The Englishman’s Home is His Castle – But are the Foundations Stable? (Q3 2000)

Sharp swings in the housing market have become an accepted characteristic of the UK economy over the past 30 years. Indeed, so pronounced have the swings in the housing market been that they have often seemed to be the defining characteristic of the UK economic cycle. Just a few months ago, with prices rising strongly, the idea of stability emerging in the housing market would have seemed incredible.

But it now looks as though the housing market is coming off the boil. What is more, the end to this cycle will almost certainly differ markedly from the crash that characterised the end of the last. With interest rates, inflation and unemployment low, and personal incomes still rising smartly, it appears that the fundamentals governing housing market activity remain strong.

Is it possible that, with greater macroeconomic stability, the boom and bust era of the housing market is over? Is this stability at last?

Housing and the economy

Chart 1 shows how fluctuations in the housing market and the national economy have been linked in the past. Now some of the closeness of this relationship simply reflects the fact that, as a large part of the economy, the housing market is bound to be affected by movements in the economy.

But the influence can also work the other way. Since it is consumers’ biggest asset, as the price of property rises, so does their wealth – both perceived and actual. By encouraging consumers to spend more, rises in house prices may cause aggregate demand and output to rise still further. The link works just as effectively in the opposite direction. Rises in unemployment and slower wage growth begin to impact on incomes and confidence thereby reducing peoples’ ability and willingness to bid up house prices. This produces a slowdown in house price inflation, or even an absolute fall in house prices. As asset values fall, this hits consumer confidence again, thereby reducing the inclination to spend, not only on housing, but on anything.

So the housing market and the macro-economy have been in a symbiotic relationship which has created substantial instability in both.

The Housing Roller-Coaster

The instability in the housing market has been nothing short of extraordinary. Chart 1 shows that there have been three periods of rapid house price inflation over the past 30 years – in 1972/73, 1978/79 and 1987/88. During each of these periods, the annual increase in house prices reached 30% - a good deal larger than the 13% increase seen during 1999. Of course, the 1970s and the late 1980s were also associated with periods of very high retail price inflation. But, in each of the three housing booms, the surge in house prices preceded the increases in retail prices, so that property prices were rising alarmingly quickly in real terms – by 35% in 1972, by 20% in 1978 and by 24% in 1988.

But in the period following the housing peaks, the process went into reverse. Just as the rate of increase of house prices began to slow, retail price inflation picked up, resulting in huge falls in real property prices. In real terms, house prices fell by 14% in 1975, 11% in 1980 and by 20% in 1990.

It is often argued that the movement of house prices is governed by, or at least linked to, the rate of increase of average earnings. Over the medium term, this may well be true, but volatility in the growth of average earnings is certainly not the explanation for volatility in the housing market. The ratio of average house prices to average earnings, shown in Chart 2, tells the story. Each of the three housing booms we referred to was accompanied by sharp increases in this ratio. In other words, in boom periods, house-buyers were prepared to pay a higher multiple of average earnings to secure the average house. It wasn’t earnings growth which caused these booms but bursts of optimism.

The Sources of Instability

So what has caused this extreme volatility in house prices? To some extent, as we have seen, it has been directly related to volatility in the wider economy. But several features of the financial and tax regime conspired to increase volatility in the housing market.

First, high inflation tended both to boost the real demand for housing and to exacerbate volatility. In the 1970s and 1980s, capital gains on owner-occupier houses, which were, and still are, tax-free, were one of the few ways of protecting capital values from the ravages of inflation. Moreover, because rising prices increased the value of householders’ equity, they lubricated the market by making high mortgage to income ratios more comfortable for both borrowers and lenders and by creating an increased deposit for the next house purchase. Given the usual dose of money illusion, these factors could easily translate into a route to “making money” rather than simply preserving wealth. The feelings of optimism engendered by these forces went though a clear cycle of their own, which contributed to and was then affected by the cycle in house prices.

