BCC Quarterly Economic Forecast: The next issue of the BCC’s Quarterly Economic Forecast will be issued early in August. The previous full Forecast was issued May, and was circulated in the usual way to all Chambers and to the media. The current Briefing reviews monthly developments, and indicates possible revisions to the forecasts where appropriate. The monthly Briefing also updates our global economic forecasts, and our interest rate & exchange rate assumptions.

Preliminary GDP figures for Q2 2004 show stronger growth, at 0.9% quarterly & 3.7% year-on-year. Revised figures published last month also show faster growth in Q1 2004, at 0.7% quarterly & 3.4% year-on-year. Our May forecast for UK GDP growth (3.1% in 2004 & 2.7% in 2005) will probably be raised, to 3.3% or 3.4% in 2004. But, as already indicated in last month’s Briefing, in view of the faster pace of likely interest rate increases, we may have to lower our 2005 GDP growth forecast, to 2.5%.

Key Points:
· The UK repo (base) rate was kept at 4.50% in July; it is likely to rise to 4.75% in August, to 5% by end-2004, & to 5.50% in 2005. Sterling is set to weaken in 2005.
· UK Q2 2004 preliminary GDP growth was 0.9% quarterly & 3.7% year-on-year.
· UK GDP growth forecast: raised to 3.4% in 2004, unchanged at 2.5% in 2005.
· UK prospects are positive. But employment has fallen slightly & inflation is edging up. Strikes & regulations are a serious problem for business.
· The US economy still drives the global upturn. But US growth is decelerating.
· US employment growth was only 112,000 in June, well below expectations.
· US Q1 GDP quarterly annualised growth was revised down, from 4.4% to 3.9%.
· US GDP growth forecast is lowered marginally, to 4.6% in 2004 & 3.6% in 2005.
· US underlying inflation is edging up, but is not near an alarming level.
· US consumer prices rose 3.3% in the year to June. But core producer & consumer inflation has risen less, from some 1% a few months ago to near 2% currently.
· Oil prices, after easing in June, have risen in July, and reached a 14-year peak. But higher OPEC output & slowing demand should reduce crude prices by Q4.
· US interest rates will rise at a moderate pace, but there will be no credit crunch.
· Share prices have fallen in July, and the financial markets are in a cautious mood.
· Terrorism, higher interest-rates, high oil prices, & huge budget/trade deficits remain dampening influences on the global economy.
· Japan’s 2004 GDP forecast is up further, to 4.3%. 2005 is unchanged at 2.2%.
· Eurozone GDP forecast is unchanged: 1.7% in 2004 & 2.0% in 2005.
· The US Fed Funds rate, having risen to 1.25%, is set to increase to 2.25% by Q1 2005, & to 3.75% by end-2005.
· The ECB interest rate will stay at 2%; modest rises are likely in 2005.
· The $ will be robust near-term, but falls are likely towards end-2004 & in 2005.
UK background: The economic recovery continues at a satisfactory pace, with strong growth and high employment levels. But employment recorded a small fall in the last quarter and inflation is edging up. Share prices have fallen to a 2004 low.

UK FTSE 100 INDEX, LAST 12 MONTHS

Preliminary figures show quarterly GDP growth of 0.9% in Q2 2004, higher than the 0.7% rise in Q1, but slightly below market expectations of a 1.0% increase. Year-on-year GDP growth accelerated to 3.7% in Q2, after 3.4% in Q1. Manufacturing output rose 0.5% in May, slightly better than expected, bringing the official figures further into line with the more upbeat messages conveyed recent by most business surveys. Our forecast for UK GDP growth is being raised to 3.4% in 2004, and remains unchanged at 2.5% in 2005. The repo (base) rate was kept unchanged in July, at 4.50%. But further interest rate increases are likely, to 4.75% in August, to 5.00% by end-2004 & and to a peak of 5.50% in 2005.

Public finances are still stretched, and the economy remains over-dependent on the upsurge in public sector spending & recruitment. But the UK Budget deficit is lower than predicted in the March Budget, and the fiscal pressures have eased further. Low public debt levels give the Chancellor room for manoeuvre. Even so, there is a distinct risk that tax rises of some £8bn-£10bn may still be needed, mostly after the General Election, to avoid breaking the Golden Rule. There is a clear risk that the large fiscal deficit may put upward pressure on interest rates. Although strikes & labour militancy are serious short-term risks, the 2004 & 2005 outlook is satisfactory overall, with good growth, high employment, & low (albeit rising) inflation.

