Prospects for The UK Economy

Introduction

The sharp fall in the price of oil over the past few months has led financial markets to re-assess when the Monetary Policy Committee (MPC) of the Bank of England is first expected to raise the Bank Rate. Markets view the middle of 2016 rather than the middle of this year as the point at which the majority will now vote for the rise. Our assessment of the outlook for the UK economy, discussed in detail below, suggests to us that the start of 2016 is a more likely candidate for the first, and largely symbolic, 25 basis point move. Nevertheless, this still represents a half-year delay compared to our expectations in the November 2014 Review.

At first glance, the UK economy ended 2014 on a marginally more subdued note than had been expected: the Office for National Statistics’ (ONS) Preliminary Estimate of GDP, suggests the economy expanded by 0.5 per cent in the final quarter of last year (see figure 1), in comparison to our monthly GDP estimate of 0.6 per cent per quarter. Such differences are statistically insignificant, even more so when viewed in the context of the impact of recent ONS revisions, as discussed in the Demand section of this chapter.

OPEN IN VIEWER

Figure 1.

Real GDP growth (per cent per quarter)

Revisions to historical GDP estimates are technical issues that forecasters must address on a near continual basis, a point neatly summarised in the fan charts around historical data presented by the Bank of England in every Inflation Report. The important question is: have these recent ONS revisions changed our view of the outlook for the UK? They have not. What has changed our view of the outlook (see figure 2) are recent oil price developments.

OPEN IN VIEWER

Figure 2.

GDP growth forecasts

The average of Brent and Dubai crude spot prices has fallen by around 45 US$ per barrel relative to our last forecast. For a net oil importer such as the UK this helps to boost consumer spending via a positive terms of trade effect, and may translate into an improvement in the trade balance. We have raised our forecast for consumer spending for 2015 by around ¾ percentage point to almost 3½ per cent per annum as a consequence of the on-going oil price shock. This is the major factor behind our 0.4 percentage point upward revision to GDP growth for this year (see figure 2), with much of it concentrated in the first half of this year (see figure 1 for the quarterly profile of GDP growth). Looking further ahead, our modal forecast is for GDP growth rates in excess of the 2 per cent per annum pace of economic potential, closing the negative output gap over a sustained period.

OPEN IN VIEWER

Table 1.

Summary of the forecast Percentage change

	2011	2012	2013	2014	2015	2016	2017	2018	2019
GDP	1.6	0.7	1.7	2.6	2.9	2.3	2.3	2.5	2.4
Per capita GDP	0.8	0.0	1.0	1.9	2.2	1.6	1.6	1.8	1.8
CPI Inflation	4.5	2.8	2.6	1.4	0.6	1.6	2.1	2.0	1.9
RPIX Inflation	5.3	3.2	3.1	2.4	1.4	2.1	2.6	2.5	2.3
RPDI	−1.9	1.6	0.1	1.6	3.6	2.5	2.4	2.9	2.9
Unemployment, %	8.1	8.0	7.6	6.2	5.4	5.3	5.3	5.3	5.4
Bank Rate, %	0.5	0.5	0.5	0.5	0.5	0.8	1.3	1.8	2.2
Long Rates, %	3.1	1.8	2.4	2.5	1.8	2.4	2.9	3.3	3.5
Effective exchange rate	−0.1	4.2	−1.2	7.9	1.5	0.2	0.2	0.2	0.3
Current account as % of GDP	−1.7	−3.7	−4.5	−5.5	−3.9	−3.8	−3.4	−2.4	−1.2
PSNB as % of GDP(a)	7.5	7.3	5.5	5.5	4.5	2.2	0.6	−0.6	−1.5
PSND as % of GDP(a)	72.3	77.4	79.8	81.9	82.8	82.7	80.3	76.6	72.3

Notes: RPDI is real personal disposable income. PSNB is public sector net borrowing. PSND is public sector net debt.

(a)

Fiscal year, excludes the impact of financial sector interventions, but includes the flows from the Asset Purchase Facility of the Bank of England.

The short-term outlook for the global economy is more subdued, as discussed in the World chapter of this Review. The exceptions to this are the outlooks for the US and the UK. In both instances we have raised our forecast for GDP growth in 2015 on the back of oil price developments and the impact on their respective domestic economies, in particular consumer spending growth. ¹

We are more pessimistic about the outlook for some major emerging markets, notably Brazil and Russia. Our expectations for short-term economic performance in the Euro Area remain subdued. These are expected to inhibit the performance of our external sector, where deficient demand in export markets is the key to the contribution of net trade remaining a drag on UK economic growth this year and next.

The growth enhancing effects from the recent oil price shock are expected to dissipate by 2017. This is only partially behind the expected softening of domestic demand growth. Households improving their balance sheets, further fiscal consolidation and business investment growth decelerating as the capital stock approaches its equilibrium level are all factors in this. That this translates into a more subdued period of import growth is no surprise, although recovery in demand in the Euro Area is still a necessity if we are to see a positive contribution from net trade from 2017 onwards, as we expect.

The near-term effects of the oil price shock are most acutely observed in consumer price developments. The annual rate of inflation has already dropped to a 14-year low of 0.5 per cent in December 2014, and we expect it to remain at about this level, on average, throughout 2015. There is considerable uncertainty around any economic forecast, and our projections published here are no different. Figure 3 presents our modal forecast for CPI inflation through to the end of 2019, embedded within a series of confidence intervals derived from stochastic simulations on our latest baseline. While we expect the impact on the rate of inflation from oil price developments to be only temporary, the magnitude and speed of pass-through are uncertain. The distribution of potential forecast outcomes is skewed below the Bank of England's 2 per cent target in the near term. We attach a 1 in 10 chance that the price level will report an outright fall this year. Similar probabilities exist for the later years of our forecast horizon, but this relates more to the spread of the distribution, given that the rate of inflation is close to target in 2018 and 2019.

OPEN IN VIEWER

Figure 3.

CPI inflation rate fan chart (per cent per annum)

Headline figures for the labour market remain buoyant. Overall employment continues to expand at a relatively rapid pace, while the unemployment rate continues its downward march. In the final quarter of this year, the unemployment rate reached 5.6 per cent of the 16+ labour force. We expect the rate of unemployment to fall further in the near term (figure 4), reaching 5.2 per cent by the end of this year.

OPEN IN VIEWER

Figure 4.

Unemployment rate fan chart (per cent of labour force)

As we have noted in previous Reviews, the corollary to this robust employment growth and, until recently, weak aggregate demand growth, has been the absence of any persistent productivity growth. We assume that productivity growth returns gradually and that this will drive future increases in real consumer wage growth and the living standards of the UK population. In the near term, real consumer wages bounce back to growth of around 1 per cent per annum this year due to the disinflationary effect of the oil price shock: the terms of trade adjustment allows a greater increase in real consumer wages than would otherwise have been the case. Beyond this year and next, it is the performance of productivity that is the key determinant of sustained real consumer wage growth, and is also the most significant domestic risk to the UK economy.