Second, until the recent establishment of a new policy regime under the Monetary Policy Committee (MPC), base rates tended to rise too little and too late in relation to the emergence of general inflationary pressures. This meant that on several occasions, just as the economy was heating up and threatening to boil over, the level of real base rates actually fell – exactly the opposite of what was needed to bring stability.

Third, not only did the system of mortgage interest tax relief (MIR) favour house purchase in general but the extent of the advantage was greatest when inflationary pressures were strong and interest rates were higher. For MIR applied to the whole of the interest payment, regardless of the division of interest rates between a “real” and a nominal component. Suppose that inflation rose by 1% and interest rate were increased by 1% to keep in step. With MIR at a rate of 25%, after-tax interest rates would only rise by ¾%, so real after-tax rates would have fallen.

The result of the interaction of these factors was that once the housing market got going there were powerful forces conspiring to push the valuation of the market to unsustainable levels. Once in a powerful upswing, only two things could stop it, a general economic downturn or the realisation that interest payments, despite MIR, had risen to such a level that the burden was insupportable. This might happen through interest rates finally rising to crucifying levels, as they did in 1979 and 1990, or simply through the effect of rising house prices on the average value of outstanding mortgage debt.

Then came the downswing. But this could not be a smooth, instant, or painless adjustment. For a start, once increased to painful levels, interest rates could not be brought down rapidly, not least because inflation itself, against which higher interest rates were supposed to guard, typically rises to its peak late in the cycle. Moreover, once the housing bubble was burst, rates of interest were no longer critical. With prices having been driven to unsustainable levels, they had to subside, or, at the very least, languish, until earnings caught up. So the boom inevitably led to bust.

Why should things be different now?

Suppose we accept that this is a fair description of the way the housing market interacted with the macro-economy. Why should we believe that things are different now? There are three reasons. The first is the shift to much lower rates of inflation. This has prevented the sort of mad scramble for property which has happened three times in the past.

Secondly, there has been a major change in policy regime. Monetary policy is now pre-emptive. It has been very noticeable that the MPC has twice followed a policy of increasing interest rates while inflation was currently stable to falling. This has meant that real rates have risen when inflationary forces might otherwise have been building up. Moreover, the expectation has become established that they would continue to operate in this way, even if it meant pushing interest rates very much higher.

But the third factor may be more powerful, even though it receives much less attention. There has been a dramatic change in the tax treatment of property. At its introduction in 1974, MIR was extremely generous. But the amount of the loan for house purchase on which MIR was allowable, was only increased once, in 1983, when the limit was raised from £25,000 to £30,000. Given the very high rates of house price inflation over that period of 25 years, the effect of failing to revalorise has been to decrease the share of new loans to which MIR could be applied.

The first column of Table 1 shows how the average value of a housing loan has risen against the almost fixed MIR limit shown in the second column. The third column shows the ratio of the two.

In 1974, the MIR limit, at £25,000, was three and a half times the value of the average UK loan. In the mid-1980s, the limit of MIR still comfortably exceeded the average mortgage loan. By contrast, just before its abolition in April 2000, the MIR limit covered just over a half of the average loan value.

What is more, as column 4 of Table 1 shows, up to the late 1980s, the tax advantages of owner-occupation were even greater for some people. Before 1988, for two taxpayers buying the same property together, provided they were not married, the full MIR limit was allowable to each borrower. Accordingly, in some cases, the amount of the loan on which MIR was available was doubled. This meant that in 1974/75, a double MIR limit covered a loan seven times the UK average.

By implication, even some of the most expensive property available at the time could be bought with a loan on which full mortgage interest tax relief was available.

Whittling Away the Value

Even though the implication of Table 1 appears to be that even in recent years, MIR was a valuable perk, other tax changes in fact rendered MIR nugatory by the time of its ultimate demise earlier this year. Before 1991, relief was available at the borrower’s marginal rate of income tax. When MIR was introduced this was as high as 83%, but it fell to 60% in 1979 and was reduced again to 40% in 1988. This reduction in marginal tax rates reduced the size of the saving which could be secured by borrowing up to the MIR limit.

