Under its terms of reference the new Office for Budget Responsibility is required to provide updated forecasts for the economy and the public finances at the time of each Budget in order take into account the impact of those measures contained in the Budget. Here we consider those economic forecasts contained in the June 2010 OBR Budget Forecast relating to economic growth. In particular, we consider the OBR’s interpretation of how growth is likely to be affected by the policy measures unveiled by George Osborne in his first Budget as Chancellor of Exchequer on 22 June.
The OBR forecasts that the UK economy will grow by 1.2% in 2010 and by a further 2.3% in 2011. These estimates are lower than those published by the OBR in its Pre-Budget Forecast published on 14 June. The Pre-Budget Forecasts predicted growth of 1.3% in 2010 and 2.6% in 2011. The downward revisions reflect the OBR’s assertion that the Budget’s measures to meet the Government’s fiscal mandate and, hence the resultant fiscal consolidation package, will weaken aggregate demand.
In terms of the components of aggregate demand, the fiscal consolidation will mean restraints on government spending (G) and, if the OBR is right, lower growth in household consumption (C). Lower consumption growth is expected as a result of reduced growth in household incomes and the rise in the standard rate of Value Added Tax next January from 17½% to 20%.
The OBR now forecasts that real household consumption will grow by just 0.2% in 2010, following last year’s contraction of 3.2%, and by 1.3% in 2011. General government final consumption – the Government’s expenditure on current goods and services – is forecast to grow in real terms by 1.7% this year before falling by 1.1% next year. The forecasts for general government capital spending are for a real fall of 4.9% this year, following last year’s rise of 15.7%, followed by a sizeable 19% decline in 2011.
A more positive note emerging from the OBR forecasts relates to capital expenditure by businesses. The measures to reform corporation tax, which include a reduction in the main rate of corporation tax from 28 per cent to 24 per cent over four years beginning with a one per cent reduction from April 2011, are predicted to have a favourable effect on investment. Business investment is forecast to rise in real terms by 1.4% this year, following last year’s fall of 19.3%, and to rise again in 2011 by 8.1%.
The projections for growth from 2013 are now stronger than in the OBR’s Pre-Budget Forecast with the economy portrayed as adjusting more quickly at this point towards its potential output. Potential output is the level of output level when the economy’s resources are operating at ‘normal capacity utilisation’. But, in 2015, which is at the end of the OBR’s five year forecast period, the UK economy is still forecast to be experiencing a negative output gap. In other words, actual output will still be less than potential output.
To help paint a picture of how the economy’s output will adjust towards its potential level consider the OBR estimates for the output gap. The OBR estimates that in financial year 2009-10 the economy’s output was 4.1% below its potential. This negative output gap is now expected to be reduced to 3.7% of potential output in 2010-11, to 2.8% in 2012-13 and to 0.9% of potential output in 2015-16.
Office for Budget Responsibility
OBR home page
Office for Budget Responsibility Terms of Reference
Documents
Budget Forecast June 2010 OBR (22/6/10)
Pre-Budget Forecast June 2010 OBR (14/6/10)
Budget 2010 HM Treasury (22/6/10)
Articles
OBR endorses Budget but faces questions over its own predictions Telegraph, Philip Alrdrick (23/6/10)
UK growth forecasts could be revised again, says Sir Alan Budd Citywire, Deborah Hyde (23/6/10)
OBR says growth will take bigger hit Financial Times, Norma Cohen (22/6/10)
Budget 2010: Government cuts will slow economic recovery, says watchdog Telegraph, James Kirkup (23/6/10)
Highlights from the Budget BBC News (22/6/10)
Budget statement: George Osborne’s speech in full BBC Democracy Live (22/6/10)
Questions
- What do you understand by the concept of aggregate demand?
- What are the component expenditures of aggregate demand? Which of these do you think is the largest in value terms?
- The OBR is forecasting the household sector’s disposable income to grow in real terms this year by 0.2% and by 1.2% next year. Why then is the OBR identifying weaker consumer demand as a result of the Budget measures as a major reason for revising down its predictions for economic growth?
- The OBR argues that the fiscal consolidation measures will have a ‘direct effect’ on household incomes and so on spending, but that this will be ‘partially offset by a decline in saving’. Why might the OBR be arguing that a fiscal consolidation will lead to a decline in saving? Evaluate the OBR’s arguments.
- What do you understand by the concept of an output gap? What does a negative output gap signify?
- To see the sorts of problems that forecasters commonly face, try identifying reasons why the output gap could be eliminated more quickly or less quickly as a result of the Budget measures.
The second estimate of UK output for Q1 2010 from the Office for National Statistics reports that the economy grew by 0.3%. The first estimate, based on limited data, put growth in Q1 at 0.2%. But, it appears that more recently available data picked up evidence of stronger growth in the latter stages of the quarter, particularly in the production industries, such as manufacturing, as well as in capital spending by firms.
When analysed in terms of the composition of demand for our firms’ goods and services, there has been something of a rebound in investment expenditure. This follows a marked collapse during 2008 and the first half of 2009. In 2010 Q1 investment volumes increased by 4.2% on the back of a 2.4% rise in the last quarter of 2009.