If the recent poor productivity performance is a structural rather than an assumed cyclical phenomenon, then this has serious implications for economic policy. The Coalition government's fiscal consolidation programme is expected to move the public sector into an absolute surplus towards the end of the next parliamentary term. A structural productivity problem would mean that far more of current borrowing is structural rather than cyclical.

The Office for Budget Responsibility (OBR) has left their estimates of the magnitude and profile of the output gap broadly unchanged. The Autumn Statement of December 2014 was fiscally neutral, moving the OBR's forecasts by little. In the near term we have marginally revised up the magnitude of public sector net borrowing, due to the treatment of payments in the EU Budget. Over the next parliamentary term, the paths for the fiscal aggregates are broadly unchanged. We expect the public sector to reach an absolute surplus in fiscal year 2018–19, while public net debt, as a per cent of GDP, is expected to peak at almost 83 per cent of GDP in 2015–16. These projections suggest the new targets of the Fiscal Mandate, published in December 2014, are met.

Of course, we are fast approaching a General Election, which could well see a government elected with a different view about the implementation of fiscal policy, alongside a different set of fiscal rules. The Commentary, in this Review, illustrates the impact on the macroeconomy from some plausible paths for fiscal instruments given the pronouncements of the main political parties, to date. This pivots the forecast published here into a rather odd situation, that would not have occurred were the government seeking re-election not a coalition: the modal forecast is based on a set of fiscal policy assumptions that are clearly not modal beyond 2015–16. However, as the Commentary highlights, the impact on the wider economy from plausible alternatives would be relatively small.

Monetary conditions

Increasing interest rates now seems a more distant prospect than it did in November. The dramatic fall in annual CPI inflation to ½ a per cent in December, from an already low 1 per cent a month earlier, appears to have been enough to persuade the two previously dissenting voters to re-join the consensus view and vote to maintain the status quo.

Markets appear to have pushed back their expectation of the first rate rise to the middle of 2016, which is now later than they price in the first tightening by the Federal Reserve's Open Market Committee. It is worth noting here that just six months ago the central expectation of markets was that the MPC would have already tightened rates in time for the February Inflation Report.

Our own view is that markets are currently exaggerating the change in policy stance that has occurred in the past three months (see figure 5). Nonetheless, there is increased uncertainty surrounding both the outlook for prices and the potential reaction function of the MPC, and we have therefore pushed back our own estimate of when they will begin to tighten compared with our previous forecast, published in November 2014. The path of Bank Rate which underpins our current forecast assumes that rates will begin to rise gradually in the first quarter of 2016, reaching 1 per cent by the end of that year and 1.5 per cent the year after.

OPEN IN VIEWER

Figure 5.

Interest rate expectations (per cent per annum)

There are uncertainties to both sides of this projection, and it should be stressed that this represents the most likely path for what the MPC will do. It does not address the more complex issue of what they should do. That question is key to understanding the risks around our forecast and at its heart is the nature of the disinflationary pressure the UK is currently experiencing.

If this pressure derives purely from a temporary oil shock, of short duration, which leaves medium-term inflation expectations well anchored, then the correct thing to do, as noted in the previous Review, would be to leave the stance of policy unchanged and look through the current low inflation, just as the MPC looked through the above target inflation in 2010–12. If this is the driver, then the now expected delay to raising rates could lead to too loose a policy stance and thus a build-up of underlying inflationary pressure, albeit masked by temporary disinflationary factors. This would mean that rates would have to rise more sharply in the first half of 2016 than we currently expect as inflation snaps back aggressively.

Should it transpire that factors beyond the oil price movement, such as increased disinflationary pressure in the Euro Area or increased uncertainty about the future of that monetary union, are weighing on demand and contributing to below target inflation, then the expectation of delayed interest rate increases seems justified. Were persistent deflation to take hold in the Euro Area, then it would be appropriate for the MPC to delay an increase in rates even further.

There is also a risk that persistent weak inflation outturns, be they caused by the oil price movement, a general malaise of prices or weakening demand in our trading partners, will de-anchor inflation expectations. This in turn would be expected to feed back into weaker wage and price growth. The latest minutes of the MPC meeting, held in January 2015, highlight the need to watch for this possibility, and even the threat of it may be justification enough for delaying a rate rise until 2016.

Currently, the low level of core inflation suggests that there is more to price weakness than can be explained just by the reduction in the cost of crude oil. The change in policy stance of the MPC, although minor, suggests they are at least cautiously aware of this, since they have persistently communicated to markets that they plan to look through the oil price shock and focus on underlying inflationary pressures.

On balance, given the asymmetry of the nominal zero lower bound for monetary policy, it is our judgement that the risks to the real economy associated with tightening too early outweigh those from delaying the turning point of policy by a few more months, both in likelihood and magnitude of outcome. Thus the marginal loosening of policy would appear appropriate, at least for now.

One implication of the lower inflation profile is that short-term real rates have increased compared to where we envisioned them in our last forecast. Consequently, policy has already effectively tightened somewhat and, all else equal, would be expected to be tighter over the next twelve months. Potentially, this could partially stymie the increased economic activity from the improvements in the purchasing power of consumers by making saving relatively more attractive in real terms. However, figure 6 shows how this has been offset by the fall-back in our expectations of the future path of nominal rates; thus we expect the impact on longer-term rates to be negligible and the current real monetary stance to be little changed.

OPEN IN VIEWER

Figure 6.

UK short-term real rates

Prices and earnings

The near-term outlook for prices in the UK has moved considerably from our forecast published in the November 2014 Review. Headline 12-month CPI inflation fell to just ½ a per cent in December from 1 per cent a month earlier. This requires a written response from Governor Carney to the Chancellor, who himself publicly welcomed the fall for the boost it would provide to household purchasing power.

Much of the disinflationary pressure has been attributed to the reduction in oil prices. Our November forecast priced in a fall of $10 a barrel between the third and fourth quarter of 2014. The actual fall was over $25 and prices have fallen a further $25 already this year to less than $50 a barrel. The Energy Information Administration (EIA) projections which underpin our forecast expect oil prices to have reached their trough in the first quarter of this year, returning to $75 a barrel, on average, in 2016, but remaining below $83 for the rest of our forecast period.