Base rate & £: At its July meeting, the MPC kept its key repo (base) rate at 4.50%, after two successive increases to 4.25% in May and to 4.50% in June. The “no change” decision was widely expected. The minutes of the July meeting reveal that although the Committee discussed the possibility of a rise, all the nine members supported the decision to keep the rate at 4.50%. The references in the July minutes to the “gradual tightening in labour market conditions”, “growth still around or a little above trend”, and “little, if any spare capacity”, all support the expectations that interest rates will continue rising gradually but steadily. It is extremely likely that the next Base rate increase, to 4.75%, will occur in August; this will be followed by further gradual repo rate rises, to 5.00% by end-2004 & to a peak of 5.50% around mid-2005. The pound has recorded little net change in July. Looking ahead, we expect £ to weaken (against both the $ & the €) towards end-2004 & in 2005, due to increased concern over the large UK external deficit.

US$ PER UK£, LAST 12 MONTHS

The Global Economy: Global growth remains rapid, and the US economy still drives the global upturn. But US growth is decelerating. US employment growth was only 112,000 in June, well below the expected increase of 250,000. US GDP quarterly annualised growth for Q1 2004 was revised down, from 4.4% to 3.9%. After successive upgradings over the past year, our forecast for US GDP growth is lowered marginally, from 4.7% to 4.6% in 2004 & from 3.7% to 3.6% in 2005. While economic activity is expected to continue expanding, the mix is becoming less favourable, with less real growth and more inflation. Terrorism, higher interest-rates, high oil prices, & huge budget/trade deficits remain dampening influences. But, although global growth is set to slow in 2005, economic activity will continue at a satisfactory pace in the next 2-3 years.

Inflationary pressures are rising, and the financial markets expect further interest rate increases. US inflation is edging up, but is not approaching an alarming level. US consumer prices rose 3.3% in the year to June. But core producer & consumer inflation has recorded a smaller rise, from some 1% a few months ago to near 2% currently. Oil prices, after easing in June, have risen in July, and reached a 14-year peak. The persistent high level of oil prices will inevitably have the effect of damaging growth & worsening inflation. Although higher OPEC output & slowing demand, mainly in the US & China, should reduce crude prices over the next 6-9 months, oil prices are unlikely to fall significantly. The damaging effects of the upsurge in energy costs will be felt for some time. We expect the price of Brent crude (currently almost $40 per barrel) to fall to a range of $30-$35 per barrel by mid-2005. Based on current price relationships, the price of West Texas Intermediate will be some $3 per barrel higher.
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BRENT CRUDE OIL, US$ PER BARREL, LAST 12 MONTHS

In Japan, prospects are improving, and we are upgrading the 2004 GDP forecast, from 4.1% to 4.3% in 2004. For 2005, Japan’s forecast is unchanged, at 2.2%. In the Eurozone, growth remains weak & inadequate, and our GDP forecasts are unchanged, at 1.7% for 2004 & 2.0% for 2005. Asia’s prospects remain positive. In China, GDP annual growth was 9.8% in Q1 and 9.6% in Q2. But, in response to tough restrictive policies aimed at cooling the excessive boom, China’s growth is set to decelerate, to 8.5% in 2004, and to 7.4% for 2005. Chinese consumer price inflation rose to 5.0% in June, but China should be able to cool the boom without a hard landing. In India, the new government is set to adopt reformist policies, and growth will stay high. Our GDP forecasts for India are unaltered, at 7.0% in 2004 & 6.5% in 2005. The table below shows our GDP forecasts for the world’s major economies.

Equity markets rose in June, but have fallen back markedly in July. Share prices are now below their January 2004 levels. The financial markets are in a cautious mood, and there is apprehension about interest rates, oil prices, and corporate earnings.

US DOW JONES INDEX, LAST 12 MONTHS

Eurozone data remains downbeat. In Germany, investor’s confidence strengthened in June, but the June jobless rate remained very high, at 10.5%, and retail sales fell 2.3% in the 12 months to May. Eurozone retail sales fell sharply in May (down 1.3% on the month & down 0.9% over the year), while industrial production remained subdued in May in most Eurozone countries. Consumer prices in the Eurozone rose 2.4% in the year to June (after 2.5% in May), well above the low point of 1.6% in February, and above the ECB’s 2% target. The upturn in Eurozone inflation, in spite of the economy’s ample spare capacity, is a source of concern, because it may force the ECB to tighten before a genuine upturn in output has gathered momentum.

