Prospects for the UK Economy

Introduction

Coinciding with the arrival of spring is an economy showing signs of vigour. Economic growth has been accelerating since the end of 2012, reaching its recent pinnacle of 0.8 per cent per quarter at the start of 2014; three times the rate of expansion in the whole of 2012. The rate of unemployment remains on a downward trajectory, dropping to 6.9 per cent of the labour force in the three months to February 2014. This is around a 1 percentage point drop in the space of only a year, and this level represents its lowest point since the end of 2008. These two phenomena have occurred in a shift to a seemingly more benign inflationary environment, with inflation below target for the first three months of this year.

But vigour does not pervade all the dimensions of the economy. The corollary of robust growth in demand and the labour input is the absence of productivity growth. Intertwined with this is a rapid increase in the number of self-employed. Whether this is actually a manifestation of a weaker labour market than the headline employment figures suggest remains to be seen. However, the continued absence of a resumption of productivity growth is of obvious concern. Long-run prosperity is intextricably linked with an economy's ability to raise levels of productivity. In the absence of any meaningful improvement in the productive performance of the UK, the commentariat's euphoria over a perceived single month's increase in real consumer wages will be short-lived.

Nevertheless, we expect GDP growth to continue at relatively buoyant rates throughout the course of 2014, albeit not quite at the pace experienced in the first quarter of the year (figure 1). Overall we expect GDP growth of 2.9 per cent this year, an upward revision of almost ½ percentage point on our forecast published just three months ago (figure 2). We have also lifted our GDP growth forecasts for 2015 through to 2017; nonetheless, these represent a softening compared to the expectation for this year. Our modal forecast is for GDP growth of 2.4 per cent per annum in each of these three years.

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Figure 1.

Real GDP growth (per cent per quarter)

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Figure 2.

GDP growth forecasts

A more robust outturn for the first quarter of this year is partially behind the upward revision, but we have also lifted the forecast in the face of a more positive outlook. The factors underpinning the robust growth this year remain broadly unchanged from our previous forecast: growth is underpinned by consumer spending, which is expected to provide a similar contribution to last year's. This expansion is expected to be supported by a similarly strong rebound in business investment volumes.

Upward revisions to growth in the face of an improved outlook are a welcome development. But this does not change the fact that the future is, by definition, uncertain. With a modal forecast of 2.9 per cent per annum this year, it is unsurprising that we attach a greater likelihood to an outcome of 3 per cent growth or more than in the forecast published in our February Review. Figure 3 presents confidence intervals around our modal forecast for GDP growth. These confidence intervals are derived from stochastic simulations using our global econometric model, NiGEM.

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Figure 3.

GDP growth fan chart (per cent per annum)

The labour market continues its remarkable feat of significant net job creation. The level of employment continues to set new records and unemployment has commenced a relatively rapid rate of decline. In the three months to February 2014, the unemployment rate declined to 6.9 per cent of the labour force. We expect net job creation to continue to rein in the unemployment rate, which is expected to drop to close to 6 per cent from 2015 onwards (figure 4). Figure 4 also presents confidence intervals around our unemployment rate forecast, derived from stochastic simulations. These suggest an approximately 15 per cent chance that the unemployment rate will drop below 5 per cent by the end of this year. There is also a 1 in 5 chance that the unemployment rate will rise back above 7 per cent by the end of 2014.

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Figure 4.

Unemployment rate fan chart (per cent of labour force)

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Table 1.

Summary of the forecast Percentage change

	2010	2011	2012	2013	2014	2015	2016	2017	2018
GDP	1.7	1.1	0.3	1.7	2.9	2.4	2.4	2.4	2.5
Per capita GDP	0.9	0.3	−0.4	1.1	2.2	1.8	1.6	1.7	1.8
CPI Inflation	3.3	4.5	2.8	2.6	1.9	1.8	1.7	1.9	2.0
RPIX Inflation	4.8	5.3	3.2	3.1	2.8	2.5	2.2	2.3	2.4
RPDI	0.8	−1.2	2.5	−0.5	2.0	2.9	2.5	2.7	2.7
Unemployment, %	7.9	8.1	7.9	7.6	6.5	6.2	6.1	5.9	5.9
Bank Rate, %	0.5	0.5	0.5	0.5	0.5	0.7	1.2	1.7	2.2
Long Rates, %	3.6	3.1	1.8	2.4	2.8	3.0	3.2	3.5	3.7
Effective exchange rate	−0.5	−0.2	4.2	−1.2	6.4	0.2	0.1	0.3	0.4
Current account as % of GDP	−2.7	−1.5	−3.8	−4.4	−4.1	−2.9	−3.0	−2.7	−2.1
PSNB as % of GDP(a,b)	9.3	7.7	5.2	5.9	5.3	3.7	2.2	0.9	−0.4
PSND as % of GDP(a)	66.1	71.1	74.3	76.7	78.6	78.9	78.4	76.3	72.7

The first quarter of 2014 saw the annual rate of CPI inflation dropping below the Bank of England's target rate of 2 per cent for the first time since November 2009. This dip in the rate of inflation has been supported by the 8 per cent appreciation of sterling in the year to the second quarter of 2014. There are few signs of domestic inflationary pressure at present. Average wage growth remains anchored at just under 2 per cent per annum, and we expect nominal wage growth to accelerate only modestly from the second half of this year onwards. This would be a concern, but for the resumption of productivity growth, expected to accelerate gradually through to the end of the forecast horizon. As figure 5 highlights, we expect the rate of consumer price inflation to remain relatively subdued over the forecast horizon.