Then in 1991 there was a further restriction. The tax rate at which MIR was allowed was reduced to the standard rate of income tax, which was 25% at the time. Subsequently, the rate was reduced still further to 20% in 1994, 15% in 1995 and 10% in 1998, before abolition in April 2000. The impact of these measures on post-tax mortgage rates has been dramatic, as Table 2 shows.

Pre-tax mortgage rates have in recent years been extremely low and the contrast with the peak years in which, as the table shows, mortgage rates averaged close to 15%, is remarkable. But once you take account of even standard rate tax relief, recent rates are no longer particularly low. They are similar to the rates which ruled in the mid to late 1970s. And once you allow for tax relief at the highest marginal rate, the average post-tax mortgage rate which ruled over the last fiscal year was actually higher that the equivalent rates ruling from 1974 to 1988.

The contrast is even stronger if you look at real after-tax interest rates, as shown in Chart 3.

The Last Straw?

But the changing tax treatment of home ownership does not stop there. Policy on stamp duty has also shifted against house purchasers. Owing to the failure to uprate the thresholds for liability to stamp duty, as house prices have risen, more and more houses have moved into a given band, thereby increasing the Treasury’s tax take on property.

On top of the failure to revalorise, the current Government has raised the rates of duty. The recent increase in duty to 4% for properties above £500,000 may have acted as a substantial brake on the housing market in London.

Why did the market boom last year and then slow down?

If the market is now moving towards a moderate rate of increase of prices, a major question mark hangs over what happened in the market last year and the early part of this, when it looked to many observes as though another housing boom was in the offing. What was it that stopped this from occurring?

Part of the answer is official policy changes. Between September 1998 and February 1999, base rates were cut from 7.5% to 5.5% over five successive months. The Bank of England then cut rates twice more by June of the same year, leaving them at 5%. This clearly had the effect of boosting the housing market. Indeed, it was specifically intended to have this result since the MPC had concluded that with international demand weak, domestic demand needed to be boosted in order to keep the economy on track.

But subsequently base rates were increased by 1% between August 1999 and February 2000 as consumption appeared to be growing too quickly. Coming on top of the movements in interest rates, the reduction and eventual withdrawal of mortgage tax relief in the budgets of 1999 and 2000, and the increase in stamp duty, helped to damp housing market optimism.

But perhaps more important in explaining the surge in housing market activity in 1999 was what had happened in the years before. The scale of the falls in house prices in the early 1990s was so large compared to the upward march of earnings that housing became cheap. This implied that once the economy had recovered its poise, house prices would have to rise quite sharply for a period simply to reach normal valuations. This happened last year. But the recovery of the market to fair value, even though, for a time, it involved rapid rates of price increase by no means represented a return to the housing frenzies of the past.

The Outlook – Stability at Last

Because of the emergence of low inflation, the change in the policy regime, and the dramatic change in the tax treatment of home ownership, the era of boom and bust in the housing market may now be over. Rapid rises in house prices – of 20% and more – will now be a thing of the past - and so will the painful downswings when the real price of houses fell.

From now on, while there will still be minor fluctuations, house prices may rise in line with the general level of prices plus an amount for changes in housing fundamentals, such as the degree of land shortage and the rate of household formation. Taking these factors into account, increases of between 4-5% per year should be regarded as the norm.

The housing market is the last piece of the low-inflation jigsaw to fall into place. Stability in the housing market will be the clearest sign yet that the UK has fully adjusted to low inflation and is set to enjoy stable macro-economic conditions overall. After everything we have been through that is a considerable prize to have won.

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Analysis: The World Economy

Desperately Seeking Slowdown...