The direct effects of the sharp drop in oil prices have started to become apparent: average pump prices for unleaded petrol were 108.9 pence a litre in December compared with 131.2 pence a year earlier. Wholesale energy prices have eased to varying degrees. A number of domestic energy suppliers have announced price cuts of between 1.5 and 5.1 per cent that will be introduced over the next twelve months. However, the cost prices faced by energy firms have fallen by considerably more than this. As many energy suppliers link the price they pay for gas to the global oil price, the wholesale gas price has fallen around 20 per cent since the beginning of December 2014. Lower energy input costs mean that energy firms’ profit margins are expected to increase this year, an assumption supported by the recent supply market indicator from OfGEM. ²

Given that energy and fuel expenditure make up approximately 8 per cent of the CPI basket there is a clear direct effect from oil on the most recent CPI figure. There is also a more indirect impact which will continue to pass through over the next year or so as lower oil prices lead to lower input prices for producers and they in turn pass these on, at least partially, to lower factory gate prices and eventually consumers. In the twelve months to December 2014 producer input prices fell by 10.7 per cent per annum, much of which came from energy input prices which fell more than 35 per cent. Factory gate prices (producer output) fell 0.8 per cent over the same period.

There are at least two important caveats to the oil price narrative in explaining low inflation. The first, as mentioned in our November Review, is that exchange rate movements have acted to partially offset some of the impact on the sterling price of oil. Sterling moved more than 5 per cent against the dollar between November and January and, based on amended views of the future paths of monetary policy, our forecast for the average bilateral dollar rate has been revised by down 5.5 per cent from 1.59 to 1.5 $/£ in 2015. Over the remainder of the forecast horizon Sterling stays an average of 5 per cent lower against the dollar than it was in our November publication, dampening the downward revisions in the oil price.

Secondly, a look beyond the headline CPI figure shows that the easing of inflation is a broader phenomenon than just direct oil price effects. Twelve-month consumer price inflation less energy was still barely above 1 per cent in December 2014, and the more commonly used ‘core’ inflation was 1.3 per cent (see figure 7), considerably below the Bank of England's target of 2 per cent per annum.

OPEN IN VIEWER

Figure 7.

Consumer price inflation, with and without energy

OPEN IN VIEWER

Figure 8.

UK inflation measures

Import prices were also weak, contracting roughly 1.2 per cent in the third quarter of 2014, predating the oil price collapse, as subdued wage costs and deflation in the Euro Area weigh down on price growth. Recent work by the ONS shows that it is the segments of the consumer basket which are most intensively sourced from abroad which are weighing down most heavily on current CPI inflation. This is forecast to intensify throughout 2015 and will continue to detract from UK price growth until inflationary momentum can be sustained in Europe.

We have revised down our central forecast for 12-month consumer price inflation for 2016 by 0.2 percentage point to 1.6 per cent as the effect of oil price falls passes through to consumer prices (see figure 9). Once the oil price shock passes out of the annual calculation, our forecast is for consumer price inflation to return to levels more consistent with the Bank of England's target. This leaves our projection for subsequent years broadly unchanged. This is predicated on an assumption that inflation expectations remain anchored. There is some tentative evidence from inflation swap rates and surveys that expectations have eased in recent months. YouGov/Citigroup's monthly survey of households’ expectations of inflation over the next twelve months hit just 1.2 per cent in January, down from 1.5 per cent in December and the lowest outturn for six years. Were this to become entrenched, it would represent a significant downside risk to our forecast, especially as the ability of the MPC to respond effectively to deflationary shocks is complicated by the lower bound on policy.

OPEN IN VIEWER

Figure 9.

Inflation forecasts

In January 2015 the Johnson Review into consumer prices reported its findings. It made two key recommendations. The first is that a move is made to use CPI-H, the consumer price index which takes account of housing costs as the main measure of inflation. This presents little difference to the outlook for inflation in the UK as the two series follow each other closely (figure 8). The more significant suggestion was that the government and regulators should abandon their use of RPI, which has not been an officially recognised statistic in the UK since 2013. Whilst this has far-reaching implications for government debt, interest rates and many welfare payments, it also represents a downside risk to our inflation forecast. Currently, a number of industries tie annual price increases to RPI, which has been higher than CPI inflation in every year since the latter was introduced in 1997, excepting 2009, and is expected to remain so over our forecast horizon by an average of 1.2 per cent per annum. This difference stems in large part from RPI's underlying Carli formula, which has been shown to overstate prices during periods of inflation. A switch to basing off CPI or CPI-H would thus slow the pace of inflation in these sectors and lower CPI relative to our published forecast. An interesting outcome would be that parts of the consumer basket which are not priced off an index would have to inflate by more on average than previously if the 2 per cent inflation target is to be maintained.

Despite the recent depreciation against the dollar, the broad effective sterling exchange rate consistent with our forecast actually appreciated by just over 1 per cent between November and January. This was driven by a 4 per cent appreciation against the Euro which, due to a stronger trade-weighting, dominated the dollar losses. As expectations of monetary policy cycles evolve and diverge, it will be these two forces, where the UK is in relation to the US and the Euro Area, which will determine the path of the exchange rate. Given the significant loosening of policy in the Euro Area announced in recent months, and the current outlook for prices and the macroeconomy, we feel that the Euro Area will loosen relative to the UK more than the US tightens and thus we have revised our forecast for the effective exchange rate in 2015 from a mild depreciation to an appreciation of around 1½ per cent. As noted in Kirby and Meaning (2014), exchange rate movements are likely to have a pass-through impact on domestic prices, and a continuing appreciation will further exacerbate the disinflationary pressure caused by the significant rise seen since the start of 2013.

Nominal wage growth remains weak by historical standards but strengthened somewhat in the final quarter of 2014. Regular average weekly earnings increased by 1.7 per cent when comparing November 2014 against the same month a year earlier. This was down slightly from 1.9 per cent in October but marked the third consecutive month in which it was noticeably above the rate of consumer price inflation. This follows a prolonged period where real wages contracted. Real consumer wages are now around 5¾ per cent lower than they were at their previous peak in the third quarter of 2007. Despite our forecast that nominal earnings will persistently outstrip inflation over the forecast horizon, averaging 2 per cent per annum this year and 2.9 per cent next year as productivity growth resumes and the labour market tightens further, it will not be until early 2020 that this previous peak is regained.

The components of demand

The ONS’ Preliminary Estimate of GDP suggests the economy expanded by 0.5 per cent per quarter in the fourth quarter of 2014. This places economic growth, for 2014 as a whole, at 2.6 per cent, in line with our December Monthly GDP estimates. The ONS estimates were revised down for the first two quarters of 2014 by 0.1 per cent each; in both cases investment and exports were both weaker than previously thought.