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Figure 5.

CPI inflation rate fan chart (per cent per annum)

Arthur Okun's ‘misery index’, a summation of the rate of consumer price inflation and the unemployment rate, highlights the continued improvement on measures other than just GDP growth. The misery index peaked in 2011 and has gradually eased as both the unemployment rate and CPI inflation rate moderated.

Budget 2014 has had little macroeconomic impact. Government spending plans remain largely unchanged from those presented in the Autumn Statement, while the announced policy changes were fiscally neutral. Perhaps of greater importance than this recent Budget is the Autumn Statement of 2014, alongside which will be the announcement of the new fiscal framework the current government wants to introduce for the UK.

The Chancellor has alluded to a change in the primary target from a cyclically adjusted current budget in balance to one of an ‘absolute surplus’, that is where the public sector is a net lender to the rest of the economy, rather than a net borrower. The forward looking time horizon for such a policy is unknown, but it may at least benefit from reducing the weight attached to estimates of the output gap in the government's approach to fiscal policy. On the basis of current fiscal policy and our modal forecast for the real economy, we expect the Chancellor to realise an absolute surplus within the next parliamentary term.

Monetary conditions

At first glance, the stance of monetary policy looks to have been unchanged since the last Review in February. Bank Rate remains at 0.5 per cent and the Asset Purchase Facility's (APF) balance sheet has been held at £375bn, with principal payments on maturing assets being reinvested to maintain this value. However, there have been a number of interesting developments which have a bearing on monetary policy.

The first is that the 7 per cent threshold for unemployment, laid out in phase one of forward guidance, was officially crossed in February. In anticipation of this, the Bank detailed the framework for phase two in the February Inflation Report. The focus in this second phase has been shifted from unemployment as a narrow proxy for slack in the economy to a broader sense of spare capacity, which the Bank currently estimates at around 1–1½ per cent of GDP. The Bank has communicated that it believes monetary policy can remain accommodative to absorb this spare capacity without inflationary pressure building. The case for this has been aided by the recent reduction in the CPI inflation rate to below the Bank's target of 2 per cent.

The key question then becomes, how will spare capacity evolve over our forecast horizon? An integral factor in this will be the extent to which productivity picks up. Improvements in productivity will see potential output rise faster, and so spare capacity will diminish at a slower rate. This may however also feed in to higher wages and feed inflationary pressure, necessitating a sharper increase in interest rates. Without any improvement in productivity, it seems clear that robust economic growth will see spare capacity absorbed relatively quickly.

The Bank has also communicated that when Bank Rate rises, it will do so slowly, and that it expects the new equilibrium level to be “materially below the 5 per cent level set on average by the Committee prior to the crisis”, even when inflation and capacity levels have normalised. What is more, Governor Carney revealed, in a Treasury Select Committee hearing in March 2014, that even when traditional policy normalises the Bank expects the equilibrium size of its balance sheet to be significantly larger than it was prior to 2009.

Despite these communications, markets' expectations for the future path of Bank Rate have been little changed since the start of the year, with the first rise still expected in the first half of 2015 (see figure 6).

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Figure 6.

Interest rate expectations (per cent per annum)

The second noteworthy development concerns the exit from quantitative easing. In contrast to the previous Governor's expectation that asset sales would quickly follow the first increase in Bank Rate, Mark Carney has expressed his preference for the policy rate to be increased a number of times before embarking on any unwinding of the asset purchase facility. The rationale behind this is to give monetary policy more flexibility in responding to any shocks which may occur during the transition period. The question remains, however, about just how high rates would have to rise before there is sufficient space for balance sheet reduction to begin. Given the projected path for interest rates underlying our forecast, if a 50 basis points rise were adequate then exit from QE can be expected to begin at the start of 2016. However, a 150 basis points rise, placing Bank Rate at the still historically low level of 2 per cent, would delay the exit until the around the start of 2018. Additionally this highlights the relatively subdued level of interest rates expected over the forecast horizon (figure 6).

This also leaves unanswered the question of exactly how QE will be unwound when the time comes. In theory, there exist two options. The APF can return the assets to the market via asset sales and use the cash to pay down the loan from the Bank of England, or they can hold the bonds to maturity and use the principal payments from the government to reduce the loan. In reality it is likely they will employ a combination of the two.

Arguably the difference between the two exit strategies is not drastic. As principal payments are funded through the issuance of new debt, without the principal being reinvested by the APF to withdraw an equivalent amount of supply, both methods will result in an increase in the publicly available supply of gilts and to some degree an increase in interest rates in those markets.

Some differences are apparent though. In the former the drawdown of the APF is an active policy tool, the pace and size of which can be controlled and coordinated with Bank Rate to apply stimulative or contractionary pressure to the economy. This brings with it a degree of uncertainty about how the Monetary Policy Committee's reaction function will weigh up asset sales against interest rate movements and more than likely be met with volatility, as we have seen following the Fed's tapering. In the ‘roll-off’ scenario the redemption date of the securities held on the APF is already known, so there would be no uncertainty. In fact, we show the path the nominal value of the securities holdings would take under this scenario in figure 7. This would create certainty around the exit trajectory but also render the APF redundant as a policy tool, as the Bank of England cannot control the pace with which the gilts reach maturity.