• Recent data from the US has provided some evidence that, at long last, successive increases in interest rates could be causing a slowdown in domestic demand. (See Chart 1.) Some commentators have even begun to assert that the US economy is heading for the much sought-after soft landing.
• But the signs of slowdown are still only tentative and US rates may yet have to go higher to bring the necessary adjustment.
• And the current account is still signalling that the adjustment needs to be massive, (see Charts 3 and 4), even though the US fiscal position is extraordinarily healthy and looks set to become even more so. (See Chart 5.) The reconciliation of these two factors is to be found in the private sector’s finances. Although the personal savings ratio is up somewhat, it still looks pitifully low. (See Chart 6.)
• A cursory look at some recent US stockmarket indicators might persuade you that at least the stockmarket adjustment is now accomplished. Both the Dow Jones Industrials index and the S&P Composite are now well below the level at which they started the year, while the NASDAQ Composite index has fallen by nearly 25% since it breached the 5000 barrier in mid-March. (See Chart 7.)
• But this conclusion would be unjustified. Although recent weakness may have injected a dose of realism into equity markets, it has hardly dented the extreme bull run of recent years. (See Chart 8.) US stocks remain fundamentally overpriced, and as such, the downward correction will probably have much further to go. As a result, we believe that the threat to US and, by implication, world economic performance that we outlined in previous editions of the Review remains.
• Many commentators see an equally potent threat now emerging on the world economic scene. Following OPEC’s inability to agree to substantial increases in production quotas in June, the price of Brent crude has been above $30 p/b for a sustained period for the first time since the Gulf war-induced hike of 1990, although recent news that Saudi Arabia will act as a swing producer has held out the prospect of prices much closer to $20 p/b. (See Chart 9.)
• Even without this news, though, we would be relatively sanguine about the oil threat. Comparisons with earlier oil crises are seriously misplaced. For one thing, the magnitude of the recent price increase, with prices rising by 50% since early April, while significant, is much smaller than the 130% hike in 1990 and nowhere near the quadrupling of prices in the early 1970s.

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  The World Economy Charts

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Analysis: The World Economy (continued)

...while threat to stability from higher oil prices exaggerated

• Moreover, once you account for inflation and express oil in today’s prices, the real cost of oil rose to more than $90 p/b in 1974 and to more than $100 p/b in 1979, much higher than the prices we are witnessing today. (See Chart 10.)
• At the same time, developed countries are now less structurally reliant on oil-hungry heavy industry, as more of their GDP consists of services which use comparatively little energy.
• Furthermore, although non-oil commodity prices have picked up a bit after a period of serious weakness, their recovery is tame. (See Chart 11.)
• If we are fairly relaxed about the oil “threat”, we are still worried about the threat posed by the weakness of Japan – despite some signs of recovery. At first sight, output growth of more than 2% in the first quarter seems impressive. (See Chart 12.) But it was heavily distorted by the extra working day arising from the leap year, which was not accounted for in the seasonal adjustment.
• The Bank of Japan has been itching to end the zero interest rate policy. This is another example of the Japanese authorities shooting themselves (and Japanese citizens) in the foot. The Bank complains that this policy was highly artificial and unusual. But so is the state of the Japanese economy, with the deflation danger far from over. (See Chart 13.) They risk causing a damaging loss of confidence.
• Things do seem to be genuinely better, though, in the other major source of weakness in Asia, namely China. Signs of a decrease of the rate of price deflation have prompted a renewed bout of optimism. The State Statistics Bureau has predicted that prices will be rising by the end of the year. (See Chart 14.)
• In Euroland too, conditions are improving. In Q1, domestic demand was boosted by a 1% increase in government spending and a jump of 1.8% in fixed investment. The weak euro continues to have a beneficial impact on export performance with exports increasing by 2.6% on the quarter. Now that Germany and Italy are recovering quite well, the divergence in growth rates will probably not be as serious as it was in 1999, but it may still be significant. (See Chart 15.)
• The divergence in inflation rates, though, is getting wider. The gap between the best and worst inflation rates among member states was 3.6% in May, up from 3.1% in February. This poses a serious problem for the ECB in setting a single interest rate for all these countries. (See Chart 16.)

