2%. Whilst the UK has recovered confidently from the near zero growth levels in late 1998, European economies are growing with the aid of low interest rates and an undervalued single currency, whilst the USA is in danger of growing too rapidly.

Britain saw growth last year averaging 1.9% spurred on by a final quarter rate that was 2.7% higher than a year previously. The annual rate was not far short of the 2.2% figure for the previous year (despite dipping towards zero early in 1999) and three times the average forecasts made just a year ago by the City. The Chancellor was widely criticised when he predicted economic growth of about 1% to 1.5% in his budget last year - estimates that proved far more accurate than the over-gloomy predictions of most City institutions. The UK economy has now grown for 30 quarters in succession without any fall in output - the longest unbroken period since the mid 1970s.

The March 21st Budget shows that both Treasury and City estimates are now broadly similar and predicting that the economy will grow in a range of between 2 and 3% during 2000. Growth of 2 to 2% is forecast for both 2001 and 2002 with long term growth rates predicted that average of 2% for the rest of the decade. According to the Treasury, average public expenditure will increase no faster than the rate of whole economy GDP expansion.

Meanwhile the latest data shows UK inflation remaining well below the 2% rate re-iterated in the March Budget. This "RPIX" underlying rate which excludes mortgage interest payments, fell to 2.1% from 2.2% in December - the tenth month in a row it has undershot the Bank of England's target rate. However, the headline rate of inflation, which includes mortgage payments, rose to 2% from 1.8%, the highest level since last March - mainly due to home loan costs which were falling a year previously as interest rates fell. The harmonised index of consumer prices - which uses a different basket of goods consistent with Euro-zone measurement methods - fell to 0.8%, down from 1.2% in December and was the lowest figure since the measure was introduced in January 1996.

Reports by the normally cautious CBI shows the employer organisation expects the economy to continue growing strongly before slowing slightly in 2001 with inflation set to remain low into next year. Annual GDP growth is now expected to average 3.1% this year and 2.6% next year. These estimates for growth support the 2-to-3% range forecast by the Chancellor in his pre-budget report last November - which were inched up marginally in the March Budget.

Household spending is expected to be the main driver of growth - consumption is expected to grow by 3% in 2000 and by 2.4% in 2001 contributing two thirds of the anticipated growth in both years.

The CBI expects a recovery in exports over the next two years due more to a resurgence in world trade with Sterling's strength continuing to hold back exports. Export volumes are expected to grow by 5.0% in 2000 and by 4.3 per cent in 2001. But import growth is again expected to be strong at 5.6% in 2000 and 4% in 2001. Manufacturing output is expected to rise by 2.6% this year and 2.2% in 2001.

The CBI has also revised its projection for interest rates which are now expected to rise to 6% in the second quarter of 2000, remaining at that level until the second quarter of 2001 before edging down to 5% by end-2001. Underlying retail price inflation is forecast to remain below the government's target, ending 2000 at 2.2% and edging up marginally to 2.4% by end-2001. Average earnings are projected to remain under control, averaging 4.8% by end-2001.

The CBI forecast for unemployment is not too upbeat. Measured by the LFS ILO definition unemployment is expected to fall only slowly averaging 1.66 million at the end of 2000 and 1.62 million by end-2001. Overall employment is expected to rise by 516,000 over the two years to the fourth quarter of 2001 as economic growth continues to attract more people into the labour market.

However, stronger growth is forecast by the Ernst & Young "ITEM club" - a research group that uses the same economic model as the Treasury. It expects the UK economy will grow at a healthy 3% this year and says this will be driven by stronger exports. The group also expects underlying inflation to be just over 2% this year, below the Bank of England's 2% target. The researchers predict more interest rate increases this year, but say that rises in the cost of borrowing will level-off this summer at 6%, well below the last peak of 7% in the summer of 1998.

Average of all independent forecasters, UK , March 2000

 

2000

2001

GDP growth

3.1%

2.6%

Claimant unemployment (total)

1.08m

1.05m

Annual growth in employment

0.9%

0.7%

Europe

Economic revival has arrived in the 11 country Euro-zone - mainly driven by economic growth in Germany where the Federal Government expects the economy will expand by about 2% this year - up from just 1.4% achieved during the past 12 months. However, many economists believe that this is too cautious, and expect rates of 3% and higher which are consistent with growth forecasts for the whole Euro region. Deutsche Bank forecasts the economy will grow at a pace that ranks alongside the USA - predicting that German GDP will grow by 2% in the first quarter, 4.6% in the second, 4.8% in the third, and 4.3% in the last quarter of 2000.

