Abstract
The forecasts for the world and the UK economy reported in this Review are produced using NIESR's model, NiGEM. The NiGEM model has been in use at the National Institute for forecasting and policy analysis since 1987, and is also used by a group of about 50 model subscribers, mainly in the policy community. Most countries in the OECD are modelled separately, and there are also separate models of China, India, Russia, Hong Kong, Taiwan, Brazil, South Africa, Estonia, Latvia, Lithuania, Slovenia, Romania and Bulgaria. The rest of the world is modelled through regional blocks so that the model is global in scope. All models contain the determinants of domestic demand, export and import volumes, prices, current accounts and net assets. Output is tied down in the long run by factor inputs and technical progress interacting through production functions, but is driven by demand in the short to medium term. Economies are linked through trade, competitiveness and financial markets and are fully simultaneous. Further details on the NiGEM model are available on http://nimodel.niesr.ac.uk/.
There are a number of key assumptions underlying our current forecast. The interest rates and exchange rate assumptions are shown in tables A1–A2. Our short-term interest rate assumptions are generally based on current financial market expectations, as implied by the rates of return on treasury bills of different maturities. Long-term interest rate assumptions are consistent with forward estimates of short-term interest rates, allowing for a country-specific term premium in the Euro Area.
Interest rates Per cent per annum
Nominal exchange rates
In this context, we note the latest ECB Governing Council's decision to maintain key interest rates at the record low of 0.75 per cent. This decision comes in response to weak growth expectations and high uncertainty in financial markets, whilst medium-term inflation expectations for the Euro Area remain in line with the 2 per cent target. Meanwhile, the Bank of England maintains its interest rate at its record low 0.5 per cent and expanded its programme of asset purchase by a further £50 billion in July. Asset purchases have reached a total of £375 billion to date. The Bank of Japan also maintained its current essentially 0 rate unchanged in the short term in order to support economic growth. In the US, the Federal Reserve aggressively eased monetary policy in September 2012, announcing that interest rates will remain exceptionally low until at least mid-2015, extended the Maturity Extension Programme (MEP) to the end of the year, and introduced a third, and open-ended, round of quantitative easing (QE3), purchasing agency mortgage-backed securities at a rate of $40 billion per month. The US will maintain a highly accommodative stance for a considerable period after economic recovery strengthens. Canada maintained the target for the overnight rate at 1 per cent, anticipating sluggish global growth in the medium term, whilst inflationary pressures have softened.
Monetary policy in many emerging economies has softened recently, as global inflationary pressures appear to ease and activity is slowing down. The People's Bank of China lowered benchmark rates by a further 31 basis points to 6 per cent in July, whilst the main policy rates in Korea were recently reduced by 25 basis points to 2.75 per cent. The South African Reserve Bank cut interest rates for the first time since September 2010 by 50 basis points, down to 5 per cent. In Brazil, the central bank continues to loosen its monetary policy as a response to lower growth expectations with 10 consecutive interest rate cuts since August 2011, which now stands at a record low of 7.25 per cent.
Figure A1 illustrates our projections for real long-term interest rates in the US, Euro Area, Japan and Canada. Long real rates have followed nominal rates in a sharp drop since the second quarter of 2011. Announced policies indicate that the monetary stance should remain highly expansionary until the end of 2014. Real interest rates in North America are expected to stabilise close to historical levels by 2017–18, while they are expected to ‘normalise’ earlier in the Euro Area, due to the high risk premium on borrowing in some Euro Area economies. We see real interest rates in Japan stabilising around a level rather below international rates of return.
Long-term real interest rates
Figure A2 depicts the spread between 10-year government bond yields of Spain, Italy, Portugal and Greece over German yields, regarded as a safe haven in the Euro Area. Sovereign risks in the Euro Area have been a major macroeconomic issue for the global economy and financial markets over the past two years. The final agreement on the Private Sector Involvement in the Greek default in January 2012, and more recently the Outright Money Transactions (OMT) introduced by the ECB in September 2012, have brought some relief to bond yields in the vulnerable economies. In our forecast, we have assumed spreads remain at current levels until the end of 2014, and start to recede in 2015.