We have revised up our forecasts of GDP from 2.5 to 2.9 per cent per annum in 2015. This is primarily due to higher consumption, supported by the real income gains from the positive effect on the purchasing power of wages that is the consequence of the fall in global crude oil prices, as well as a relatively benign inflationary environment, as suggested by current rates of core inflation (see figure 7). The appreciation of sterling against the euro, which began in March 2013, continued with further gains in the middle of December through to the end of January on the back of ECB monetary policy announcements. This will reduce import prices further, helping to support consumption growth. Consequently consumption is expected to contribute around 2.2 per cent towards GDP growth in 2015. The increase in consumption growth is a temporary phenomenon, as oil prices are assumed to rebound partially in 2016, when consumption growth slows and contributes a smaller percentage towards GDP – around 1½ per cent per annum from 2016 through to the end of our forecast period. Underlying our forecast is the assumption that productivity growth, which has so far remained stagnant throughout the recovery, picks up from 2016 onwards and this supports real wage growth. Should productivity growth remain stagnant, increases in living standards will not be realised, representing a downside risk to our forecast.

Our projections for the volume of general government consumption are based on those published in the OBR's latest Economic and Fiscal Outlook. In 2014 government consumption provided a positive contribution to GDP growth of 0.3 percentage points; we expect a further positive contribution in 2015 before fiscal consolidation efforts actually lead to contractions in real government spending.

Figure 10 shows the one year ahead forecast errors of the real and nominal government consumption forecasts produced by the OBR, for three years beginning in 2011. The forecasts for the volume series appear to show a negative bias. Many of the projected ‘cuts’ to departmental spending in the coalition government's fiscal consolidation plan were expected to affect real government consumption. Due to the method of measurement, government consolidation appears in the data mostly as a nominal phenomenon. To elaborate, around 64 per cent of government consumption is measured on an output only basis (Pope, 2013), for example, the number of pupils taught or the number of operations undertaken. ³ As a result, if the amount of goods and services the government supplies rises, the volume of government consumption will also rise. Therefore, if government employment or the wage bill is reduced, this will impact on the deflator for government consumption rather than depress the volume. In the most recent projections from the OBR, this has been explicitly taken into account. As a result the forecast for the level of government consumption in volume terms has been revised upwards. Nevertheless, it remains contractionary over the medium term.

OPEN IN VIEWER

Figure 10.

One-year ahead government consumption forecast errors

Despite the upward revisions, current projections would still imply a strong contraction of around 1.5 per cent per capita in 2016 and 2017 and a further 1 per cent per capita in 2018, the largest since 1997. There would be an upside risk to our forecast should government consumption not be reduced so significantly.

For the external sector both import and export growth are expected to pick up in 2015, due to the improvement in purchasing power in both the domestic and foreign markets as a result of the dramatic fall in the global oil price. In 2015 we project that imports will grow by 6.5 per cent per annum while exports will grow slightly slower, by 6.1 per cent per annum. That exports growth is not higher is primarily due to relatively weak Euro Area demand, as, despite the recent 4 per cent appreciation in the sterling–euro exchange rate between November and January, UK exporters in 2015 are expected to gain price competitiveness when compared to 2014. In the medium term we expect that import growth will slow as consumption moderates; between 2017 and 2019 imports are forecast to grow around 3 to 3.5 per cent per annum. Export growth is also projected to moderate slightly. However, the rebounding of the global oil price coincides with a recovery in the Euro Area. After 2015 we expect exports to grow by between 5 and 5.5 per cent per annum through our forecast period.

For 2014 the trade deficit was 2.1 per cent of GDP, at around the level of the past five years, and significantly higher than before the crisis. Between 2001 and 2008 the trade deficit, 2.6 per cent of GDP. As the UK is a net importer of oil, the recent fall in the global oil price should provide a positive impact on the trade balance. In November the deficit on the balance of trade in oil and related products was around £1100 million smaller than when compared to September. Since 2011, on average the balance on trade in oil and related products contributed 38 per cent to the overall balance on goods and services and the overall effects of the fall in the global price of oil should cause an improvement in the trade balance, all else equal. We therefore expect the trade deficit to narrow in 2015 to around 1.6 per cent of GDP, with little improvement in the outlook for the global economy. In our forecast published in November 2014 we had expected a deterioration in the trade balance. We project that by 2019, the trade deficit will be between ½ and 1 per cent of GDP. This path is conditioned on a gradual recovery of the Euro Area. Should the recovery occur more slowly than implied, the deficit of the trade balance could be significantly larger; this represents a downside risk to our forecast.

Household sector

Household consumption remains one of the main drivers of growth, contributing 1.5 out of 2.6 percentage points to output growth in 2014. The increase in household expenditure for 2014 was driven by services and durable goods, the latter reflecting households’ improved confidence with regard to future developments. Purchases of durable goods grew, according to the seasonally adjusted chained volume measure, by 8.8 per cent on a 12-month basis in the third quarter of 2014. Within durables, expenditure on recreation and culture goods – which include audiovisual and information processing goods – and motor cars are the ones that displayed the highest growth rates, contributing 3.9 and 2.8 percentage points to the total, respectively; a very stable pattern for the past two years. In line with our upward revision of output growth, we expect consumer durables to remain a significant contributor to growth this year. Prospects for household expenditure remain optimistic based on our expectations of real consumer wage and employment growth over 2015, where we forecast a contribution of household expenditure to total output growth of 2.2 percentage points.

We estimate real disposable income grew by 1.6 per cent during 2014, and expect growth to pick up in 2015. We have revised our forecast up to 3.6 per cent from 2.9 per cent. The acceleration we forecast for 2015 in our previous Review was driven by an increase in total nominal income growth, explained by an increase in wages as well as an increase in employment. The upward revision we have introduced in this Review is almost exclusively derived from a sharp deceleration in projected inflation this year (see figure 11). We expect real disposable income growth will moderate from 2016 onwards as inflation picks up and unemployment stabilises under 5½ per cent, at which point it will rely on real consumer wage growth which will be driven by productivity increases. Our projections of real disposable income growth, together with our population growth assumptions, imply a per capita growth rate of around 2 per cent over the medium term.

OPEN IN VIEWER

Figure 11.

Contributions to household real income growth in 2015: comparison between our current and previous Review (percentage points)

The strength of real disposable income growth in 2015 is reflected in the behaviour of the saving ratio which we forecast to increase from 6.8 per cent in 2014 to 7.1 per cent in 2015. We then expect it to remain fairly constant until 2016, as real disposable income growth flattens before increasing from then on. This view regarding the future saving rate path conforms to our expectation of household expenditure growth remaining subdued, relative to pre-crisis trends, over the medium term. The saving rate is currently below the average pre-crises level, but, following a peak of an average rate of 9.5 per cent between 2009 and 2011, it may just be that households are now gradually implementing all the spending plans they had postponed when the recession started, which could also explain the importance of the contribution of durables to total consumer spending in recent years.