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Figure 7.

The Asset Purchase Facility (nominal value of gilts held by APF) ‘roll-off’ scenario

The strategy chosen also has implications for the profit and loss position of the APF and ultimately the fiscal transfer eventually required under the government indemnity. If all bonds were held to maturity then we can see from their nominal value that the APF would receive approximately £325bn in principal payments, leaving a shortfall of £50bn. This would be more than covered by the coupon payments received over the life of the bonds, except that since this is now being transferred back to the government on a regular basis, the future shortfall will have to be funded by the government of the day through taxation or borrowing. In the case of asset sales the outcome is more uncertain, as the APF would receive market price for the gilts sold, which, though very likely to be higher than their nominal value, may not be equal to or greater than the price paid for them. This will be dependent on prevailing interest rates at the moment of sale, the speed with which gilts are returned to the market and many other factors. Mclaren and Smith (2013) detail these factors and allow one to see the impact of changing the underlying assumptions on the final profit and loss position. However, the lack of a clear stance on the Bank's own preferences to these questions only adds to the uncertainty about how and when normalisation will occur.

Prices and earnings

Inflation moderated further in the first quarter of 2014, with the 12-month change in the consumer prices index continuing the downward trajectory it has had since September, reaching 1.6 per cent per annum in March. This fall was slightly more than we, and consensus forecasts, had expected and means that CPI inflation has been below the Bank of England's 2 per cent target throughout the first quarter of this year.

The biggest contribution to this moderation was transport costs, most notably petrol and diesel prices. The price of both fell in the three months to March, compared to a period of significant growth a year earlier. This movement is echoed in world oil prices which, after strong growth in the third quarter of 2013, look to have contracted on a quarter-on-quarter basis for two quarters in a row in dollar terms. In light of this, and coupled with the ongoing slowdown of demand in China and increased production in both Iraq and the US, the US Energy Information Administration have downgraded their projections for oil prices in 2014 and 2015 to contractions of 4.5 per cent and 5.1 per cent per annum, respectively. This is compared to the projected falls of 3.7 per cent in both years which underpinned the forecast published in our February Review.

The repercussions of cheaper world oil can be seen in UK producer prices. The ONS' index of producer's input prices contracted by 6.5 per cent in the twelve months to March, driven almost entirely by the large fall in the cost of crude oil. The fall in the price of crude was mirrored by significant slowdowns in the price of other input commodities, such as imported metals and chemicals, again most likely driven by China's cooling demand for manufacturing inputs. This reduction in costs was passed on to producer output prices, which saw the smallest rate of increase since October 2009, rising just 0.5 per cent over the same 12-month period. As one would expect, the aggregate figure was heavily influenced by the price of petroleum products which fell more than 7 per cent over the year. If this weakness in factory gate prices persists, it would reasonably be expected to pass though to consumer and retail price measures, acting as a downward influence on broader inflation over our forecast.

Given the UK's trade connections with the Euro Area, import prices have softened significantly and are forecast to remain lower as prospects for Euro Area inflation have been revised down since February. Lower import and oil prices will act as a deflationary consideration insofar as they will lower the cost of manufacturing inputs for firms. Firms may then choose to pass this on to consumers, as appears to be happening in the current data, which would be deflationary. Conversely they may use it to improve their margins, not lowering price growth and limiting the pass-through to domestic consumer inflation.

The softening of import prices and the reduction in world oil prices have been amplified by the continued appreciation of sterling, which has risen 4 per cent against the euro in the past six months, and almost 5 per cent against the US dollar. Barrell and Holland (2008) suggest a rule of thumb that half of any movement in the exchange rate is reflected in domestic prices, but the extent to which these factors will actually weigh down on domestic inflation is uncertain and in part dependent on what is driving them. If, rather than sterling appreciating, other currencies have depreciated against sterling due to their own bad performance, or weak demand for their goods, this may have a deflationary impact as it could be a leading indicator of a fall in their own demand and as such undermine demand for UK exports. If, however, the depreciation of the other currencies is driven by an expected loosening in monetary policy, as is currently the case in the Euro Area, this will have little to no impact on UK domestic prices. Conversely, if what we are observing is a true appreciation of sterling, for instance caused by the improvement in our recent economic performance as well as the economic outlook, then the movement in the exchange rate is more a symptom than driver, and inflationary pressure will only result in as much as productivity growth does not keep up with output growth, and spare capacity is diminished.

Balancing these factors, our modal forecast for the path of CPI inflation is shown in figure 5. We have revised down our forecast for 2014 by 0.3 per cent to an average of 1.9 per cent per annum, whilst 2015 is broadly unchanged from February at 1.8 per cent (see figure 8). As with any forecast there is an element of uncertainty and the chart also shows confidence bounds derived from stochastic simulations. They show a slightly higher risk to the downside of our forecast rather than the up as the zero lower bound is still likely to impair conventional monetary policy's ability to respond to negative shocks in the medium term.

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Figure 8.