Following the increase in the US Fed Funds rate to 1.25% on 30 June, the markets now accept at face value the Open Market Committee’s statement that it will proceed at a “measured pace in removing accommodation”. Fears of very aggressive tightening have eased, following signs that US growth is decelerating. At the same time, concern over higher inflation may still result in US monetary tightening becoming a little more forceful. We expect the Fed Funds rate to reach 2.25% by Q1 2005, followed by further increases to 3.75% by end-2005. In the Eurozone, the ECB remains concerned that higher energy prices could push up labour costs and inflation, and no longer considers interest rate cuts, We now expect the official eurozone (repo) rate to stay unchanged over the next few months, before starting to edge up slowly in Q4 2004 or Q1 2005. In the UK, the repo (base) rate was left unchanged in July at 4.50%; but further increase are likely, to 4.75% in August, to 5.00% by end-2004 & and to a peak of 5.50% in 2005.

The US dollar will remain robust, and may rise slightly in the near term, benefiting from relatively high US interest rates. But, notwithstanding further expected increases in US interest rates, renewed dollar falls are likely towards end-2004 & in 2005, as concerns over the unsustainable US external deficit re-emerge; these falls could result in market exchange rates in 2005 of US$1.27-$1.29 per €, and Y103–Y99 per US$. The Eurozone economy remains over-dependent on exports, and will suffer pain if the $ falls markedly. Japan is reducing its forex market intervention, allowing the yen to strengthen in due course. Sterling is set to weaken towards end-2004 and in 2005. China is now tightening its economic policies, in response to overheating & higher inflation. China may allow more renminbi flexibility, leading to an effective 5%-10% revaluation in the next 12 months. The US will continue to adopt a relaxed attitude to any future $ fall. Gradual and orderly $ falls can ease global imbalances; but a $ collapse will be damaging.

US$ PER €, LAST 12 MONTHS

UK GDP: Preliminary GDP figures for Q2 2004 show that quarterly growth was 0.9%, above the 0.7% rise in Q1, but slightly below market expectations of a 1.0% increase. Year-on year GDP growth was 3.7% in Q2, above trend, but not a raging boom that requires a sharp policy reaction. Both services and the production industries have recorded the same quarterly growth (0.9%) in Q2 2004, in line with the 0.9% growth in total GDP. But the more meaningful year-on year comparisons show services growth at 4.0%, against weak annual growth of only 0.9% for industrial production. This sharp contrast highlights the serious difficulties still facing UK industry. Our forecast for UK GDP growth is being raised to 3.4% in 2004, and remains unchanged at 2.5% in 2005.

Detailed figures for the GDP components in Q2 2004 will only be available towards the end of August, and our forecasts remain mostly unchanged. We forecast household consumption growth of 3.0% in 2004 & 2.5% in 2005. Investment growth is forecast at 5.1% in 2004 & 3.0% in 2005. Exports of goods & services are forecast to register growth of 0.9% in 2004 & 2.2% in 2005. We expect the current account deficit to worsen to £27bn in 2004 & £28bn in 2005, (some 2.3% of GDP), after an estimated £20.4bn in 2003.
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UK main sectors: Service sector quarterly growth was 0.9% in Q2, after 0.9% in Q1 and 1.3% in Q4 2003; year-on-year services growth was 4.0% in Q2, after 3.6% in Q1, and 3.0% in Q4 2003. Our forecast, in annual average terms, is that services will grow 3.7% in 2004 & 2.7% in 2005, after 2.5% in 2003. Construction output is forecast to stay buoyant, benefiting from strong public spending, with annual average growth at 6.1% in 2004 & 6.8% in 2005, after 4.9% in 2003.