The Bank of England's December Money and Credit report suggests mortgage approvals for new purchases increased in December, by 2.2 per cent compared to the previous month, after falling for six months in a row since June. HMRC data show that property transactions, which lag mortgage approvals, have declined modestly since February 2014; the latest December figure displays a year-on-year decline of 0.4 per cent. We interpret the six-month fall in mortgage approvals and the downward trend in property transactions as a sign of a cooling housing market. The rebound in mortgage approvals observed in December could be the consequence of the modification, introduced in the Autumn Statement 2014, of residential stamp duty, which has made transactions costs cheaper for 98 per cent of properties with a value below £1 million according to an OBR estimate.

Most recent house price data support the view of a softening housing market. House price inflation is gradually decelerating. According to our preferred measure of house prices, the seasonally and mix-adjusted index from the ONS, prices in the UK have increased 9.9 per cent on November 2014 compared to twelve months earlier; the equivalent September and October figures were 12.1 and 10.3, respectively. The Nationwide house price index, which acts as one of the leading indicators for the ONS measure as it is derived earlier in the house purchase process, provides a similar picture: on a 12-month basis, house prices in January 2015 are still rising in most, but not all, of the UK, albeit at a slowing pace. The Halifax house price index for the same period contradicts this national level picture somewhat, reporting a modest acceleration in prices.

According to the Halifax, Nationwide, and our own database the price to earnings ratio is close to historically high levels; we project a peak in 2015. Mortgages are still ‘affordable’ due to the Bank of England's low interest rate policy (see the income gearing profile in figure A5), but, with household debt levels hovering around 136 per cent of income, the exposure of households to interest rate hikes remains significant. For instance, the Bank of England's December Financial Stability Report estimates that around 40 per cent of households with a mortgage would have to curtail spending in the event of a 2 percentage point increase in interest rates. From this perspective, and consistent with our forecast of interest rates rising from 2016 onwards, we maintain the view that real house price growth will moderate further, where it is expected to be below the rate of growth in per capita real disposable incomes.

Supply conditions

Business investment has shown robust growth recently and was estimated by the ONS (2014) to be £44.4 billion in the third quarter of 2014, £2.4 billion higher than its recent peak in the second quarter of 2008. This represents a growth rate of 5.2 per cent compared to the same quarter a year ago, but a fall of 1.4 per cent compared to the previous quarter. This fall in growth in the third quarter, combined with the ONS downward revision to business investment in the third quarter of 2014, has led us to revise our forecast for 2014 down by 2.8 percentage points to 6.5 per cent. Our forecast for business investment in 2015 has been revised downwards by 0.9 percentage point to 7.3 per cent due to some uncertainty about future demand given external risks. We still expect business investment growth to remain relatively strong throughout 2015 and 2016, followed by a slowdown in the pace of growth as business investment ‘catch-up’ comes to an end. According to the most recent Bank of England Credit Conditions Survey, lenders reported that the overall availability of credit to the corporate sector was unchanged in the fourth quarter of 2014 and expected to remain unchanged in the first quarter of 2015.

In constructing our forecast we assume that the general government investment evolves broadly as spelled out by the current government's fiscal plans. On this basis, we expect the volume of general government investment to grow by around 4.4 per cent in 2015, following three years of contraction between 2011 and 2013. Growth is expected to slow in subsequent years, reaching around 2 per cent per annum between 2016 and 2019.

Housing investment continued to increase in 2014, expanding by 10.4 per cent, year-on-year. As of the third quarter of 2013, total housing investment has remained around a third lower than its pre-crisis peak in the second quarter of 2007, however much of this decline is due to a reduction in transfer of non-producer asset costs which fell by 86 per cent between the second quarter of 2007 and the first quarter of 2009. Transfer costs of non-producer assets, which are comprised of transport and installation costs as well as administrative expenses including lawyers’ fees and taxes related to the transfer of ownership, have declined sharply as a proportion of total housing investment after the onset of the Great Recession from a peak of 47 per cent in the second quarter of 2007 to 13 per cent in the first quarter of 2009, before rising to 21 per cent in the third quarter of 2014 (see figure 12). We expect housing investment to expand by between 6 and 10 per cent per annum over the period 2015 to 2019. This expansion is expected to be dominated by the construction of new housing and improvements to existing dwellings. Subdued housing market activity suggests a more modest contribution from the transfer cost of non-produced assets. However, this slowdown in the housing market poses a risk to the outlook to our overall housing investment forecast via weaker new builds.

OPEN IN VIEWER

Figure 12.

Transfer costs of non-producer assets as a percentage of total housing investment

We estimate that the unemployment rate reached 5.6 per cent in the last quarter of 2014, down from 6 per cent in the preceding quarter. This represents an almost 1½ percentage point fall since the end of 2013 and a 2.4 percentage point improvement from the peak at the end of 2011. It is now at its lowest level since the onset of the Great Recession, at the start of 2008. ONS data shows that recent falls in unemployment have been concentrated amongst the longer-term unemployed, with the number of people who have been unemployed for twelve months or more falling by 22.2 per cent between the three months to November 2013 and the same period one year later, compared to a fall of 17.9 per cent in the total number of unemployed people over the same time period. The unemployment rate of 18–24 year-olds fell by 2.9 percentage points between the three months to November 2013 and the three months to November 2014 to 15.1 per cent, down from a peak of 20.3 per cent in the three months to November 2011. The fall in the unemployment rate has been largely driven by rapid employment growth, which accelerated throughout 2014. We estimate that employment expanded by 2.3 per cent in 2014, following growth of 1.2 per cent in 2013. Growth in self-employment has been expanding at approximately four times the rate of growth of employees in the first three quarters of 2014, continuing a pattern seen over much of the post-recession period. The outcome of this is an increase in the share of self-employment in overall employment. This does not necessarily translate into self-employment as the main determinant of employment growth. As figure xx shows, self-employment was the largest positive contributor to net employment change over the period 2009 to 2011, but even as self-employment continued to expand rapidly over the period 2012 to 2014, it was the resumption of positive net changes in employment that underpinned overall employment growth.

ONS estimates suggest temporary workers accounted for 6.4 per cent of total employees in the three months to November 2014. This represents a slight fall from the previous year but is significantly higher than the pre-recession nadir of 5.4 per cent in the three months to July 2008. The total number of temporary employees increased by 4.9 per cent between September–November 2013 and the same period in 2014, with the increase coming mostly from employees who did not want a permanent job rather than those who could not find a permanent job. The increased availability of permanent jobs may be due to less uncertainty weighing on firms’ hiring decisions than had previously been the case.

