• The UK economy grew by 0.4 per cent in the final quarter of 1997, the slowest rate of growth since 1995 Q2. In 1997 as a whole, GDP is estimated to have grown by 3.2 per cent. The Treasury anticipate that GDP will slow this year, as domestic demand growth slows in response to the rises in interest rates and the tightening fiscal stance, and as net trade exerts a negative influence on growth.
• Underlying inflation fell to 2.5 per cent in January 1998. The Monetary Policy Committee's latest central projection for inflation, published in February, is for underlying inflation to fall slightly over the next year or so before rising to just above the target of 2½ per cent by the end of the two-year forecasting horizon.
• The Index of Production and Construction for Scotland (excluding oil and gas) rose by 6.0 per cent over the year to 1997 Q3 as increases were recorded in manufacturing (7.4 per cent), construction (1.8 per cent), electricity, gas and water supply (5.7 per cent) and mining and quarrying (3.3 per cent). The UK Index (excluding oil and gas) rose by 2.0 per cent over the same period.
• ILO unemployment (not seasonally adjusted) in Scotland fell by 32,000 in the year to Autumn (September to November) 1997 to 185,000 or 7.4 per cent of the workforce. Claimant count unemployment (seasonally adjusted) in Scotland fell throughout 1997 but rose slightly in January 1998 to 141,100 or 5.8 per cent of the workforce - the first rise since April 1996. However, latest available data on employment suggest more substantial growth in employment in Scotland. This article includes a discussion of the factors influencing the future size of the Scottish labour force.
• The Scottish Council Development and Industry estimate that the value of Scottish manufactured exports rose by 6.4 per cent in 1996 to £18.42 billion. For the first time since 1988, UK manufactured exports growth outpaced that of Scotland. Four sectors - Office Machinery, Radio/TV/Communication Equipment, Whisky and Chemicals - continued to dominate Scottish manufactured exports in 1996, accounting for 75 per cent of the total.
• The independent forecasters expect a deceleration in Scottish GDP growth this year to around 2 per cent. Prospects for 1999 are less clear. All independent forecasters anticipate some growth in employment to 1999. A fall in the average claimant unemployment rate is forecast for this year. However, given current unemployment rates, some increase in unemployment is implied. There is less consensus of view in 1999.

The UK Economy

Output and Demand

The UK economy is approaching its seventh year of expansion. The estimate of gross domestic product (GDP) for the fourth quarter of 1997 shows a rise of 0.4 per cent. This was the slowest rate of growth since 1995 Q2 and compares with growth of 0.9 per cent in the third quarter. In 1997 as a whole, GDP is estimated to have grown by 3.2 per cent.

Chart 1 shows the quarterly growth profile of GDP since 1990 Q1, together with the growth in the manufacturing and service sectors. Although overall growth slowed in the final quarter, the rate of growth in the service sector accelerated slightly, to 1.1 per cent. Meanwhile, output in the production industries fell by 1.1 per cent and across all main sectors and, as shown in the Chart, by 0.4 per cent in the manufacturing sector. This reflects a consistent feature of the post recessionary period, in which the service sector has been more buoyant, expanding by 22.5 per cent since the trough of 1992 Q1. By contrast, the production industries have had a much weaker growth profile with output in manufacturing only 11.2 per cent higher than 1991 Q3. These latest data appear to confirm that while domestic demand remained fairly solid, the strength of sterling may now be having a significant impact on output in the manufacturing sector. There appears to be mounting evidence to support this view, both from latest trade data (discussed below) and business survey evidence.

CHART 1 HERE

Data for the fourth quarter of 1997 confirmed that domestic demand continued to play a strong role in overall growth, rising by 1.3 per cent, buoyed by strong growth in consumption and a return to growth in fixed investment.

Over the past year or so consumers' expenditure has been growing at an annualised rate in excess of 4 per cent. This has been financed by strong growth of real personal disposable income - 3.4 per cent in the year to 1997 Q3 - and the rapid growth in wealth. The windfall payments from the flotation of building societies and insurance companies accelerated growth in the second and third quarters. £34½ billion was paid out - equivalent to around 7 per cent of (nominal) consumers' expenditure in 1996. Treasury estimates, using Bank of England survey evidence, suggest that around 10 per cent (£3½ billion) of the windfall capital represented additional spend in 1997, boosting growth in consumers' expenditure by ¾ of a percentage point. Latest data on retail sales - a major component of consumers' expenditure - show a rise of 1.8 per cent in January 1998. In the 3 months to January, the volume of sales was 1.6 per cent higher than the previous 3 months and 5.7 per cent higher than a year earlier.