Manufacturing output rose 0.5% in May, slightly better than expected by most analysts. In the three months March-May, manufacturing output was 0.4% higher than in the previous three months, and 1.4% higher than in the same period a year earlier. While the May figures narrow further the gap between the official ONS figures and business surveys, the 0.4% decline between Q4 and Q1 (shown by the ONS figures) is still questionable. The recovery in manufacturing, although welcome, is still very modest and fragile. To put today's figures in a longer term perspective, manufacturing output fell 1.4% in 2001 and 3.1% in 2002, before edging up 0.4% in 2003. Manufacturing output is still 3.9% below its end-2000 peak, and the share of manufacturing in UK GDP has fallen to just over 17%. Chemicals (+5.5%) recorded the strongest year-on-year rises in March-May, while textiles (–9.4%) recorded the worst year-on-year figures. Basic metals & engineering staged strong recoveries in March-May, compared with the previous 3 months. Looking ahead, our forecast envisages that manufacturing output will continue to recover gradually; while growth will be fragile, we are raising our forecast to 2.1% for 2004 & to 3.0% for 2005. Manufacturing employment is expected to decline further, but at a more modest pace than in recent years. The following table summarises our main UK forecasts:

UK labour market: Britain’s labour market remains strong, but the recent figures have been slightly softer than expected: employment fell, while unemployment & wages displayed mixed trends. Claimant-count (CC) unemployment in June was 850,900, down 9,600 from the revised May figure, down 97,500 over the year, & lowest since August 1975. But on the Labour Force Survey (LFS) measure, unemployment was 1,432,000 in the three months March-May, a surprising rise of 6,000 on the previous three months, but still down 52,000 over the year. The jobless rate was 2.7% (June) on the claimant count, and 4.8% (March-May) on the LFS measure. The employment level was 28,301,000 in March-May, down 29,000 on the previous three months, & but still up 206,000 over the year. The working age employment rate was 74.7% in March-May, down 0.2% on the quarter, but unchanged over the year. Manufacturing employment was 3,372,000 in March-May, 106,000 lower than a year earlier, and the lowest level since comparable records began in 1978. The jobless rate (LFS measure) was lowest in the South West (3.3%), the South East (3.8%), & the Eastern (4.0%). Regional jobless rates were highest in London (6.8%), Scotland (6.1%), & the West Midlands (5.6%).

Average earnings growth (year-on-year) rose 4.3% in March-May, below forecasts, and unchanged from the 4.3% level in February-April. Excluding volatile bonuses, earnings growth strengthened further, from 4.1% in February-April to 4.2% in March-May, a two-year high. Private sector earnings growth edged up to 4.4% in March-May, from 4.3% in February-April. Public sector earnings growth remained unchanged at 4.3%. Looking ahead, the labour market will remain resilient, as robust output growth and low unemployment continue exerting upward pressure on wages. Strong public sector spending and recruitment could trigger intensified public sector wage claims, as well as strike threats & labour militancy; but this may be partly mitigated by the Gershon Efficiency Review and the planned downsizing of the Civil Service. On balance, the upward trend in earnings growth is set to strengthen gradually over the next year.

UK Inflation: CPI inflation, which is the basis of the UK inflation target, edged up from 1.5% in May to 1.6% in June. Inflation on the all-items retail price index (RPI) rose from 2.8% in May to 3.0% in June. Inflation on the ‘underlying’ retail price measure (RPIX) - which the Government targeted until recently & excludes mortgage interest - was 2.3% in June, unchanged from May. The June inflation measures were marginally below market expectations. The largest upward effects on June CPI inflation came from recreation & culture (e.g. games, toys & hobbies), and from advance booked foreign holidays. The biggest downward effects on June CPI inflation came from cultural services, mainly theatre admissions. But the biggest upward effect on all-items RPI inflation came from housing. This reflected higher mortgage rates, following the May Base rate rise, and higher depreciation, in line with the strong rise in house prices. The gap between RPIX and HICP fell to 0.7%. June goods price inflation was 0.5% on the RPI measure, and 0.0% on the CPI measure. May services price inflation was 3.2% on the RPI measure, and 3.3% on the CPI measure.

Margins in the high street remain under pressure, even though retail sales volumes accelerated, with a 6.6% year-on-year increase in March-May. High street prices remained in negative territory, and were 1.3% lower than a year earlier in March-May. Looking at UK inflation prospects, inflation is likely to edge up further in the next few months, mainly because of higher petrol prices. But the upturn will be modest. CPI inflation, the measure that the Government is targeting, is set to remain below 2% for the next 6-12 months.

Contact details: David Kern, Kern Consulting
Economic Adviser to the BCC
Tel: 020 8904 6293 E-mail: david.kern@btinternet.com