Similarly, the 1.5 per cent increase in the number of part-time employees came from a 5.1 per cent increase in the number of employees who did not want a full-time job, while the number of part-time employees who were unable to find a full-time job fell by 8.7 per cent. This could be because the matching process has improved for those searching for full-time employment. As figure A10 highlights, labour market matching continues to improve. The relaxation of household budget constraints due to rising wages may have eased the search for full-time employment by part-time workers. The latter hypothesis may become more apparent if real consumer wages continue to rise. Whatever the mechanism, part-time employment as a proportion of total employment has fallen throughout 2014 to 26.9 per cent, but remains higher than its level before the Great Recession, when it was stable at just over 25 per cent.

OPEN IN VIEWER

Figure 13.

Contribution to employment growth by employment type

We forecast that employment will continue to expand, by 1.3 per cent in 2015 and then slowing to around 0.8 per cent per annum between 2016 and 2019. We expect the unemployment rate to fall to 5.3 per cent in 2015 before rising to around 5½ per cent between 2016 and 2019.

Labour productivity growth has been very weak since the onset of the recession with whole economy output per hour remaining around 16 per cent lower than the level implied by its pre-recession trend. Barnett et al. (2014) conclude that there is little evidence that this is due to firm-level spare capacity and other cyclical factors relating to demand conditions and instead is likely to be due to more persistent factors such as reduced capital investment and suboptimal resource allocation. Another possibility suggested by Carney (2014) is that more workers have accepted employment at real wages below their pre-crisis levels, effectively a positive labour supply shock, leading to firms hiring more workers at lower wages instead of investing in capital. We forecast low but accelerating labour productivity growth in the next few years, rising from 1.3 per cent per annum in 2015 to 1.8 per cent in 2019. This is due to a gradual return of productivity growth as demand picks up, together with an assumed increase in higher productivity employment. We assume that some in low-productivity employment will flow to higher-productivity jobs as they become available, reversing some of the recent rapid self-employment growth. This should translate into higher average productivity and wages. At the same time further falls in unemployment should push up wages via the wage bargaining process in a tighter labour market.

Public finances

December 2014 saw the Chancellor deliver his final Autumn Statement before May's General Election. A number of discretionary policy changes were announced, the most significant of which were an increase in the already planned rise in the personal income tax allowance from £10,000 to £10,500 by an additional £100 to £10,600, and reform of how Stamp Duty Land Tax rates are determined. These are both expected to lower Exchequer revenues in the near term, according to the OBR around £0.5bn and £0.4bn respectively this year, though if the latter can generate a higher volume of transactions in the housing market then there may be medium-term benefits. Taken in their entirety though, the policy changes proposed are broadly neutral in their implications for the fiscal outlook.

Central government receipts in the fiscal year to December grew at a lower rate than consistent with the OBR's expectation for the year as a whole. This mostly related to lower income tax receipts through PAYE caused by weak wage growth and compositional effects in the labour market such as a shift to traditionally lower paid jobs and an increased incidence of self-employment. Receipts from self-assessment income tax payers are likely to be strong in January, making up some, but probably not all of the ground lost in the year so far. In his Royal Economics Society lecture in January 2015, the Chancellor intimated that the lower than forecast tax intake was not only expected, but the result of a deliberate decision to allow the automatic stabilisers to operate whilst keeping course with spending cuts (Osborne, 2015). This is consistent with the idea that tax receipts should begin to provide a more substantial contribution to the fiscal position once conditions in the labour market improve, but it also implies that the automatic stabilisers have had to work harder than was originally anticipated, slowing the pace of deficit reduction.

The fall in the oil price is likely to significantly affect tax receipts from the UK's oil extraction industry, but not the overall fiscal position. Given the outlook for oil prices (based on the EIA's current projections), we expect tax revenues to the government from oil companies in 2015–16 to be around £2bn, roughly half the amount we forecast in the November 2014 Review. However, in the context of a forecast for total receipts of over £660bn this is little more than a rounding error; for instance in December, data for central government current receipts for the period April to November were revised up by the ONS by an average of £1.7bn compared with the November release. What is more, even this relatively small loss is likely to be attenuated by the positive fiscal impact of second-round macroeconomic effects from the decline in the oil price, such as higher VAT receipts induced from increased spending and the positive supply-side shock feeding in to firms’ taxable profits. OBR (2010) analyses the fiscal impact of both a permanent and temporary $10 increase in the oil price. It concluded that macroeconomic effects were likely to nullify the direct boon from higher oil duties in the first year, before dominating them over the more medium term, worsening the fiscal position. Assuming symmetry and linearity this would imply a modest net contribution from the current fall in the oil price over our forecast horizon.

OPEN IN VIEWER

Figure 14.

Unemployment rate forecasts

Our forecast for tax receipts is based on the growth of money GDP and assumptions about effective tax rates. Tax receipts grow in line with the tax base after adjusting for discretionary policies announced in previous Budgets and Autumn Statements. Our current forecast for 2014–15 is, in essence, unchanged from November at around £638bn, but weaker in 2015–16 by around £4bn, largely due to lower receipts from taxes on expenditure.

In forecasting spending we assume current government plans for spending on goods and services are broadly met, but allow for spending on government interest payments to be endogenously determined by the evolution of the debt stock and market interest rates. Our forecast for expenditure this fiscal year has been revised up by around £4bn to £674bn. This is in part due to the additional £2.7 billion which was added to government spending in the final quarter of 2014 as a result of additional payments to the EU Budget, around £2bn of which was not factored into our November forecast.

The revisions to spending and receipts have pushed up our forecast for public sector net borrowing this fiscal year by just over £2bn, to £99.2bn. Coupled with revisions to the historical series which have changed the PSNB figure for 2013–14 this means that net borrowing is now increasing between 2013–14 and 2014–15 rather than falling as we expected in our November forecast, though as a percentage of GDP it is flat at 5.5 per cent in both years. This reduces each year of our forecast until the government becomes a net lender in 2018–19. Given our forecast of economic growth, net debt as a percentage of GDP begins to fall two years earlier than this in 2016–17. It peaks at just below 83 per cent of GDP next fiscal year before falling to just 72 per cent of GDP by 2019–20. This is broadly in line with the profile expected by the OBR in its December Economic and Fiscal Outlook where net debt peaks slightly lower in 2015–16 at just over 81 per cent of GDP, mainly due to their forecast for more robust GDP growth, but still reaches 72.8 per cent of GDP in 2019–20. Government interest payments are currently the equivalent of around 2 per cent of GDP (figure 15). This is broadly in line with where it has been since the turn of this century, but given the larger stock of debt currently in issue it is lower than one might expect. UK government bond yields are close to record lows. Bond yields are determined by a number of factors. However, the current figures are further flattered by the recent consolidation of interest payments between the government and the Bank of England's Asset Purchase Facility (APF). Absenting this, the government interest burden would be approximately one percentage point of GDP higher, much more in line with the levels seen in the mid-1990s.