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  The World Economy Charts

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Analysis: Output and Activity

The economy slows to a steady pace

• GDP figures for the first quarter of 2000 revealed a sharper slowdown in UK economic activity than many commentators had expected. Output increased by 0.5% on Q4 99, down from 0.8% in the previous quarter, and up by 2.1% on the same period a year ago – below most estimates of the economy’s trend rate of growth.
• More surprising though, was that most of this slowdown was focused in areas of domestic economic activity. Growth in consumer spending fell to 0.6% in Q1 00 on Q4 99, down from 1.1% on the previous quarter, while fixed investment increased by only 0.2% in Q1, compared with 1.6% in Q4. Indeed, it was the strength of net exports which sustained GDP growth at a reasonable figure. 
• In contrast to weaker consumption, exports performed remarkably well in the first quarter, growing by over 2.4% in real terms on Q4 99, despite the strengthening of sterling that began in the second half of last year. 
• While a rebound in consumption growth is likely in Q2, some slowing is consistent with the picture emerging from other signals of activity. 
• Both the Nationwide and Halifax house price indices have weakened, with the June Halifax index showing prices rising by less than 10% over the year for the first time since September 1999. (See Charts 6 and 7.) 
• There has been some bounce-back in housing activity following weak data in March. The volume of transactions increased by 11,000 in April, while the number of approvals for house purchase increased by 9,000 – after both fell in May. However, activity remains less buoyant than during the first quarter. Together, the price and activity data suggest that the market has passed its peak.
• A slowdown in the housing market would help to rebalance the economy both sectorally and regionally.

The rebalancing process in the economy would be boosted by a further fall in sterling against the euro, which we still expect to occur later this year. This would benefit net trade, while a fall in stock prices would undermine consumption.

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Output & Activity Charts

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Analysis: Output and Activity (surveys)

But surveys warn of a heavy impact from the strong pound

• The most recent survey evidence provides further warning on the imbalance in growth. 
• The manufacturing sector has entered a renewed period of downturn, after appearing to recover in 1999. The CBI reported that business optimism among manufacturers fell in the second quarter for the first time in a year. (See Chart 1.) 
• By contrast, in the service sector, as the CBI/Deloitte & Touche Survey reveals, optimism continues to rise. The improvement in optimism among consumer service sector companies remains modest, but it has crept up from last quarter’s negative balance. (See Chart 2.) Optimism is stronger among business and professional service firms. 
• To some extent, the weakness in manufacturing may reflect the pervasive gloom surrounding the effect of the strong pound. But producers in the domestic market have also seen their order books weakening. (See Chart 3.) 
• The sharpest deterioration has come in industry’s investment in buildings, which has fallen further back into negative territory, while expectations of future employment remain stubbornly negative. (See Charts 5 and 7.) 
• Again, the picture is sharply different in the service sector. The balance on expected business volumes remains strongly positive, and among business and professional service firms, is at its strongest on record. (See Chart 4.) 
• On expected tends in both employment and expenditure on buildings, the contrast with struggling industry has become even clearer than it was. Service sector firms remain strongly positive with regard to hiring prospects. (See Chart 6.) While both consumer and business and professional services firms now expect to increase expenditure on land and buildings (Chart 8), in contrast to industry, where most companies expect it to fall.

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  Output & Activity Survey Charts