Fixed investment rose by 0.8 per cent in the final quarter of the year, following a slight fall of 0.2 per cent in the third quarter. In 1997 as a whole, fixed investment is estimated to have increased by 2.7 per cent. More detailed information is available to the third quarter.²

Despite falling by 4.4 per cent in the third quarter (due in large part to a decline in vehicles, ships and aircraft investment), manufacturing investment remained almost 20 per cent higher than a year earlier. However, other industries³ - accounting for around ¾ of total investment - have been weaker, falling by 0.2 per cent in 1997 Q3 and 2.5 per cent in the year. Private sector investment has had a stronger growth profile than public sector investment over the recovery, growing by 25 per cent since the trough in 1992 Q4 and, despite falling by 2.5 per cent in 1997 Q3, the level remained 6.2 per cent higher than a year earlier. Public sector investment (comprising general government and public corporation investment) rose strongly in 1997 Q3 but was over 15 per cent down on levels a year previously.

Trade data for the fourth quarter are currently incomplete. Although sterling is around 25 per cent higher than 18 months ago, exports have been resilient, rising through much of 1997, as in 1996. Exports in 1997 Q3 were still 9.1 per cent higher than a year previously, but the 0.8 per cent growth in the third quarter followed much stronger growth of 2.1 per cent and 3.3 per cent in the first and second quarters of the year. More recent data reveal that, in the 3 months to November, the volume of exports (excluding oil and erratics) fell by 1.3 per cent, compared with the previous 3 months.

Less surprisingly, with sterling's appreciation and strong consumer demand, imports have increased. Growth was particularly strong in the second quarter - 1.7 per cent - with further growth of 0.6 per cent in the third quarter, 9.0 per cent higher than 1996 Q3. The volume of imports (excluding oil and erratics) rose by 2.0 per cent in the 3 months to November. Over this period, the UK's balance on trade in goods and services was £1.9 billion in deficit, a deterioration of £1.8 billion on the previous 3 months,⁴ suggesting that the trend in the UK trade balance is widening. Hence, while net trade had a negligible impact on GDP growth in 1997 Q3, available data suggest that it exerted a downward influence in the fourth quarter.

Prices

As shown in Chart 2, since 1992 underlying inflation (as measured by the 12-month increase in the Retail Prices Index (RPI), excluding mortgage interest payments) has averaged around 3 per cent. Despite downward pressure from the appreciation of sterling since August 1996, underlying inflation did not fall back in 1997 and, with the exception of April and May, remained above the Government's target rate of 2½ per cent, as it had been since the end of 1994.

CHART 2 HERE

However, latest figures for January 1998 reveal that headline inflation (the 12-month increase in the all items RPI) fell by 0.3 percentage points to 3.3 per cent. Underlying inflation also fell, by 0.2 percentage points, to 2.5 per cent. Stripping out both mortgage interest and indirect taxes such as excise duties and council tax,⁵ inflation fell to 1.9 per cent, the lowest rate on this measure in almost 3 years. The fall in the underlying rate was due to reductions in food prices and from sales for clothing, footwear and household goods.

The appreciation of sterling has led to lower import and export prices which, in November 1997, were 4.6 per cent and 5.1 per cent below a year earlier respectively. Producer input prices have also fallen sharply - by 9.7 per cent in the year to January 1998. Meanwhile, producer output inflation (excluding food, beverages, tobacco and petroleum) has been fairly stable since the beginning of 1997, increasing by 0.5 per cent in the year to January 1998.

Concerns about inflation have been fuelled by latest data on growth in underlying earnings which has edged up since October from 4¼ per cent to 4¾ per cent in December. With high levels of skills shortages reported and continued falls in UK unemployment on both the ILO and claimant count measures, this is further evidence of labour market tightening. Ultimately some pressure will be eased with the predicted slowdown in growth but the question is whether this will happen quickly enough to ease inflationary pressures.

After the election the Chancellor announced that the Bank of England would have operational responsibility for setting interest rates to achieve the Government's target for underlying inflation of 2½ per cent. The Monetary Policy Committee (MPC) now meets monthly to determine interest rates. As shown in Chart 2, each of the 3 meetings from June resulted in a ¼ per cent increase in base rates to reach 7 per cent in August. Base rates were increased by a further ¼ per cent after the November meeting. In each of the three meetings since then, the MPC has voted to leave interest rates unchanged. Despite rises in base rates, long term rates (10 year gilt yields) - determined largely by the expected path of future short (base) rates - have continued to fall since the last peak of 7.6 per cent in April 1997 and, as also shown in Chart 2, are currently around 6 per cent.

Prospects and Forecasts

The Treasury's latest forecasts of the UK economy were published in the November 1997 Pre-Budget Report. Forecasts for 1998 and 1999 are summarised in Table 1, which also gives the latest (February) average projections of 45 independent forecasts made in the last 3 months and monitored by the Treasury.