OPEN IN VIEWER

Figure 15.

The impact of APF flows on government interest payments, as a per cent of GDP

This accounting protocol will continue to reduce the government's interest payments all the time the APF holds the current stock of gilts at a stable level. In our forecast we assume the Bank of England maintains the size of the APF at £375bn until Bank Rate reaches 2 per cent per annum in 2019, requiring it to reinvest around £77bn of principal payments as the existing holdings mature. Over this period there will be a direct effect on the government's net borrowing and net cash requirements equating to about 0.6 per cent of GDP each year (see table 2). Cumulatively, this leads to a significant reduction in the net debt stock. On our calculations, by the end of 2014–15 this will already mean public sector net debt is 3.3 per cent of GDP lower than it would have been in the absence of a consolidation of the APF flows. By 2019–20 we expect this figure to have risen to the equivalent of 5.7 per cent of GDP. At this point we assume the Bank of England no longer reinvests principals from maturing gilts and the APF is unwound passively through the roll-off scenario outlined in the August 2014 Review. As the stock of debt held on the APF shrinks, this will increase the fraction of debt in the market on which the government has to pay interest, putting additional upward pressure on government interest payments. In our forecast this happens at a time of tightening monetary policy which compounds the effect, but the two influences are expected to be broadly countered by economic growth, so interest payments stay at a stable percentage of GDP.

OPEN IN VIEWER

Table 2.

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

	2012–13	2013–14	2014–15	2015–16	2016–17	2017–18	2018–19	2019–20
Surplus on the current budget
Excluding APF flows	−5.8	−4.8	−4.6	−3.7	−1.5	−0.1	1.0	2.2
Including APF flows	−5.1	−4.1	−3.9	−3.0	−0.8	0.6	1.7	2.8
Public sector net borrowing
Excluding APF flows	8.0	6.3	6.2	5.1	2.9	1.3	0.1	−0.9
Including APF flows	7.3	5.5	5.5	4.5	2.2	0.6	−0.6	−1.5
Public sector net cash requirement
Excluding APF flows	6.6	4.8	6.2	5.2	3.8	1.9	0.5	−0.5
Including APF flows	5.9	4.1	5.5	4.5	3.1	1.2	−0.2	−1.1
Public sector net debt
Excluding APF flows	77.4	79.8	85.2	86.7	87.1	85.1	81.9	78.0
Including APF flows	77.4	79.8	81.9	82.8	82.7	80.3	76.6	72.3

Source: NIESR database and forecast.

Note: APF is Asset Purchase Facility.

Saving and investment

In table A9 we present data and our forecast for the current account of the balance of payments for the saving and investment positions of the three broad sectors of the economy: household, corporate and general government. For each sector, if saving is greater than investment then this sector is a net lender to the rest of the economy and vice-versa. The difference between aggregate saving and investment of these sectors provides the current account of the balance of payments for the entire economy. Investment greater than saving results in a deficit that must be externally financed. No inference about optimality of investment and saving can be drawn from these figures, rather they present a guide to the immediate funding requirements of the economy.

Following the Great Recession, household saving peaked at 7.9 per cent of GDP in 2010. Subsequently, the household saving rate dropped as consumer spending outstripped income growth, almost halving to 4.4 per cent in 2013. Our estimates suggest a modest pick-up to 4.7 per cent of GDP in 2014. This puts household saving rates at around the same levels as in the years immediately preceding the financial crisis and Great Recession. We expect the saving rate to pick up gradually from its current levels; however, in the short term the marked decline in oil prices complicates the picture as it provides two offsetting dynamics for the saving rate. Firstly we expect consumption growth to increase as a result of the improved purchasing power of consumers. At the same time, the subdued inflationary environment should lead to improvements in real disposable income growth as real consumer wages increase despite relatively weak nominal wage growth. On balance we do not expect all of the real income gains from the decline in oil prices to translate through to increased spending, even though we expect the volume of consumer spending growth to reach almost 3½ per cent annum this year. The household saving rate is expected to rise throughout our forecast period, reaching between 6.25 and 6.5 per cent of GDP by 2019.

Housing investment was 4.9 per cent of GDP in 2014, implying that the net financing position of households was broadly neutral. We forecast housing investment to grow throughout our forecast period as the stock of housing remains well below desired levels. The gap between desired and realised housing capital has been a persistent feature of the UK economy, caused by factors such as strict planning regulations depressing supply, while demographic changes such as the increase in single occupancy residence have increased the demand for housing (Barker, 2004). Holmans (2013) estimates that for England, 240,000 new builds per annum until 2031 are needed in order to satisfy future demand. Currently the number of new starts is significantly below this number, with 139,500 commenced in England in the twelve months up to September 2014. This indicates that a significant amount of housing investment remains for the stock of housing to close the gap towards optimal levels, which implies household investment as a proportion of GDP will increase across our forecast period, reaching between 6¼ and 6½ per cent by 2019.

The households’ net position is expected to be broadly neutral over our forecast period, with the exception of 2016 and 2017 when household investment is expected be in excess of household saving. In each of these years households are expected to require funding of around ½ per cent of GDP from the rest of the economy.

In the past two years corporate savings have reduced slightly, as a share of GDP. In 2014 they reached 10.9 per cent of GDP, below the average of 11.7 per cent achieved between the years 2003–11. We project that in 2015 corporate saving will increase to around 11.7 per cent as the improvement in domestic demand leads to a larger increase in retained profits. We expect this increase to be transitory. As domestic demand begins to moderate in 2016, corporate saving eases to 10.6 per cent of GDP, and this downward trajectory continues through our forecast period. By 2019 we expect corporate saving to be around 8 per cent of GDP. Corporate investment reached 10.9 per cent of GDP in 2014, its highest level since 2002, continuing the general upward trend seen in recent years. As uncertainty around domestic demand diminished, firms began the process of recapitalising; we expect this process of catch-up to continue in the near term with further increases in corporate investment to 11.1 and 11.5 per cent of GDP in 2015 and 2016, respectively. We project that business investment growth will slow in 2017 as firms approach their optimal levels of capital. Thus corporate investment will gradually reduce as a proportion of GDP, to about 11.2 per cent by 2019. Should data outturns be realised as implied by our forecast, the corporate sector will be a net lender to the economy in 2015. From 2016 this position will be reversed as the corporate sector becomes increasingly a net borrower requiring around 3 per cent of GDP by 2019.

OPEN IN VIEWER

Figure 16.

Decomposition of the balance of the current account

OPEN IN VIEWER

Figure 17.