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Analysis: Inflation

Inflation set to fall still further

• Inflationary pressures in the economy remain extremely subdued. The underlying rate of inflation (RPIX) rose in June but it still stood at 2.2%, below its targeted rate of 2.5%. The European Harmonised measure of inflation, the HICP, which stood at 1.0% at the time of the last Review, has now fallen even further to stand at just 0.8%, which is easily the lowest in the E.U. (See Chart 1.)
• The discrepancy between these measures has become a serious problem. We think that HICP is probably giving a truer reflection of inflationary pressures in the economy, although it will be some while before a switch to HICP for the target can be contemplated.
• There have been some signs in the early part of 2000 that the gap between inflation in the goods sector – where prices are falling - and in the services sector –where prices are rising - may be narrowing. (See Chart 2.)
• For goods, the rate of fall in prices intensified again in June, after appearing to be on a slowing path. But this may turn out to be a something of a blip. Indeed, the pick-up in PPI inflation may suggest that deflation in the goods section of the RPI has not got much more time to run. (See Chart 3.) Nevertheless, the detailed analysis of individual sub-sectors, which follows below, reveals several areas where deflationary pressures are still strong.
• Moreover, if the recent slowdown in service sector inflation continues, (See Chart 2.) that will be more significant than a slight pick-up in goods inflation.
• Deflation in the household goods sector appears to be slowing, although a recovery in prices at the sharp rate witnessed in April has proved somewhat premature. (See Chart 5.) Similarly, despite a modest easing since the turn of the year, prices for leisure goods are falling by 4% per annum. In both cases, there is a sharp contrast with their service equivalents (shown in Charts 6 and 8) where inflationary pressures remain strong.
• While second hand car prices have continued to fall, the rate of decrease has slowed a little. (See Chart 9.) The reason is probably that this market anticipated falls in new car prices which are only now materialising. Nevertheless, with price cutting on new cars probably set to intensify, second-hand prices could stay extremely soggy.

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  Inflation Charts

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Analysis: Inflation (continued)

Some surveys show expectations of higher prices – but can they be realised?

• Recent cuts in electricity prices have sent fuel and light prices falling again, after they had begun to rise at the end of 1999. Tariff changes are expected to continue to filter through into prices over coming months.
• A key role in the inflation outlook is played by the housing component of the RPI, which is currently running at an annual rate of around 10%. Since it accounts for nearly one-fifth of the entire retail price index, it alone contributes an increase in the overall RPI of some 2%.
• Survey evidence continues to point towards falls in both prices and unit costs in the retail sector. The CBI Distributive Trades survey showed price falls deepening in the second quarter of 2000. (See Chart 1.) A balance of –14 of firms reported prices falling in Q2, compared with a –2 balance in the preceding quarter. Moreover, as Chart 3 shows, the balance is expected to remain in negative territory.
• In industry, cost pressures remain very weak, as evidenced by the negative balances shown in the CBI survey question on costs per unit of output and expectations for the future. (See Charts 5 and 7.)
• In the service sector, things are rather different. The balances for costs per employee, both realised and expected, are heavily positive. (See Charts 6 and 8.) But at least they have shown little sign of accelerating since the end of last year. In the CBI/Deloitte & Touche survey of service sector firms, a positive balance of 30-40% have seen costs per employee increase since Q1 2000, slightly down from Q4 1999.
• While expected selling prices in the service sector have increased quite dramatically since the middle of 1999, there has been no sustained evidence of firms’ ability to turn these expectations into reality. Although consumer services firms, including hairdressers, hotels and restaurants, registered price increases in the May survey, the balance of firms in the business and professional service sector saw price falls intensify. (See Chart 2.)
• Despite the superficially alarming picture for consumer services inflation shown in Chart 4, we suspect that with growth turning out somewhat weaker this year than originally expected, there is every prospect of a decrease in the rate of service sector inflation. That means that overall inflation may turn out to be even weaker than we had previously expected – perhaps ending the year at close to 1.5%, the lower boundary of the Government’s inflation target.
• Indeed, should the pound remain strong, inflation may fall even further in 2001, causing the Governor of the Bank to have to pen his first explanatory letter to the Chancellor.