Unlike Britain or the USA, where interest rate rises are feared - Europe will continue to have low borrowing costs. In early March, the European Central Bank (ECB) decided to keep rates for the 11-member Euro-zone unchanged at 3% - after raising them by a quarter point in February. The bank has resisted pressure to raise interest rates to support the Euro, which over recent weeks has fallen as low as 93 US cents compared with its launch value a year ago of $1.17.

For Euro-zone countries, a weak currency has boosted exports, but with oil prices rising, external inflationary pressures may force the ECB to raise interest rates. This could choke the economic recovery before its benefits are fully felt.

USA

The strength of the US economy has been breathtaking and reached a new peak at the end of 1999 - growing at a rate of 5.7% during the third quarter of the year and by a blistering 7.3% in the final quarter. By February, the USA had clocked up the longest ever period of expansion in its history. Along the way, these levels of growth have created 20 million new jobs - a rate that has not significantly slowed down in recent months - there were 315,000 new jobs in December, a further 384,000 jobs in January 2000 although only 43,000 were jobs added in February.

Between February 1999 and February 2000, in total, the US employed labour force - which is almost exactly 5 times larger than the UK - grew by 2.9 million. To match this level of jobs growth, UK employment would need to have expanded by nearly 600,000. In fact, UK employment grew by just half this equivalent figure.

Since 1992 the US economy has expanded by 37% and has now set a new record for the longest-ever economic expansion. By the end of February 2000, the USA had seen 107 months of consistent growth - surpassing the previous record boom of 1961-69. The unemployment rate is at a 40-year-low having dropped from 7.8% to 4% while the economy has created some 20 million jobs. The story of economic success has led to a high level of optimism reflected in investor confidence that has caused the Dow Jones industrial average of 30 leading stocks to triple in value over the last five years.

However, the US trade deficit reached a record of $300bn in 1999 - the equivalent of almost $2,000 for every working American. This deficit may cause a turnaround to the economy. Thus far, it has been financed by foreign investors who could take fright if the stock market continues to weaken this year, followed by a cut in the value of the US dollar. More expensive imports would cause inflation which has already been threatened by higher oil prices. The monetary authorities are trying to slow down the boom and boost the dollar by raising interest rates. But over-excessive action could cause either a recession or a run on the dollar.

The US government has now revised its long-term forecast for the US economy, partly on the basis of these trends. It now says the economy can grow on average by 2% each year, an increase of %.

With recent growth far higher than the 3% most economists believe is sustainable in the long run, paradoxically some very recent signs of slowdown may be exactly what policy makers want. The pace of US growth has lead to inflationary fears and the Federal Reserve Bank has raised interest rates five times in 9 months - to 6% - to slow down the economy. The most recent rate hike on March 21st was accompanied by a statement from the monetary authorities warning of a threat that "inflationary imbalances would undermine the economy's record economic expansion".

With both companies and individuals carrying high levels of borrowing, there is the potential for a sharp turn-around in the US economy this year, if higher interest rates really begin to bite. But it also looks like the rapid adoption of new technology has cut costs and boosted productivity allowing the economy to grow much faster than before without an inflationary effect.

Productivity gains have been spectacular - rising by 5% in both the third and fourth quarters of 1999. For the whole of 1999, labour productivity was up 2.9%, the strongest annual rise since 1992.

Labour productivity gains offset wage rises. Recent data showed average earnings growing by 3.6% year on year, but overall labour costs fell 0.3% in the third quarter and by 1.0% in the fourth quarter. Productivity in the manufacturing sector, which has been recovering from a slump, rose 6.4% in 1999 - the fastest productivity in the sector since a 7% gain was registered in 1971.

Despite productivity gains, the economy may still face shortages of labour which could bid-up wages.

Although economists fear inflation, US retail prices in 1999 actually grew at their slowest "core" rate since the l960s. The rate, which excludes volatile food and energy prices, was up just 1.9% in the twelve months to December 1999, the best figure since 1965, when it was 1%. The overall rate of inflation was 2.7%, as high oil prices pushed up the index slightly from last year's figure. However, energy prices were up by 13.4%, the biggest increase since the Gulf War in 1990, as OPEC producers succeeded in reducing output. And the rate of inflation appears, if anything, to be slowing down, with consumer prices rising just 0.2% in December - less than expected. Forthcoming price rises seem unlikely too as core producer prices - the cost of raw materials - were even lower at 0.1%.

So the news that the jobs growth has slowed - and unemployment inched upwards in February - eased fears that the US central bank, will raise interest rates even further.

There were only 43,000 jobs added to the US economy in February, substantially below the 205,000 expected by analysts, and well below the 384,000 jobs created in January. As a result, unemployment rose slightly to 4.1%, up from 4.0% last month. That is still one of the lowest rates of unemployment since the 1960s. The biggest slowdown in jobs occurred in the interest-rate sensitive construction sector, which had added a large number of jobs in January to the mild weather.