The Year Ahead from the National Institute: Replies to the FT Christmas Survey
Three senior members of the Institute were asked by the FT for their views on the year ahead. In the interests on transparency, we publish those replies. The answers given are from the Director, Professor Jagjit Chadha (JC), the Director of Macroeconomic Modelling and Forecasts, Dr. Garry Young (GY), and the Associate Research Director for Trade, Investment and Productivity, Dr Monique Ebell (ME).
1. Economic prospects
How fast do you think the UK economy will grow in 2018 and how will this compare to other countries? Please explain your answer
JC: The UK economy will continue to grow below its longer run trend, in increasingly stark comparison to other advanced economies which look to be returning to more robust levels of growth. The basic cause is the reduction in the growth of potential capacity because we are perturbing our exiting trading relations and injecting enduring uncertainty into the economic system. Whilst the competitive level of the exchange rate in conjunction with overseas growth will help the contribution from net trade the prospects for investment and consumption will limit economic growth next year.
GY: The NIESR central case is that GDP will grow by 1.7% in 2018, pretty much the same pace as this year and last. This is a bit weaker than in the OECD countries as a whole, where growth is expected to average 2.1% in 2018. There is a lot of uncertainty about growth in the major economies. Partly this reflects well-advertised uncertainty around productivity which has disappointed in many economies in recent years. And Brexit uncertainty is layered on top of this in the UK and other closely connected economies, such as Ireland and the Netherlands. While uncertainty is likely to continue to hold back UK investment, demand for UK goods and services are likely to be supported by net exports driven by a competitive sterling exchange rate.
ME: If it becomes increasingly clear that the UK is heading for a Canada-style trade deal with the EU, then in 2018 UK economic growth is likely to underperform compared to the rest of the advanced economies, continuing the trend established in 2017. Investment and real wage growth have already stalled, and the uncertainty surrounding the shape of the UK’s future relationship with the EU has made it difficult to capitalise on the weak level of Sterling.
Compared to what you thought 12 months ago about the UK's long-term economic prospects outside the EU, are you now: more optimistic, more pessimistic or do you feel about the same as you did 12 months ago? Please explain your answer
JC: My assessment is broadly unchanged. The UK’s long term prospects, as for any economy, are highly uncertain as they depend on the ability to translate technological progress, which is determined globally, into secure jobs and income. Trade represents the best way for that transfer of knowledge to occur. The potential for re-orienting trade towards the rest of the world depends on whether the agreements we reach bilaterally are better than our share of what the EU would negotiate on our behalf and the extent to which we can maintain good trading and strategic relations with our European partners.
GY: I think that the most likely outcome is that, in the long term, the UK will be able to negotiate a deep trading agreement with the EU that covers goods and services. It is by no means certain that we will get there, but I am slightly more optimistic than I was a year ago as the costs of not doing so, especially threats to the Irish peace accord, seem more apparent. So if we are lucky we will end up where we started before the referendum.
ME: I am more pessimistic about the prospects of the UK getting a good trade deal with the EU than 12 months ago, and hence am more pessimistic about the UK’s long-term economic prospects outside the EU. It looks increasingly likely that the UK will only be able to get a Canada-style trade deal, which will not give decent services market access, and will even be inferior to single market membership for goods. CETA does not offer market access for financial or professional services that is anywhere near as good as that of Norway-style single market membership, and these are key industries. Also, CETA would fall short of customs union membership, so that while manufacturing would benefit from tariff-free access to the EU, it would still introduce non-tariff barriers in the form of customs checks and potentially complicated rules of origin. This means that of the pre-Referendum scenarios, I would be placing increasing weight on a Canada-style trade agreement, which would not be far off from a WTO scenario. Whilst staying in the single market (and customs union) is probably the best among the Brexit options, it does not give the UK a say in future rules, and would thus still make the UK worse off than before Brexit. Thus despite its economic advantages, Norway (+/- customs union) seems a less logical option than either Canada or staying in the EU completely.
3. Outlook for consumers
In 2017, consumers' finances were squeezed by rapidly rising prices. Will 2018 be an easier year for UK households and what are the implications for consumer spending?
JC: Inflation will start to fall back to 2% over the course of the year basically in line with expected wage growth. On average therefore there will be no increase in real household income. The real story though is in the distribution with many households either on low or fixed incomes, with young children, or expenditure concentrated on food, clothing and energy will be materially worse off next year as well. The lack of progress in living standards for many continues to be a genuine blight on the UK economy.
GY: Household real income growth has been held back in the past couple of years by the effects of sterling’s depreciation from its November 2015 peak. Now that much of that has passed through to prices, real incomes are expected to rise by about 1½% in 2018. That would allow some consumption growth. But productivity is again the key. Without some pick up in productivity growth real incomes will not grow and neither will consumption.