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  Inflation Survey Charts

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Analysis: The Labour Market

Reduced wage pressures confirm labour market improvement

• The unemployment rate has edged further below the lows witnessed last quarter. The ILO measure fell to 5.6% in March-May, from 5.8% in the preceding three months. The claimant count measure also fell, to 3.8% in May, down from 3.9% three months earlier. (See Chart1.)
• More than half of the fall in unemployment on the ILO measure over the past quarter has come from a reduction in the numbers of long-term unemployed. While this could be interpreted as an encouraging response to the Government’s ‘New Deal’ programme, it may also highlight the difficulties facing employers in recruiting.
• Employment gains have moderated, but the number of people in work, at 27.9m on the LFS measure, is at an all-time high. (See Charts 2 and 3.) While some of this increase has been undoubtedly cyclical, it would appear that the UK labour market is continuing to adjust to a permanently improved state. Moreover, according to the IMF’s estimate of the output gap, there is still a little bit of slack to be taken up. (See Chart 4.)
• The most disappointing aspect of the labour market has been poor productivity gains, although there has recently been some improvement, particularly in manufacturing. (See Chart 5.) We suspect that although the recruitment of more marginal workers acts to depress productivity performance, the figures will look much better this year, compared to last.
• The outlook for wage inflation has improved. Recent figures have seen earnings figures come back down as Millennium-related bonus payments have tailed-off. The headline measure of average earnings increased by 4.6% in the three months to May, down from 5.1% in the three months to April. (See Charts 6 and 7.)
• Combined with slightly improved productivity performance, the effect of lower wage inflation will be to reduce the growth of unit wage costs, which has already come well down from last year’s worryingly high numbers. (See Chart 8.)
• The reduction in average earnings growth will translate into relief for members of the MPC, some of whom had feared a cost-based resurgence in retail prices. The increase in whole-economy earnings in May, at 4.0% above May 1999, has now fallen below the maximum level thought by the MPC to be compatible with the 2.5% inflation target.
• Despite low unemployment, we see wage growth remaining low. With retail price inflation at around 2%, real wage growth, at around 2.5%, is probably at a sustainable level.

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  Labour Market Charts

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Analysis: Monetary and Fiscal Policy

Have interest rates peaked?

• Base rates were on hold for 5 successive months up to July. Although the MPC have been split on whether to increase base rates from 6%, with inflation still well below its target, an apparent softening in wage pressures and tentative evidence of a slowdown in domestic demand, hawks on the committee have been unable to assert their authority.
• This stance seems warranted by the continued weakness of inflation, with the result that real interest rates look plenty high enough. (See Chart 1.)
• Exporters will have received some respite with the sharp fall in sterling on a trade-weighted basis since its peak in April. (See Charts 2 and 3.) However, the pound remains overvalued on this measure. What is more, changes in the exchange rate impact on output with a lag, and survey evidence has suggested that exporters face a difficult second half of the year whatever happens to sterling over coming months.
• As a result, the MPC are unlikely to be able to apply the base rate breaks again without damaging confidence further. Indeed, the weakness of industry should be enough to persuade the MPC that the risks to output economy-wide lie on the downside. Higher rates now would risk spreading weakness in confidence to those sectors that are keeping growth afloat. • Indeed, we see the only development that could take base rates higher would be a further sharp fall in sterling. Even if, as we expect, this were to occur later in the year, it may come at a time when UK economic growth is showing clear signs of moderation. In order to avoid turning a slowdown into recession, the MPC might wait until signs of inflation actually emerge before pulling the interest rate trigger.
• But it could be some time before this scenario is played out. Indeed, the most likely prospect is for a period of stability for base rates over the next six months, leaving room for small cuts in 2001 as it becomes clear that the economy is not growing above trend.
• The public finances have been boosted by £22.5bn through the auction of 3G mobile phone licences. However, while the extra cash will have an immediate impact on both the net cash requirement and net debt, accounting rules will mean that the impact on borrowing will be spread over the 21-year lifetime of the licences. (See Chart 6.)
• However, it will be difficult for the Chancellor to avoid pressure from his own party to divert some of the money towards voter-sensitive public services in the November Pre-Budget Report. Moreover, any further reductions in borrowing at the long-end of the market will be opposed by pension funds already squeezed by the gilt shortage.

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  Monetary & Fiscal Policy Charts

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Analysis: External Trade

Strong pound will see export crunch...

