What lies ahead, an economist's view

Maurice Fitzpatrick reviews the strength of the UK economy in 2003 and looks ahead to the changes which lie on the horizon.

This feature looks at the three main areas of interest to economists:

Economic growth

The trend growth rate of the UK economy is estimated by the Treasury to be some 2.75% per annum (or 0.7% per quarter). Growth slowed to well below trend in the winter of 2002/03, largely due to uncertainties caused by the Iraq war, but bounced back to 0.6% in the second quarter of 2003 ('2003Q2') and to 0.7% in 2003Q3. Assuming that rate of quarterly growth is maintained in 2003Q4, economic growth in 2003 as a whole will reach 2%, the lower end of the Treasury's 2003 Budget forecast of 2%-2.5% growth.

The plus factors which have helped growth throughout the latter part of 2003 include the 'Baghdad Bounce' together with improving economic growth in Euroland, Japan and most important of all the USA. In 2004 all of these should be present to a gradually strengthening degree. Assuming that average quarterly economic growth this year accelerates slightly to 0.8%, then economic growth in 2004 will be 3%: again at the lower end of the Treasury's most recent forecast of 3%-3.5% growth in 2004 as contained in the November 2003 Pre-Budget Report ('PBR'). I think that economic growth in 2004 should either reach the lower end of the Treasury's forecast or at least be very close to it.

Inflation/interest rates

The Monetary Policy Committee ('MPC') of the Bank of England sets interest rates to keep underlying inflation close to its central target of 2.5% being the middle of the inflation range of 1.5% to 3.5%. Inflation has remained stubbornly above that central target during 2003 and partly in response to this the MPC raised interest rates in November from a 48-year low of 3.5% to 3.75%. Meanwhile, the Bank of England November 2003 quarterly inflation forecast, which assumes an unchanged interest rate of 3.75%, suggests that inflation will be below the central target in 2004 but will be above the central target by 2005 on the back of stronger UK and world growth. I believe that we are currently in an interest rate upswing and think that the UK interest rate will reach 4% by the end of the winter and 4.5% by the end of 2004.

Public finances/prospects for tax increases

In Chancellor Brown's December 2003 PBR he forecast public borrowing of £37bn for 2003/04 and £31bn for 2004/05. Many commentators believe that public borrowing will reach £35bn+ for each of those years, mainly because economic growth is set to be below the rate assumed by the Treasury in its forecasting together with the fact that each £1 of economic activity appears to be generating slightly less revenue than the Treasury has assumed for the purposes of its forecasts. So will taxes have to increase as a result? To answer this question, it is necessary to review the impact of the two rules the Treasury uses for the purposes of its public finances: the 'Golden Rule' and the 'Sustainable Debt Rule'.

Under the Golden Rule, over the course of the economic cycle, borrowing is only permissible to fund net public investment ('NPI'). In the two years to 2003/04 and 2004/05, NPI is set to total £42bn against commentators' estimates of say £70bn public borrowing in total: this would lead to a Golden Rule deficit of £28bn. However, from 1997, the year the current economic cycle could be argued to have started, to 2002/03 there was a Golden Rule surplus of £40bn in total, enough to absorb the £28bn deficit noted above together with a further (say) £10bn Golden Rule deficit in 2005/06.

In terms of the Sustainable Debt Rule which states that net public sector debt ('NPSD') should not exceed 40% of GDP, this percentage is currently 31% and could absorb a good few years of sustained borrowing.

Assuming that public borrowing continues at around £35bn per annum on an ongoing basis and that NPI rolls out at around £25bn per annum, the crunch point would appear to be reached in 2006/07 at which time taxes would have to be raised by around £10bn per annum: equivalent to 3p on the basic rate of income tax. Fortunately, for Chancellor Brown, this point is not reached until after the next election, likely to be held in 2005!