ME: If it becomes increasingly clear that the UK is heading for a Canada-style trade deal with the EU, investment is likely to stall further, more services firms may begin to press the button on plans to shift some operations abroad, and the pound may fall further. All of these developments would put further pressure on household budgets, be it via inflation and rising consumer prices (Sterling depreciation) or continued weak wage growth (investment stalling, weak jobs market).
With unemployment at a 40-year low, how much of a pay rise will British workers get in 2018? Please explain your answer
JC: The traditional relationship between the level of unemployment and wage pressure is under severe scrutiny. And yet, firms can employ workers internationally and are acutely aware of ensuring that their costs and mark-ups do not lead to internationally uncompetitive final goods prices. When setting prices, firms are also factoring in the long period of price stability we have experienced with inflation tended to hover around 2%. So, given little evidence of increasing labour productivity, we expect wages to grow by around 2%.
GY: Despite low unemployment and above target inflation, average earnings remained subdued in 2017 as workers effectively accepted a reduction in real wages following sterling’s depreciation. There is little sign so far of any material increase in wage pressure and so I would expect average earnings to grow at a similar rate of 2 to 3% in 2018.
ME: If it becomes increasingly clear that the UK is heading for a Canada-style trade deal with the EU, then I would expect investment and jobs growth to weaken, and for real wage growth to continue to stagnate. While in the short term difficulties in recruiting skilled staff from the EEA may put some upward pressure on wages for some highly in-demand skills, this is likely to be counterbalanced by a reluctance to invest and create jobs in the UK, weighing down on labour demand.
More generally on weak UK wage growth: UK unemployment insurance provides only a relatively weak safety net for many workers, particularly those with partners who are still in work or who have even modest assets. As a result, when jobs are lost, many workers are under intense pressure to find a new job quickly, even if it means taking a pay cut, leaving little space for retraining or upskilling. [Indeed, the OECD has nice data showing that the UK has a very low percentage of prime-aged workers participating in training measures compared to other OECD countries.] Thus, the UK’s relatively weak safety net may be one reason – together with the UK’s long-standing productivity weakness – that generating wage growth in the UK economy has been particularly challenging.
5. Monetary policy
How far will the Bank of England raise interest rates next year? Do you think they should? Please explain your answer
JC: Lower levels of growth in the UK reflect a reduction in the growth of capacity, reflecting insufficient investment and trade compression. This kind of negative supply shock is the central bank’s nightmare with inflation likely to jump up. To the extent that the inflation does not unhinge inflation expectations there need not be a proportional response but in order to prevent growth in demand outstripping capacity some elimination of monetary accommodation is probably required. So we expect a couple of 25bp increases in Bank Rate next year.
GY: In my view we should expect to see a couple of interest rate increases in 2018 as the Monetary Policy Committee seeks to carry out its mandate. The only reason for delay would be if there was a material risk that CPI inflation would fall significantly below target and that does not appear very likely.
ME: The Bank of England may well be faced with the return of stagflation, rising inflation driven by further depreciation in Sterling, coupled with sluggish growth. This would put the MPC in a difficult position, as despite its inflation-targeting mandate, it has established some precedent for ‘looking through’ inflation caused by external factors in the wake of the financial crisis. My own view is that inflationary pressures caused by Sterling’s depreciation are likely to be transitory, and that the MPC should indeed ‘look through’ at least a moderate degree of inflation of up to about 4%.
Will the UK experience a resurgence of productivity growth in 2018? Please explain your answer
JC: It would be ironic if just at the moment all major economic forecasters have revised down their views of the growth in long run productivity to 1% per year, that productivity suddenly surges. Were it to do so it would be very welcome and would solve many of the problems identified of limited capacity, little or no growth in real household incomes and private and public indebtedness. And yet, investment remains low, R&D is below international levels in advanced economies, infrastructure requirements remain unfulfilled, the financial system is still somewhat hampered and trade is likely to become more compressed. Unfortunately the risks are probably more on the downside.
GY: I doubt very much that we will see a resurgence of productivity growth in 2018. Brexit uncertainty is holding back investment among businesses that trade with the rest of the European Union and that is likely to continue until the final deal is signed. It is possible that productivity will surge then if the right deal is agreed.
ME: A resurgence of UK productivity growth in 2018 seems quite unlikely. The UK’s productivity performance has been very uneven across regions and sectors. While the recent increased policy focus on regional development and industrial strategy may be helpful in the medium to longer term, in the shorter term it is difficult to see how leaving the EU will help solve these problems. Any looming loss in market access for our highest productivity industries (such as financial services, professional business services, automotive and pharmaceutical) is likely to weigh down further on the UK’s productivity levels.