Decomposition of the balance of the primary income account

As a proportion of GDP, general government dis-saving was stable between 2013 and 2014 at around 3 per cent. However, the level of dis-saving has almost halved from 5.7 per cent in 2009. We expect further decreases in government dis-saving throughout the forecast period. If fiscal consolidation is implemented as the planned broad spending envelopes imply, then the general government will return to a positive saving rate by 2017. Over our forecast period nominal general government investment grows at around the same rate as nominal GDP, thus implying that the government will become a net lender to the rest of the economy by around 2018. This is consistent with the Conservative Party's current ambition for the public sector to achieve an ‘absolute surplus’.

Since 2011 the current account deficit has widened dramatically from 0.2 per cent of GDP to 5.5 per cent of GDP in 2014. This is principally due to the deterioration of the balance of the primary income account (see chart 16), caused by a large fall in net income earned on direct investment (see chart 17). A sharp reduction in the income earned by UK companies abroad, rather than an increase in foreign companies earnings in the UK, was behind the 2.1 per cent of GDP decline in net income between 2011 and 2013. Over this period, rates of return on direct income from abroad have remained relatively stable, suggesting this fall might be a result of returns from a reduced stock of foreign assets. That this is a temporary phenomenon is a key assumption for our forecast. Net factor income returns to surplus in our forecast by 2018. If this transpires to be a structural change and direct income on investment abroad remains subdued, a significantly larger current account deficit would be expected. We expect the economy to remain a net borrower from the rest of the world, although we project a continued reduction in the amount of external financing required. From a trough of 5½ per cent in 2014, we expect the current account deficit to narrow gradually, reaching almost 1 per cent of GDP by 2019. A narrowing of the trade balance, partially via the fall in the price of oil, supports some of this transition, but it is the return of net factor income to surplus that is essential for this projection to be realised.

The medium term

Table A10 presents our view of the medium-term outlook for the economy. This period is dominated by a gradual movement away from its current disequilibrium. This is a process whereby growth rates in excess of the long-run potential are required in order for the negative output gap to close. The growth rates reported therefore do not represent our view of the potential growth rate of the economy, a rate that our estimates suggest is much closer to 2 per cent per annum.

The future path of the economy is uncertain as future shocks, which are inherently unpredictable, move the economy away from the growth path presented in table A10. To depict this uncertainty we use fan charts (see figure 18). We predict that there is a 10 per cent chance that, by 2019, GDP growth could be greater than 4.9 per cent per annum, while there is a one in five chance that the economy will be growing by less than 0.9 per cent per annum.

OPEN IN VIEWER

Figure 18.

GDP growth fan chart (per cent per annum)

A key assumption underlying our economic projections is the return of meaningful productivity growth. We expect productivity growth to resume in a gradual fashion, from 2015 onwards. By 2020–24 economy-wide productivity growth is forecast to average 2.1 per cent per annum. While the exact timing as to when this might occur remains difficult to predict, this underpins our projections for per capita GDP and real consumer wage growth. As with the period of sustained above-potential output growth, these productivity rates are consistent with a temporary period of productivity catch-up, rather than our view of trend productivity growth, which is assumed to be below 2 per cent per annum over the medium to long-run.

Alongside improvements in productivity growth, we expect the growth of the labour input to ease to around 0.6 per cent per annum by 2020–24 from a projected peak of 2.6 per cent per annum in 2015. This is mainly driven by average hours falling as household incomes improve, consistent with the historical trend before the financial crisis. The participation rate is expected to remain stable throughout our forecast period (at around 81 per cent of the working age population) supporting growth of the labour input. As described in the Bank of England's November Inflation Report, despite the aging profile of the UK population, an increase in the participation of women and older people in the labour market has more than offset the demographic effects. Whether these changes are attempts to offset depressed incomes following the financial crisis, will be key in determining the growth of the labour input. The sharp falls in the unemployment rate witnessed through 2014 are expected to slow as the economy approaches the NAIRU, which we estimate to be close to levels seen before the onset of the financial crisis and Great Recession. For the period 2020–24 we forecast an average unemployment rate of 5.2 per cent of the labour force aged 16+.

PSNB is predicted to fall throughout our forecast period; by 2020–24, this is expected to have returned to a surplus of around 1.2 per cent of GDP, meaning the government will not have to finance public investment via borrowing. With the return of the public sector's accounts to a surplus, the public sector net debt stock is projected to fall sharply, to an average of 61.5 per cent of GDP in the medium term. This is from a projected peak of 83 per cent of GDP at the end of 2016.

We know that the fiscal policy projections are unlikely to evolve as we predict. As the General Election approaches, the three major political parties have outlined broad fiscal positions for the next Parliamentary term. As we discuss in the Commentary in this Review, all three parties’ positions differ from the coalition's announced fiscal plan. However, we do know that the next term of government will contain a further period of fiscal consolidation, the main differences being its magnitude and pace. This will not only affect the size of PSNB and the public sector net debt stock but also have implications for the rest of the economy, such as the pace of economic growth.

The current account deficit on the balance of payments is expected to narrow throughout our forecast period, averaging around zero over the period 2020–24. This forecast is the outcome of a general improvement in the trade balance as well as the return of net factor income to surplus. If recent weakness in the Euro Area persists, or the recent deficit in net factor incomes represents a structural rather than temporary shift, then the deficit on the current account will be expected to be much greater.

Conditioning our forecasts is a gradual tightening of monetary policy as the economy returns back towards its equilibrium; we expect Bank Rate to have reached 2.2 per cent, on average, in 2019. The speed and timing of tightening is dependent on how quickly the output gap closes, and also the future rates of inflation expected by the MPC. We expect a low inflation environment in the short term, influenced by the sharp decline in oil prices and the weakness of price growth in the Euro Area. Looking further ahead, we expect the rate of inflation to be close to target, averaging 1.9 per cent per annum between 2020 and 2024.

Risks to our forecast are apparent on either side of the distribution. On the downside, should the expected near-term low inflationary environment lead to a decoupling of inflation expectations from the Bank of England's target, then this would add disinflationary pressure and subsequently the path of monetary tightening would be slower. On the upside, the negative output gap closing faster than we expect would lead to upward pressure on prices and a policy response via a more aggressive monetary tightening.

In the medium term the effective exchange rate is expected to appreciate a further 1.1 per cent from its 2015 level. As monetary tightening in the UK starts before that of the Euro Area this represents a permanent appreciation from the levels seen in 2013. The future path of exchange rates is especially uncertain, depending not just on domestic but also on external policy choices. For instance, should the path of interest rates set by the European Central Bank, or the US Federal Reserve deviate from the path we have assumed in our forecast, then the path of exchange rates would evolve differently from our current expectation.