Prospects for the UK economy.

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.

Introduction

During 2006, output in the UK economy grew by 2.8 per cent and the robust pace of economic growth has continued in the first half of this year. After a first estimate of quarterly GDP growth of 0.7 per cent into the first quarter of this year, the official preliminary estimate suggests that the economy expanded by 0.8 per cent into the second quarter. The economy continues to be driven by business services and finance, although the production sector actually reported quarterly growth for the first time since the first quarter of 2006. The economy is now operating around full capacity, and has recovered from the weakness that was apparent in 2005. We have revised up our forecast for this year to 2.8 per cent per annum, from 2.7 per cent per annum in our April forecast. This is due to an upward revision to estimates of GDP growth at the end of 2006 and more robust growth than we had anticipated in the first half of this year. We expect growth of just below the trend rate for the remainder of the forecast period as domestic demand growth moderates.

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Continued robust growth means that this year and next the UK will be operating slightly above capacity. The obvious existence of demand pressures on the rate of inflation is clearly a worry for the Bank of England. However, the combination of the impact of inflationary pressure on competitiveness, and of the recent and anticipated monetary tightening, should mean that the growth rate of output will moderate next year and capacity output should be reached from above the year after, as we can see from figure 2. If growth does not moderate, then inflationary pressure will increase, and interest rates will rise more than currently projected.

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The rate of CPI inflation has moderated since the Governor of the Bank of England wrote an open letter to the Chancellor in March 2007, declining from 3.1 per cent in that month to 2.4 per cent in June of this year. Measured over the quarter, CPI inflation moderated from 2.9 per cent per annum in the first quarter of 2007 to 2.6 per cent per annum in the second quarter (figure 3). This deceleration is more than we anticipated at the time of our April forecast. In the short term we expect CPI inflation to continue to fall back towards the Bank of England's target, as the decline in the annual rate of growth of gas and electricity bills continues to feed through into CPI inflation.

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With the projected rise in interest rates and their subsequent path set out in table 2, we expect inflation to return to target at around the start of 2010, remaining very close to target throughout 2009. Indeed if inflation were required to be on target exactly two years out, then increasing interest rates by another 25 basis points in the final quarter of this year should force CPI inflation to reach the Bank's target rate of 2 per cent per annum. As Barrell and Kirby (2007) show, small changes in monetary policy have a small effect on the inflation rate, although they are clearly crucial in helping to reinforce the credibility of monetary policy with economic agents and keep inflation expectations in check. (1)

In comparison to previous years, the release of the National Accounts, consistent with the Blue Book, is a relatively muted affair. Unlike previous years, the updating of the base year has not taken place, nor has the balancing of the expenditure, income and output approaches to GDP through the input-output tables. (2) However, the Office for National Statistics has introduced a new methodology for the treatment of software investment into the National Accounts (for full details see Chamberlin, et al., 2007). These revisions have been taken back to 1970 and increase the level of both business investment and GDP. (3) Figure 4 shows the impact of this new methodology for business investment in current prices as a per cent of money GDP. This figure compares data available at the time of our April forecast to the current vintage of data. The impact has been to raise business investment as a proportion of GDP by approximately 0.6 percentage points since the start of 2000. From 1970 to 2006 this new methodology raises the level of money GDP by around 0.7 per cent. However, Chamberlin et al. (2007) note that the impact on real GDP growth is not smooth.

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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 1993-2006 for inflation and 1989-2006 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. Barrell, Khoman and Kirby (2007) show the reduction in the errors of NIESR's GDP forecasts as the economy shifted to a more stable macroeconomic environment and present bounds based on errors from 2000-6. 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 2 per cent chance that inflation, measured on average over the quarter, will rise above 3 per cent towards the end of this year and 14 per cent by the end of next year. Our forecast shows GDP growth of 2.8 per cent per annum this year, weakening slightly to 2.6 per cent per annum next year. Based on past experience, there is almost a 2 in 5 chance that growth will be at least 3 per cent this year and next.

Interest rates, exchange rates and prices Since our April forecast, the Bank of England has continued to tighten monetary policy with a further two rises in interest rates. The official bank rate now stands at 5.75 per cent, the highest rate since February 2001 (figure 5). The Bank has now increased interest rates by 1.25 percentage points since August 2006.