Inflation forecasts

It was widely reported in April that real wages had seen their first increase in around four years in February. However, when like-for-like figures on total average weekly earnings and CPI inflation are compared, the outcome is that the real wages were at best flat. Once the effect of bonus payments is removed, real wages continued to contract by 0.3 per cent per annum on average in the first three months of 2014. What improvement has been observed has been as much due to the lower than expected inflation outcomes, as to any significant pick-up in nominal wages and we expect this to persist in the near term. We expect wage growth to remain muted throughout 2014, before accelerating significantly ahead of the rate of CPI inflation in 2015. Driving this improvement in real consumer wages is a pick-up in productivity growth, even as the amount of slack in the labour market continues to be eroded. Under our current assumptions, real wages, which are currently still at the same level they were in mid-2004, are not expected to regain their 2009 high until the end of 2018 (see figure 9). The lower profile for inflation means this is approximately two years ahead of where we anticipated in February's Review, highlighting the uncertainty surrounding the exact timings of future events such as these.

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Figure 9.

The profile for real consumer wages and productivity

Components of demand

GDP growth in the first quarter of 2014 appears to have remained robust. The Preliminary Estimate from the ONS came in at 0.8 per cent growth compared to the quarter before, broadly consistent with our own monthly GDP estimates for growth of 0.9 per cent in those same three months. Based on these estimates, we forecast that the UK economy will regain its pre-recession peak in the next few months. We have revised up our forecasts for both 2014 and 2015 by 0.4 and 0.3 percentage points, respectively, to 2.9 per cent and 2.4 per cent.

Until the Quarterly National Accounts for a particular year have been revised, with the additional information provided in the second Blue Book ‘round’, the headline estimate of GDP is derived from the output approach. The expenditure approach to GDP suggests the level of GDP in 2013 was 0.6 per cent greater than the output approach estimates. All else equal, we should not be surprised if this were to translate into a significant upward revision to the level of GDP for 2013. But methodological changes can introduce significant revisions to the Quarterly National Accounts which could swamp the ‘regular revisions’.

Disaggregating demand growth into the contributions of each component in 2013, the biggest contribution came from household consumption which added 1.4 percentage points to the headline number (see table A3). Overall consumption growth (private and public), in real terms, has so far been the crucial driver of growth. We expect this to persist into the current year and the next before moderating further out in the forecast as the wealth effects from rapidly rising real asset prices ease and rising interest rates incentivise a greater degree of saving and the gradual adjustment of household balance sheets.

Our real government consumption projections are based on those produced by the OBR. Despite the introduction of a programme of ‘fiscal austerity’ introduced after the 2010 General Election, the contributions from real government consumption to GDP growth have not been negative in any year between 2011 and 2013. This partly relates to the government's fiscal consolidation plan's initial focus on tax increases and reductions in capital expenditure. But it also relates to the method of measurement of the output of general government. The nominal figure for government expenditure is easily measured by the statisticians of the ONS. Unlike other components of expenditure, government consumption is not deflated by a price measure, but rather the volume of that consumption is largely based on a measure of outputs (64 per cent of the total), for example, the number of pupils taught or the number of operations performed (see Pope, 2013). Thus, any squeeze on government consumption, while the volume of output continues to rise, appears as an effect on the general government consumption deflator. Over the period 2011–13 this deflator has not grown, on average. In the decade prior to this period, the deflator recorded an average rate of growth of 3.9 per cent per annum. Over the period 2014–18 we expect the deflator to grow by a modest 0.2 per cent per annum, on average. At the same time real government spending is expected to decline at an average rate of ¾ per cent per annum.

While the contribution of consumption in the economy is expected to be reasonably stable this year and next, the recovery's overall reliance on consumption growth is expected to be far less so. We expect a robust contribution from capital spending, in particular by the corporate sector in 2014 and 2015, as the resurgence of demand leads to acceleration in investment growth. Fixed capital investment is expected to contribute 1.3 percentage points per annum to GDP growth in 2014 and 2015, suggesting at least some internal rebalancing of the economy.

While one would expect this contribution to GDP growth from fixed investment to ‘tail-off’ in future years, of crucial importance to a persistent rebalancing of the domestic economy is to what degree robust rates of growth can be maintained? We are more pessimistic than the OBR in this regard as we do not project a fundamental shift in the pattern of expenditure that leads to record levels of investment, in real terms, as a share of GDP.

Whilst domestic demand remained the biggest influence on the aggregate GDP figure, net trade also contributed positively to growth in 2013. Furthermore, in the three months to the end of February 2014, the deficit in trade in goods narrowed by £3 billion compared to the previous three months. A positive contribution from net trade in goods, over this period, comes not from a marked improvement in export growth, but from rather less of a contraction than for imports. But this recent positive contribution to GDP growth from net trade is expected to be short-lived, at least for the next couple of years.

As growth strengthens in the UK's biggest trading partners, most notably the Euro Area and the US, we expect growth in the demand for UK exports to accelerate and improve the net trade position over the longer term. However, in the short term, the fact that the UK has returned to higher growth more swiftly than many other economies may mean that demand for imports is expected to outstrip export growth in 2014 and 2015, leading to a temporary deterioration in the trade balance. It is only from 2016 that we expect a positive contribution from net trade to return, as the global economy, and in particular, the UK's major trading partners, continue to strengthen.