Spreads on 10-year government bonds
Nominal exchange rates against the US dollar are assumed to remain constant at the prevailing rate in the first week of October 2012 until March 2014. After that, they follow a backward-looking uncovered-interest parity condition, based on interest rate differentials relative to the US. Figure A3 illustrates the effective exchange rate projections for the US, Euro Area, Japan, Canada and the UK. The Euro Area effective exchange rate depreciated steadily from early 2011 to mid-2012, amid growing concerns about growth and financial markets, but has seen a modest recovery in the final quarter of the year. This may be more of a reflection of the ultra-loose monetary stance in the US than a decline in the Euro Area risk premium. Meanwhile, Japanese interventions to bring their currency down against the dollar brought some relief in the first half of the year. However, the Yen effective exchange rate started to appreciate again in the second half of the year, and stands roughly 40 per cent above its level at the beginning of 2008. Sterling lost nearly 20 per cent of its value between the end of 2007 and the end of 2009, but has strengthened by 6 1/2 per cent in effective terms since mid-2011.
Effective exchange rates
Our oil price assumptions for the short term are based on those of the US Energy Information Administration, who use information from forward markets as well as an evaluation of supply conditions. In the longer term, we assume that real oil prices will rise in line with the real interest rate. The oil price assumptions underlying our current forecast are reported in figure A4 and in table 1 at the beginning of this chapter. Annual average oil prices, based on the average of Brent and Dubai spot prices, rose by almost 40 per cent between 2010 and 2011. Tight demand and supply balances and the Libyan crisis triggered this rise. Prices increased by about 9 per cent in the first quarter of this year in response to the stand-off over Iran's nuclear plans, but have reverted back since April amid growing concerns about global economic activity. In our forecast, we assume that oil prices will average $110.7 per barrel this year, up by about $4.6 per barrel compared to our July 2012 baseline assumptions.
Crude oil prices and global supply and demand
Government revenue assumptions
Notes: (a) The average income tax rate is calculated as total income tax plus both employee and employer social security contributions as a share of personal income. (b) Revenue shares reflect NiGEM aggregates, which may differ from official government figures.
Our equity price assumptions for the US reflect the return on capital. Other equity markets are assumed to move in line with the US market, but are adjusted for different exchange rate movements and shifts in country-specific equity risk premia. Figure A5 illustrates the key equity price assumptions underlying our current forecast. Global share prices dropped sharply in mid-2011 in response to the deepening of the Euro Area debt crisis and the downgrade of US government debt. However, we have seen a rebound in most of the largest economies over the past year. Within Europe, share price developments have diverged sharply, with a rise in prices in Germany, the UK and a few others, such as Ireland, while share prices have continued to deteriorate in Greece, Spain, Portugal and others. In Japan, share prices have recovered none of the losses suffered at the height of the financial crisis, and stand 55 per cent below their average level in 2007.
Equity prices
Government spending assumptions(a)
Notes: (a) Expenditure shares reflect NiGEM aggregates, which may differ from official government figures. (b) The deficit in Denmark, Finland and Sweden has not exceeded 3 per cent of GDP in recent history. In Japan and the US, deficits are not expected to fall below 3 per cent of GDP within our forecast horizon.
Fiscal policy assumptions for 2012–14 follow announced policies. Average personal sector tax rates and effective corporate tax rate assumptions underlying the projections are reported in table A3. Government revenue as a share of GDP reported in the table reflects these tax rate assumptions and our forecast projections for income and profits, as well as our projections for consumption tax revenue. Government spending is expected to decline as a share of GDP in most countries reported in the table, with the exceptions of Germany and Finland. We expect little relief in the burden of government interest payments in the vulnerable Euro Area economies of Ireland, Spain, Greece, Portugal and Italy.