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Financial markets expect this phase of monetary tightening to continue. In constructing our forecast we have taken the Libor yield curve for 2007, which suggests a further quarter point rise in the Official Bank Rate by the end of the year. Looking ahead to next year, our forecast is based on interest rates rising no further than this, implying that the Bank holds rates at 6 per cent for 2008. This deviates from the Libor yield curve, which suggests a further 25 basis point rise in the first quarter of 2008. However, determining market expectations of the future path of interest rates depends upon which yield curve is used. While the Libor rate as published in the FT suggests two further rises over the next four quarters, the commercial liability yield curve as published by the Bank of England implies only one further increase in the Official Bank Rate. The government liability yield curve as published by the Bank of England is relatively flat. Deriving a path for the Official Bank Rate from this yield curve would suggest no further interest rate rises. We have taken an intermediate position consistent with our forecast and assumed that there will be one more interest rate rise.

Since our April forecast, RPIX inflation (the Bank of England's target measure prior to CPI) has moved below 3.5 per cent per annum in May and June of this year. If the Government had maintained its previous target regime in 2003, then RPIX inflation above 3.5 per cent would have required the Governor to write an open letter of explanation to the Chancellor. Indeed, since the monetary framework gives the Governor only three months before a further open letter must be written, the Governor would have had to have written two letters to the Chancellor, one in December of 2006 and one in March of this year. (4)

Despite data suggesting that the economy is growing at a robust pace, with little spare capacity, it is our view that there is currently little need for further monetary tightening beyond a quarter point rise in the final quarter of this year. However, upward risks to inflation remain. Robust world growth translating into higher import prices is of concern, which has been reinforced by the recent rise in oil prices. At the time of our forecast the outlook for oil prices is approximately 6 1/2 per cent, or $4, higher in 2008 and 2009 than at the time of our April forecast. However, the appreciation of sterling against the USS means that the rise in oil prices is only around 4 1/2 per cent in sterling terms.

Currently there seems to be little inflationary pressure from the labour market. The average earnings index excluding bonuses suggests that underlying pay pressures have remained relatively stable. Annual growth in this measure of average earnings has remained at around 3 1/2 per cent this year, slightly below the average for 2006. This muted average earnings growth is present in both the public and private sectors. The rebound of the economy in 2006 allowed the growth rate of productivity to improve after a period of labour hoarding. Consequently, unit labour cost inflation has moderated from 4 per cent per annum in 2005 to 2.1 per cent per annum in 2006.

Other inflation measures suggest an easing in the rate of inflation. Since 1993, inflation, as measured by the implied consumption expenditure deflator (CED), has been, on average, 1/2 percentage point above CPI inflation (figure 6). However, CED inflation has remained below CPI inflation since the third quarter of 2006. The CED captures the change in the price of total household consumption and not just a basket of goods and services as the CPI, RPI and RPIX do. Indeed the weakness of CED inflation may be a sign of an overall moderation in the rate of price increases that are not currently being realised in other measures of consumer price inflation.

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Data suggest that output price inflation has moderated somewhat in the second quarter of this year. The CBI Industrial Trends Survey for June 2007 shows the pricing intentions of manufactures moderating somewhat, their pricing intentions remain robust compared to 2006. Looking ahead, we expect relatively stable output price inflation. With import price inflation expected to pick up slightly from around 1 1/2 per cent this year to around 2 1/4 per cent in 2008 and 2009, we would expect employers to contain other costs, and in particular unit labour costs, in order to maintain their profit margins. Looking ahead, we do not expect the recovery in productivity growth to feed through into an increase in the growth rate of average wages. With a moderation in demand for employment compared to the recent past, and robust economic growth, we expect unit labour cost inflation to decelerate to 1 1/4 per cent this year, from 2.1 per cent in 2006. We expect the annual average growth rate of unit labour costs to pick up to around 2 per cent in 2008 and 2009, below the average rate of growth of 3 per cent over the period 1997-2006.

The Sterling-dollar exchange rate had moved above the $2 mark at the end of June 2007, where it remains at the time of writing. The Sterling-dollar rate appreciated by 1/2 percentage point more than anticipated at the time of our April forecast. Taking the average for the first two weeks of July suggests that this bilateral rate has appreciated by a further 1 per cent. In producing our forecast we assume that most bilateral exchange rates follow a random walk for the first three quarters of the forecast. After this, bilateral rates follow the path implied by interest rate parity. Consequently, the Sterling-dollar exchange rate does not fall below $2 on an average quarterly basis until 2009. This implies that the Sterling-dollar exchange rate will have appreciated by almost 8 per cent this year. However, our measure of the effective exchange rate (see Barrell et al., 2005) shows an appreciation of only around 3 1/2 per cent. This is primarily due to the relative stability of the Sterling-Euro exchange rate. Even so, this appreciation of the effective exchange rate will help to contain inflation.

Demand

Domestic demand in …