The recent appreciation of sterling may be considered a downside risk to our forecast for exports as it could potentially affect the UK's international competitiveness. However, even with this upturn, the UK's real effective exchange rate is still 15 per cent below its peak in 2007. What is more, the relative competitiveness of UK export prices improved 1.2 per cent per annum in the final quarter of 2013 and 2.1 per cent for the year as a whole. Even factoring in an appreciating currency, we forecast that relative export prices will be flat in 2014, staying at their current levels, before improving further in the medium term (see figure 10).

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Figure 10.

Relative export prices for the UK

While the evolving crisis in Ukraine could also prove detrimental to the outlook for Russian demand for UK exports, the actual pass-through to the UK would probably be limited. As we reported in the February Review, in 2012 less than 2 per cent of the UK's total goods exports and only 1 per cent of total services exports were exported to Russia.

Household sector

Household consumption remains the biggest driver of growth, contributing 1.5 percentage points to the 2.7 per cent total year-on-year GDP rise in the fourth quarter of 2013, and 1.4 percentage points to growth in 2013 as a whole. In the latest Quarterly National Accounts, the impact of revisions to historic consumption data was minimal, lowering the rate of growth from the beginning of 2012 to the end of the third quarter of 2013 by just 0.1 percentage point. However, the data outturn for the fourth quarter of that year was lower than we had assumed in the forecast published in the February Review, with growth of just 0.3 per cent quarter on quarter. This has lowered consumption growth in 2013 by 0.3 per cent compared to our previous forecast. Given the strength of retail sales data this quarter, the softening of the fall in real consumer wages and the further increases in consumer credit, we have revised down our consumer spending forecast for 2014 only marginally. An intertemporal shift in consumer spending growth within this year results in an upward revision to our forecast for 2015. This is due to the change in the implied carry-over effect, rather than a fundamental change of view about the propensity to consumer next year.

An interesting development has been the surge in spending on consumer durables, where the annual growth rate reached 9.7 per cent by the end of 2013. Whilst this rapid growth was relatively broad-based, purchases of household appliances and motor vehicles were particularly buoyant. Purchases of these ‘big ticket’ items are another indicator of the return of confidence amongst consumers combined with a greater supply of consumer credit; approximately three-quarters of new cars sold in the UK have been bought on finance packages. This poses a potential downside risk to our forecast, as any tightening of financing conditions, such as a rise in interest rates, could adversely affect the consumption outlook.

Growth in consumer spending continues to outpace that of real disposable income of households. As with spending on consumer durables, this is indicative of the increased availability and willingness to take on credit in recent months, also relating to consumers' willingness and ability to smooth consumption in the face of increased confidence about the path of current and future incomes. But differentiating this from households' increased confidence about the current and future state of the economy and their job prospects leading to a reduction in the degree of precautionary saving is difficult.

The household saving ratio has been on a downward trend, falling from 8 per cent in early 2010 to just 5 per cent in the final quarter of 2013. We expect this fall to continue throughout 2014, before rising real incomes and the easing of positive household wealth effects translate into a rising saving ratio. We expect the household saving ratio to rise from 4.3 per cent this year to almost 6 per cent by the end of our forecast horizon.

There is considerable uncertainty around the magnitude of household saving that will be published in the Quarterly National Accounts release in September 2014 due to the implementation of the European System of Accounts 2010 (ESA10). The introduction of new methodologies for the treatment of defined benefits pension schemes in the National Accounts will result in their treatment as a current asset of an individual and as such boost their saving rate substantially. Current estimates are for an uplift of between 3.4 and 6.3 per cent. As we note in the saving and investment section, this does not change the figures that fundamentally matter, national saving, since the current liability is applied to the corporate and government sectors, reducing their combined saving by the equivalent amount to the household sector's saving increase.

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Figure 11.

The gap between household consumer spending and income growth

Household wealth has continued to benefit from strong growth in asset prices. According to the major indices, UK house prices have grown in the region of 9 per cent in the twelve months to March (Halifax 8.7 per cent, Nationwide 9.5 per cent and ONS mix-adjusted 9.1 per cent) and by some measures they surpassed their pre-recession peak in the final quarter of 2013. This growth is of course even stronger in London, which regained its peak in 2011 and grew around 18 per cent, annually, in the first quarter of this year.

This is indicative of a pick-up in demand whilst supply remains sluggish in response. In fact, survey data from the Royal Institute of Chartered Surveyors for March 2014 shows that, though new buyer enquiries continue to increase, the number of new instructions actually fell, widening the gap between supply and demand. Even with sluggish supply movements, the number of transactions in the residential market, as measured by HMRC, increased by 31.5 per cent in the first quarter of 2014 when compared to the same quarter in 2013. It is worth noting though that it is still approximately the same percentage difference again from the pre-crisis peak in the number of transactions.

Demand has been underpinned by an increase in mortgage availability with figures from the Bank of England showing that mortgage approvals for house purchases have increased by about 35 per cent per annum in the first three months of 2014, compared to the same period in 2013. The fraction of high loan-to-value mortgages continues to rise, suggesting a relaxation of credit standards, supported by government interventions in the housing market. Acceleration in gross mortgage lending has meant that net lending has risen, despite the fact that repayment levels continue to grow, albeit at a slightly more muted pace. This has a knock-on effect on the nominal value of the stock of outstanding mortgages in the UK which, while stable since mid-2012, has begun to increase again since last summer according to statistics from the Building Societies Association.