With marginally stronger growth since the July Budget, GDP was forecast to grow by 3½ per cent in 1997, compared to the Budget forecast of 3¼ per cent (as described above, the outturn is estimated to be 3.2 per cent). Thereafter, GDP is expected to slow to more sustainable rates, as domestic demand growth slows in response to the rises in interest rates since May and the tightening fiscal stance, and as net trade exerts a negative influence on growth. In order to bring down inflation to its target, it is likely that GDP growth will need to slow below its trend rate through this year and the first half of 1999. GDP is projected to grow by 2¼ to 2¾ per cent in 1998, 1½ to 2 per cent in 1999 and 2¼ to 2¾ per cent in 2000. The average of the independent forecasts are at the bottom of this range for 1998 and at the top of the range in 1999.

Treasury projections for GDP growth and its components are presented as ranges for 1998 and beyond. These ranges are intended to give an indication of how differing degrees of supply side improvement offer the prospect of a more favourable path for the economy over the next few years. The extent to which the economy evolves along a path closer to the upper end of the range will depend partly on the success of Government policies such as the New Deal for the unemployed and action on skills shortages. However, it will also depend on other factors affecting wage determination which are in the hands of the private sector.

Table 1: Forecasts of the UK economy, 1998 and 1999

Source: HM Treasury

Notes:
1. Fourth quarter
2. Financial years

Prospects for consumption depend on both the growth of incomes and the amount of income which is spent. Growth in consumer spending is forecast to decelerate as the savings ratio falls more slowly than in 1997 and income growth begins to slow. It is projected to grow by 3½ to 3¾ per cent in 1998 and by 1½ to 2 per cent in 1999. The independent forecasters agree that consumption will slow in 1999 but remain above 2 per cent.

On investment, general government investment is expected to stabilise due to additional capital spending as part of the local authority Capital Receipts Initiative. Business investment is expected to continue to grow but more slowly as firms respond to the high exchange rate and tighter monetary policy. Overall, fixed investment is forecast to rise by 6 to 6¼ per cent this year before slowing further to 2¼ to 2¾ per cent in 1999.

The stronger than expected growth in export markets and resilience in export volumes to the strength of sterling led to a slight upward revision in the Treasury's 1997 forecast of growth in exports. After growth of around 7½ per cent in 1997, export volumes of goods and services are expected to grow by between 5 and 5¾ per cent both this year and next. Slower domestic demand is anticipated to slow the pace of growth in imports. After a small surplus in 1997, the current account is expected to move into deficit this year, reflecting both an increase in the deficit on goods and services and a smaller surplus on net investment income. Deficits of around ¾ to 1 per cent of GDP are projected over the short term.

PSBR projections are generally little changed since the July Budget. The outturn for 1996-97 was £22½ billion (3 per cent of GDP) and a further sharp fall to £9½ billion (1¼ per cent of GDP) is anticipated for the current financial year, around £1½ billion lower than the Budget forecast. The forecast for 1997-98 includes the £2.6 billion of receipts from the windfall tax and £0.2 billion of Welfare to Work spending⁶. The PSBR is expected to fall further in 1998-99 to £4.5 billion (½ per cent of GDP).

With the effect of lower input prices on retail prices expected to weaken and above trend growth in demand, the Treasury expect underlying inflation to rise to 3 per cent by the final quarter of this year. However, the below trend GDP growth anticipated thereafter will begin to exert downward pressure on inflation. This is judged to be sufficient to achieve the 2½ per cent target by the end of 1999. However, the average of the independent forecasts is less optimistic for 1999 with underlying inflation of 2.7 per cent in 1999 Q4 predicted.

The Bank of England's February 1998 Inflation Report provides the MPC's latest short term forecasts for inflation. Underlying inflation is forecast to fall slightly over the next year or so before rising to just above the target of 2½ per cent by the end of the two-year forecasting horizon. The current projection embodies a slightly higher growth profile for inflation over the next 2 years than in the previous report published in November, due in large part to the less than anticipated effect of the appreciation of sterling on retail prices. The Bank concede that the balance of risks is on the upside with the main risks the possibility of a more rapid fall in the exchange rate than that implied by interest rate differentials, past rapid money growth and, in particular, pressures in the labour market. The downside risk to inflation stems mainly from a larger fall in output and demand than the Bank's central projection.

¹John Rigg is Senior Economic Adviser in The Scottish Office Education and Industry Department. Fiona Robertson is an Economic Adviser. The Economic Review is based on data available up to 23 February 1998.
²This is based on initial estimates for the third quarter in which fixed investment was reported to have fallen by 0.5 per cent.
³'Other industries' excludes manufacturing, mining and quarrying and electricity, gas and water supply.
⁴This was due to an increase of £1.7 billion in the deficit on trade in goods (from £2.4 billion to £4.1 billion) and a decrease of £0.1 billion in the surplus on trade in services (from £2.4 billion to £2.3 billion) .
⁵More specifically, this series (known as RPIY) excludes council tax, VAT, excise duties, vehicle excise duty and premium insurance tax as well as mortgage interest payments.
⁶Without these receipts the PSBR would be about £12 billion in 1997-98.