• Figures for the first quarter of 2000 have shown a further deterioration in the current account. The deficit increased to £4bn, up from a revised deficit of £1.5bn in Q4 1999. Nevertheless, the current account deficit for 1999 as a whole was revised down by nearly £2bn to £11bn, representing just over 1% of GDP. (See Chart 1.) Although likely to expand this year, the deficit will remain within manageable limits.
• The main reason for the deterioration in Q1 was a sharp fall in the surplus on investment income to £0.9bn from £4.1bn in Q4 1999. (See Chart 4.) This looks as though it reflected timing differences and technical factors. A bounceback is on the card for the next quarter.
• While survey evidence continues to point to a bleak outlook for exporters, reflecting continued pound strength against the euro, clear signs of a downturn in trade performance in goods and services remain somewhat tentative.  While the balance on trade in services was largely unchanged in the first quarter, the deficit on trade in goods actually improved by £0.6bn, thanks entirely to better export performance. (See Charts 2 and 3.)
• The most recent monthly trade data reveal some cause for concern, but attempting to extrapolate a trend remains hazardous. Volume exports of goods to EU countries fell in April for the first time since December 1999, although this should be treated with caution. Exports to non-EU countries also fell in April (albeit by less), but bounced back in May.
• Indeed, although the goods and services deficit increased to £1.6bn in April, from £1.1bn in March, all of this was attributable to trade outside the EU, limiting the effect that can be attributed to euro weakness. Moreover, latest data show that the trade deficit outside the EU narrowed again in May.
• This could mean exporters have continued to absorb the effect of the higher pound on profit margins, while attempting to boost competitiveness through productivity gains. Certainly, this would be consistent with the strong productivity gains seen in manufacturing over the past six months.
• But we are somewhat less bullish. While productivity gains have undoubtedly helped some exporters hold onto market share, it is likely that the impact of the strong pound on output has not yet fully appeared. Current export performance may relate to investment decisions made last year when the pound was significantly weaker.

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  External Trade Charts

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Analysis: External Trade

...and adjustment postponed until next year

• Indeed, it could be the end of the year before the true impact of the pound’s current strength is revealed. 
• However, our central forecast for the current account remains essentially unchanged from the last quarter. The current account will deteriorate this year, with exporters finding conditions increasingly difficult while the effect of the strong pound lingers.
• As a net exporter of oil, the current account will continue to benefit from stronger oil prices. Chart 7 shows how, as a mature producer, the value of our oil exports closely mirrors the oil price. In the 1990s, oil accounted for between 4% and 8% of all goods and services exports from the UK, depending on its price. Last year, the oil surplus was some £4bn.
• OPEC’s recent attempts to stabilise oil prices though increased production quotas proved ineffective, with prices remaining above US$30 p/b for much of June. However, this price is unlikely to be sustained for much longer in the face of Saudi determination to force it lower. Should oil prices fall sharply over coming months, as we expect, then the oil surplus should contribute less to reducing the current account deficit by the end of the year and in 2001.
• Given the possibility of a protracted period of sterling strength, the prospect of weaker oil prices, and recent survey evidence painting an increasingly bleak picture for exporters, the risks for exports are on the downside.
• However, there are good prospects for a moderation of import growth. Chart 5 shows how strong the linkage is with domestic demand. Our downward revision to domestic demand, and the corresponding weakening in imports, should offset the impact on the current balance, leaving the deficit at around 2% of GDP this year.
• The prospects for exporters should improve in 2001. Indeed, the essential mechanism by which we expect the economy to rebalance remains untouched. A correction in US stock prices should see both the dollar and the pound fall, leaving sterling slightly higher than at present against the greenback, but significantly weaker against the euro. This would provide exporters to Euroland with a significant boost. Although there would be some fallout for European exports from a slowdown in US growth, UK exporters would be provided with some cover in US markets by the fall in the pound against the euro.
• The current account deficit should fall back to 1.6% of GDP in 2001.

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