The current rate of house price inflation may be cooled slightly by the introduction, in April 2014, of the Mortgage Market Review by the Financial Conduct Authority, which will require households applying for a mortgage to detail their spending patterns and prove they would be able to maintain repayments following a considerable hike in interest rates. There is already some tentative evidence of this happening. Data from the British Bankers Association shows that, whilst still high compared to the previous year, February and March 2014 both saw small reductions in the seasonally adjusted month-on-month change in lending. However, given the extent of excess demand, the expectation of prolonged accommodative interest rates and the slow speed with which supply is responding, we continue to forecast robust house price growth through 2014 and 2015 rising 7.8 per cent and 4.2 per cent per annum, respectively. This moderates as interest rates start to rise and the temporary government intervention in the housing market, in the form of the government's mortgage guarantee scheme (the second phase of Help to Buy) ends.

Supply conditions

Business investment volumes were relatively subdued over the period 2010–13, growing at an average rate of 0.8 per cent per annum. While this performance appears weak, the current data vintage suggest this growth rate is little different from the average rate of 0.9 per cent per annum over the period 1998 to 2006. As these rates of growth suggest, business investment has declined, as a share of real GDP, from its peak. In 1998 business investment volumes equalled 10.8 per cent of real GDP. In 2013, this reached just 8.1 per cent of real GDP.

There are signs that business investment will spring back robustly this year. Whilst conditions have been favourable for some time, with low interest rates subduing the user cost of capital, this has not been reflected significantly in the realised investment data. Two potential sources for this disconnect are firms' access to/desire for credit and the prohibitive level of uncertainty surrounding future demand. Recent data show both phenomena are ameliorating.

The weight of uncertainty on investment appears to have eased considerably in recent months. Whilst it has been cited as the greatest barrier to investment intentions in surveys such as the CBI's Industrial Trends Survey for a number of years, it has fallen back dramatically since the third quarter of 2013, with one third less businesses claiming it influences their investment plans negatively. This was led by tentative increases in investment in more flexible areas such as training and recruitment but had not translated into more spending on longer-term projects which were often more expensive and harder to reverse. However, as we have forecast in previous editions of the Review, now the economic recovery has become entrenched and uncertainty has died back, firms are planning much more capital expenditure in those areas with the CBI's survey showing that the number of firms anticipating an increase in their capital expenditure on plant and machinery in the next twelve months is at its highest level since 1997. Importantly this is not the preserve of large businesses as the Manufacturing Advisory Services' National Barometer Survey of SMEs found that 85 per cent of respondents intend to carry out significant capital expenditure in 2014.

We expect these intentions to materialise and, given the current low level of investment, we predict the release of pent up business investment will result in robust growth of almost 10 per cent per annum both this year and next. Not only will this directly boost current output but we expect this to be a key driver of productivity improvements further out in our forecast as machinery and equipment is updated, improved and made more efficient.

The profitability of UK firms, as captured by the net rate of return, has picked up from its recessionary nadir, most notably in the manufacturing sector which has almost doubled since mid-2012 to 12 per cent (see figure 12). Not only will this be beneficial in providing internal funds with which to finance investment spending, or even delever, but by giving space for firms to reduce margins it should also provide a buffer through which UK exporters can weather the appreciation of sterling that may otherwise have harmed their competitiveness.

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Figure 12.

Net rates of return of Private Non-Financial Corporations, by sector

The labour market has continued to perform well, with employment rising by 0.6 per cent and 0.8 per cent quarter-on-quarter for the final quarter of 2013 and the first quarter of 2014 respectively. We expect this to continue through 2014, growing 2.3 per cent over the year as a whole and 1 per cent in the next. Much of the improvement has been in self-employment, which has grown at roughly double the rate of employees since mid-2013. Even with net inflows to the labour force from the previously inactive this has resulted in the unemployment rate falling to 6.9 per cent as of the three months to February.

The employment picture is far from binary though, and underemployment has been a central feature since the Great Recession. Plotting the Bell and Blanchflower underemployment index (see Bell and Blanchflower, 2013) against actual unemployment rates shows that a gap opened up in 2008–9. Workers' desire to work more hours than they currently do may be a result of their hours being cut, as was clearly the case in 2009. However, it may also derive from an attempt to maintain their level of income in the face of real consumer wage reductions; a plausible response to greater constraints on household budgets is to increase the supply of labour. This would imply that when real consumer wage growth recovers, workers will become more satisfied with the hours they have and we will see a strong reduction in both underemployment and unemployment. To the extent that the former is true, as conditions improve we expect the underemployment of workers to be absorbed, slowing the pace with which unemployment itself falls in our forecast. This can already be seen in the pick-up in average hours worked, which have recovered from historic lows in 2011 to a level more consistent with their average for the decade preceding the recession.

The level of productivity in the UK has been persistently weak in recent years and has yet to show strong signs of improvement. However, as slack in the labour market is absorbed and resurgent investment feeds through to more efficient capital, we forecast that productivity will recover, taking real wages with it. Output per employed hour is expected to grow by 0.5 per cent per annum in 2014 and 1.3 per cent in 2015 before strengthening further from 2016 onwards. This productivity growth should boost the UK's potential output and limit the scope for demand to outstrip supply capacity and completely erode the output gap over our forecast horizon.