This rebound in the investment figures across the last two quarters has partly been driven by firms running down their stockpiles of finished goods at a considerably slower rate. When firms build up their stocks of inventories for sales in future periods they are deemed to be engaging in investment. When firms then ‘tap into’ these inventories, as they have been since Q4 2008, they are disinvesting. It is now the case that the pace of disinvestment through running down inventories is slowing. This reflects a pick up in the demand for firms’ goods and services and, hopefully, an expectation of stronger future demand.
More encouragingly, the rebound in investment volumes in Q1 also reflected an increase in gross fixed capital formation, i.e. an increase in the purchase of non-financial fixed assets used in production, such as machinery. Gross fixed capital formation increased in Q1 by 1.5%. This was the first quarter since Q2 2008 in which there has been an increase in the volume of capital purchases by firms. Again, this is likely to reflect increased optimism about future demand since these assets are purchased to do one thing – to produce goods and services!
The improvement in the investment numbers is such that the volume of investment in Q1 2010 was 0.6% higher than it was in Q1 2009. This is largely the impact of a slower rate of disinvestment by firms through running down inventories since despite the rise in gross capital formation in Q1 2010 it still came in 5.7% lower than in Q1 2009. Nonetheless, it will be interesting to see whether the recent improvement in the UK’s investment numbers is maintained as we go forward.
Of particular concern is whether the volume of capital purchases can continue to grow. Can these purchases help to both boost growth now and our economy’s potential output in the medium term? Some of the key issues in determining the answer to this are likely to include: (i) the extent to which aggregate demand grows; (ii) the impact of fiscal consolidation measures on both firms and consumers; (iii) sentiment (confidence) across firms – especially of their own medium-term prospects; and (iv) the ability of firms to access credit from financial institutions. One can undoubtedly add many other issues to this list. One thing is for sure, these are very uncertain times indeed!
Articles
The economy: GDP growth revised up The Times, Grainne Gilmore (26/5/10)
Manufacturing pushes up economic growth The Independent, Sarah Arnott (26/5/10)
UK economic growth revised up to 0.3% BBC News (25/5/10) )
Economy tracker: GDP BBC News (25/5/10)
Boost for UK as GDP growth revised up Telegraph, Edmund Conway (25/5/10)
UK GDP growth revised upwards to 0.3% Financial Times, Daniel Pimlott (25/5/10)
UK first-quarter GDP revised higher Wall Street Journal, Natasha Brereton (25/5/10)
Data
Latest on GDP growth Office for National Statistics (25/5/10)
UK output, income and expenditure, Statistical Bulletin, 1st Quarter 2010 Office for National Statistics (25/5/10)
UK Output, Income and Expenditure, Time Series Data Office for National Statistics
For macroeconomic data for EU countries and other OECD countries, such as the USA, Canada, Japan, Australia and Korea, see:
AMECO online European Commission
Questions
- Why do the National Accounts record a positive change in inventories as investment and a negative change in inventories as disinvestment?
- What factors might explain the running down of inventories across firms in the UK since Q4 2008? Why didn’t this start in Q2 2008 when the UK economy went into recession?
- In Q1 2010 the running down of inventories was worth, at 2005 prices, some £1.347 billion. This was considerably less than the £4.883 billion in Q3 2009 and the £2.596 billion in Q4 2009 (again at 2005 prices). Why might the pace of disinvestment be slowing?
- Of what importance do you think, firstly, the change in inventories and, secondly, gross capital fixed formation are for an economy’s potential output?
- What arguments do you think there are for distinguishing between different types of investment goods and services when considering our future economic growth?
The output gap is defined as ‘the difference between actual and potential output.’ When actual output exceeds potential output, the gap is positive. When actual output is less than potential output, the gap is negative. The size of the output gap traces the course of the business cycle. In the current recession, the output gap is negative in all major economies. The worry in recent months has been that a persistent large negative gap could lead to a downward deflationary spiral. Evidence is emerging, however, that the recession may be bottoming out and the danger of deflation easing. But just how big is the current negative output gap? As the article below from The Economist states, “Estimating how big the output gap is, and how much of a deflationary threat it still poses, is not easy.”
So how is the output gap measured in practice? How do we measure ‘potential output’? The two articles consider this issue of measurement and the relationship between the output gap and the rate of inflation. The last two links are to data sources giving estimates of the output gap. The first is from the European Commission and the second is from the OECD. As you will see, there are differences in their estimates.
Put out: Uncertainty over the size of the output gap complicates the task of central banks The Economist (2/7/09)
How big is the output gap? FRBSF Economic Letter (12/6/09)
See also:
Box 1.3.2 on page 31 and Table 13 on page 140 of European Economy: Economic Forecast, Spring 2009 European Commission, Economic and Financial Affairs (From the above link, click on the little ‘en’ symbol.)
and: Table 10 from OECD Economic Outlook No. 85, June 2009 OECD (From the above link, click on ‘Demand and output’. The first 10 tables then download as an Excel file.)
Questions
- Why is it difficult to measure potential output? (See both The Economist article and Box 1.3.2 from the European Economy: Economic Forecast, Spring 2009.)
- What is meant by the ‘NAIRU’? Why may it have risen during the recession? How would you set about estimating the value of the NAIRU?
- How might you infer the size of the output gap from the behaviour of inflation?
- Plot the output gap for two countries of your choice using data from both the European Economy and the OECD Economic Outlook for the years 2004 to 2010. Discuss the differences between (a) the two plots for each country and (b) the two countries.