Public finances

The ONS have published public finance estimates for fiscal year 2013–14. These suggest both the deficit on the current budget and public sector net borrowing figures have continued to shrink. The deficit on the current budget narrowed from £85.3 billion in 2012–13 to £70.6 billion in 2013–14. Excluding the impact of the transfer of the Royal Mail pension scheme, public sector net borrowing shrank from £108.7 billion in 2012–13 to £95.5 billion in 2013–14.

We expect the magnitude of these key fiscal aggregates to diminish further over the course of the forecast horizon, presented in tables 2 and A8. This has little to do with the policy decisions contained within Budget 2014, since this budget continued the trend of fiscal neutrality. The convergence of the government's spending plans with overall tax revenues occurs via fiscal consolidation and the increases in tax revenues from a more buoyant economy.

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Table 2.

The effect of APF flows on the fiscal forecast Per cent of GDP, fiscal years

	2011–12	2012–13	2013–14	2014–15	2015–16	2016–17	2017–18	2018–19
Surplus on the current budget (as a per cent of GDP)
Excluding APF flows	−5.9	−6	−5.1	−4.3	−2.6	−0.8	0.6	1.8
Including APF flows	−5.9	−5.6	−4.3	−3.6	−2.1	−0.6	0.6	1.8
Public sector net borrowing (as a per cent of GDP)
Excluding APF flows	7.7	7.4	6.6	6	4.1	2.4	0.9	−0.5
Including APF flows	7.7	7.0	5.9	5.3	3.7	2.2	0.9	−0.4
Public sector net cash requirement (as a per cent of GDP)
Excluding APF flows	9.2	10.3	6.8	6.5	4.4	3.3	1.6	−0.4
Including APF flows	9.2	9.6	4.8	5.8	3.9	3.1	1.6	−0.2
Public sector net debt (as a per cent of GDP)
Excluding APF flows	71.1	75.1	79.3	81.8	82.4	81.9	79.6	75.8
Including APF flows	71.1	74.3	76.7	78.6	78.9	78.4	76.3	72.7

Source: NIESR database and forecast.

The overall fiscal consolidation programme was largely set in the 2010 Emergency Budget and the 2010 Comprehensive Spending Review. As was set out in those plans, from 2014–15 onwards, consolidation is dominated by reductions in government consumption (broadly equivalent to Resource Departmental Expenditure Limits). Successive Autumn Statements have provided additional information on spending envelopes for future years, as the 5-year horizon for fiscal policy, under the current Fiscal Mandate, continues to march onwards one year at a time. The 2013 Autumn Statement was no exception to this, with the Chancellor announcing government plans for spending cuts to persist into fiscal year 2018–19.

We assume government consumption evolves in line with current government plans. This implies a drop in both real and nominal terms between 2014–15 and 2018–19. As the OBR has noted, as a share of GDP, this will bring government consumption to its lowest point since records began, in 1948. We assume that government investment spending also evolves broadly as the government projects and we expect this to result in public sector net investment of just 1½ per cent of money GDP, over our forecast horizon. The other components of spending are endogenously determined in our global model, NiGEM.

Over the period through to 2018–19 we expect public sector net borrowing to be reduced by around £100 billion, suggesting the public sector will become a net lender to the rest of the economy. This is the absolute surplus that the Chancellor has suggested would form a central plank of his revised fiscal framework.

The primary balance, public sector net borrowing excluding government interest payments, is expected to return to surplus two fiscal years earlier than this – in 2016–17. This is around the same time that we expect the deficit on the government's financial balance to drop below 3 per cent (the Maastricht criteria).

Only when public sector net borrowing, as a share of GDP, falls below the rate of growth of nominal GDP will we see government debt, as a per cent of GDP, begin to fall. Our modal forecast suggests public sector net debt will peak in 2016–17 at 78.9 per cent of GDP, before falling back to under 73 per cent of GDP at the end of 2018–19. Gross debt follows a similar path, and is expected to peak at 92.6 per cent of GDP at the end of 2015, before shrinking to just over 85 per cent by the end of 2018.

Between June and September 2014, inclusive, a number of methodological changes will occur on the UK's economic statistics, including the public finance statistics. The data and forecasts presented in this Review will change dramatically. As ONS (2014) has highlighted, money GDP will be revised up by between 2½ and 5 per cent, lowering the size of the fiscal aggregates as a share of GDP. Such developments will also lower the overall debt to GDP figures, all else equa1. ¹

At the same time changes to the treatment of certain financial assets on the government's balance sheet will narrow the difference between gross and net debt. For example, the government's equity holdings in Lloyds Banking Group and Royal Bank of Scotland, compensation payments made under the Financial Compensation Scheme and loans provided to Northern Rock and Bradford Bingley Building Society will all be reclassified from liquid to illiquid assets. This accounting adjustment will increase public sector net debt by approximately £82 billion (5 per cent of GDP).

Saving and investment

The net position of the current account of the balance of payments describes the aggregate borrowing/lending position of the economy as a whole. In table A9, we decompose this across three broad sectors of the economy (the household, corporate and government sectors). Each of these sectors is a net borrower/lender if its quantity of saving is less/greater than its investment. If the current account overall is in deficit, this implies that the domestic economy is not saving enough to fund domestic investment. For the identity to hold, finance from abroad is therefore needed to fund this investment. It is important to note that optimal levels of capital cannot be inferred from the current account position, rather just the immediate funding need/surplus of the domestic economy.

The drop in household saving, as a per cent of GDP, in 2013, returned the household sector to the position of net borrowers, for the first time since 2008. Household investment, as a share of GDP, is expected to rise by around 1¼ per cent of GDP between 2013 and 2018, due to the recovery in housing market activity as well as housebuilding. At the same time the robust improvement in real disposable incomes, due to rising real consumer wages, is expected to lead to an increase in household saving. However, real disposable income growth rebounds only from next year. In the near term we forecast a drop in household saving ratio.

The corporate sector remains a net lender to the rest of the economy. However, the degree of net lending has narrowed from the recent peak of 2008, when net lending to the rest of the economy amounted to 6.4 per cent of GDP to around 1.6 per cent of GDP. A corporate sector that is a net lender to the rest of the economy is a relatively odd position to be in and over the course of the forecast we expect this position to narrow even further. By the end of the forecast horizon we project a corporate sector that has become a modest net borrower from the rest of the economy, for the first time since 2001.

Since 2001, the general government sector has been a net borrower from the rest of the economy. The degree of borrowing increased dramatically in 2009 and 2010, averaging 9.1 per cent of GDP. This net borrowing figure has moderated to around 5.4 per cent of GDP in 2013. A recovering economy is expected to support overall tax buoyancy. This, together with the government's fiscal consolidation programme is expected to return the government to a position of net lender to the rest of the economy in 2017 and 2018.

In 2013 the UK economy was a net borrower, borrowing 4.4 per cent of GDP from abroad to fund investment in the domestic economy. Over our forecast period the UK will still rely on external sources to fund investment, requiring 4.1 per cent of GDP in 2014 and 2.9 per cent in 2015; we expect this downward trend to continue into the medium term.

The adoption of ESA10 by the ONS in September 2014 will have a number of effects on the saving rates of individual sectors. Most important here will be the treatment of defined benefit pension schemes. These will now be included as an asset on the household's balance sheet. The net present value of this stock of saving will be used to increase the level of gross disposable income of the household and also saving, thus increasing the household saving rate significantly. Importantly though, the opposite effect will occur to the corporate and general government sectors, since these are the sectors on which the liability for these defined benefit pension schemes falls. For the owners of the corporate sector who are ultimately responsible for the liabilities of the government sector what matters is national saving. At the national level the sectoral changes to the treatment of defined benefit pension schemes will offset each other, leaving national saving unchanged. All else equal, this will probably leave gross national saving unable to fund capital consumption in the near term, let alone the expansion of the country's capital stock.

Medium-term projections

The medium term represents our modal view of how the economy will evolve from its current disequilibrium. For the period in question, GDP is expected to grow at a faster pace than the UK's potential rate, narrowing the UK's negative output gap. This expectation for the future excludes the effect of further shocks to the economy, from domestic or external sources, since by definition shocks are unpredictable. While we take account of more predictable influences on the economy, such as demographic developments and announced policy regimes, the future is obviously uncertain. We therefore think it useful to illustrate this by reminding readers of the confidence intervals associated with the point forecasts published throughout this chapter, examples of which are published as fan charts around our GDP growth, inflation rate and unemployment rate projections.

We have assumed that the weakness in productivity performance is only transitory, that its growth will accelerate in future years, and that over the long term there will be a modest period of ‘catch-up’ with a ‘normal’ trend. This implies productivity growth will rise marginally above 2 per cent per annum for a period over the longer term. While we assume the weakness is only temporary, the puzzle persists and poses a significant risk to the outlook: that we are wrong and the ‘new normal’ is one of significantly weak productivity growth.

Under a low productivity scenario, real consumer wages and future prosperity would grow at a significantly weaker pace than we enjoyed over the pre-crisis period. It also implies there is much less spare capacity in the economy than we presently assume. This could have significant repercussions for the current stance of both monetary and fiscal policy.

Looking beyond the current Parliamentary term highlights a degree of uncertainty over the finer details of the framework and targets for fiscal policy. The UK's fiscal framework will change, whatever the outcome of the May 2015 General Election. Where there is certainty is in the absence of any major political party advocating anything other than continued fiscal consolidation for most, if not all, of the next Parliamentary term. The broad differences between the Conservative and Labour parties appears to be related to how quickly government debt, as a per cent of GDP, peaks and the speed at which the debt stock is then reduced. In constructing our forecast we assume fiscal policy, in the form of currently announced changes to tax rates and coverage and the path for government consumption and capital spending, evolve broadly as the current government plans. Our modal forecast is for the elimination of government borrowing by 2018. As a result of this, our projections imply, not just the fall of debt as a per cent of GDP, but a decline in the nominal value of the stock of outstanding government debt. Nevertheless, public sector debt, on the basis of current definitions, is still expected to average just over 63 per cent of GDP over the period 2019–23.

We continue to expect only a gradual normalisation of monetary policy over the medium to longer term. Even by 2018, Bank Rate is assumed to rise to, on average, only 2.2 per cent. With the rate of inflation close to target over our forecast horizon, it is only in 2018 that short-term real interest rates turn positive. The MPC will probably have allowed the Bank of England's balance sheet to begin to shrink by this point in time. As we note in the monetary conditions section, there remains uncertainty over which course the Bank's balance sheet reduction programme will be steered.