2.2 UK Economy
2.2.1 Output and Demand
The UK economy grew by 1.8 per cent in 2005 and the latest data indicate that GDP rose by 0.6 per cent in the first quarter of 2006, and by 2.2 per cent over the year to 2006 Q1. This year-on-year growth rate was up on the preceding quarter and may suggest that the UK economy is regaining momentum. The UK economy had grown above trend in 2004, but began to lose momentum in the latter half of that year and this trend continued into, and through, 2005. Chart 2.4 shows that despite the below trend growth rate of last year, growth in UKGDP still remained above that of both Germany and France, as well as the EU25 average.
Chart 2.4: European GDP Growth Rates (year-on-year quarters), 2000 Q1 - 2006 Q1
Source: ONS and OECD
The output of the UK's production sector rose by 0.8 per cent between 2005 Q4 and 2006 Q1. Growth occurred in all sub-sectors, including manufacturing - accounting for 80 per cent of industrial production - which grew by 0.7 per cent. In contrast, the production sector contracted over the year to 2006 Q1, with output down 0.9 per cent. This decline took place across all production sub-sectors, with the exception of electricity, gas & water supply. Manufacturing output declined by 0.6 per cent over the year.
The service sector continued to be the engine of growth in 2005, and this has continued into 2006 Q1. Services output increased by 0.6 per cent during the quarter and by 3.0 per cent over the year to 2006 Q1. Within the service sector, which accounts for around three-quarters of total UK output, strong quarterly growth occurred across all sub-sectors in the first quarter - ranging from 0.4 per cent in distribution, hotels & catering to 0.8 per cent in business services & finance. In terms of annual GVA growth, business services & finance was the best performing sub-sector in the year to 2006 Q1, with output up by 3.9 per cent.
Looking at the performance of the UK economy over a longer time frame reveals that GVA growth has been largely driven by the service sector (given its large relative weight) and, to a lesser extent, by construction. Chart 2.5 shows that services and construction GVA has grown by around 10 per cent between mid-2002 and 2005 Q4 19. The data also show that manufacturing output has been broadly stable, while production output has contracted by around 2.5 per cent.
Chart 2.5: UKGVA Index, 2002 Q1 - 2005 Q4
Source: Scottish Executive
On the demand side, household consumption expenditure is by far the largest component of GDP, accounting for approximately 65 per cent of the total. In other words, large changes in households' spending on goods and services will tend to have a significant effect on GDP. The latest quarterly data show that households' consumption expenditure grew by 0.2 per cent over the quarter to 2006 Q1, and by 1.7 per cent over the year. Household spending still appears to be relatively subdued in comparison with recent years. Several factors, such as the cooling housing market, rising energy prices and the relatively high level of households' debt, might explain the easing of household expenditure growth. Household debt increased from 110 per cent of disposable income in 2000 to 150 per cent in 2005.
Government consumption expenditure - accounting for over 20 per cent of UKGDP - grew by 0.6 per cent between 2005 Q4 and 2006 Q1, and by 4.6 per cent over the year as a whole. This component of demand has been strongly supportive of GDP growth since around late 2000, on the back of significant investment in the public services - particularly in health, education and transport. For example, in construction, government investment (either directly or through the Private Finance Initiative) in school buildings, health facilities and social housing has continued to bolster activity in the sector.
Over the quarter to 2006 Q1, whole economy investment - gross fixed capital formation ( GFCF) - increased by 1.5 per cent, and by 3.7 per cent over the year. The annual growth rate of investment in 2005 was down on the six-year high recorded in 2004 (4.9 per cent), but it was faster than total GDP growth and provides some indication that businesses and consumers are optimistic about future economic prospects. Investment expenditure is spending on assets which will be repeatedly or continuously used over a number of years to produce goods and services, for example, machinery used to create a product. Higher levels of investment are generally viewed as desirable since they usually indicate that an economy's productive capacity is being increased.
The final component of demand is net exports - exports of goods and services minus imports of goods and services. A positive net exports balance makes a favourable contribution to GDP, while the opposite is true for negative net exports (net imports). The UK has been a net importer since 1998. Weaker economic growth in many of the UK's key export markets - such as Germany, France and Italy - has meant that they have demanded relatively fewer goods and services from the UK. The most recent data show that exports grew more slowly than imports in the year to 2006 Q1, with annual exports growing at 11.9 per cent, compared to 12.0 per cent for imports.
Chart 2.6 shows how the components of UK demand have grown since 2000. Imports have been the fastest growing component. However, exports have also grown, albeit at a slower rate. The export position has seen a strong upward trend since mid-2003, which perhaps reflects strong demand in the US. The data also show that household consumption has been a strong contributor to economic growth, particularly from late 2000 through to 2004 Q3. This is due to a number of factors but, in particular, rising real disposable incomes, rapidly rising housing wealth and buoyant consumer confidence. High consumption spending over the period has also come at the expense of a lower household saving ratio.
Chart 2.6: Components of UK Demand, 2000 Q1 - 2006 Q1
Source: ONS
The chart above demonstrates which changes in the components of demand may have been critical in explaining changes in the growth rate of GDP. For example, UKGDP growth reached 3.2 per cent in 2004, before slowing to 1.8 per cent in 2005. The above trend growth rate in 2004 was achieved despite a slowdown in GDP growth in the latter two quarters of that year. Chart 2.6 is consistent with that position - household consumption growth was broadly static between 2004 Q3 and 2005 Q1 prior to picking up at a subdued rate through the remainder of 2005. In addition, both exports and GFCF moderated between 2004 Q2 and 2005 Q1/Q2. During the same period, import growth continued unabated. Overall, the position over the period was one of slower growth in the components of GDP, and continuing growth in imports which acted as a drag on overall GDP growth.
2.2.2 Labour Market
Since 1997, UK employment has risen by over 2 million, while unemployment has fallen by almost 450,000. However, as Chart 2.7 shows, the trend in the employment rate has been downward since early 2005, while the trend in the unemployment rate has been upward over the same period. This pattern is consistent with the UK economy operating below trend in 2005. However, data show that employment increased over the latest quarter, and given that the UK economy is forecast to move back to trend growth in 2006, this could be the start of a turnaround in the downward trend.
The employment rate for people of working age was 74.7 per cent for the period February to April 2006 - up 0.2 per cent from the previous quarter, but down from 74.8 per cent over the year. The number of people in employment was 28.93 million, up 130,000 over the quarter and up 272,000 over the year.
The unemployment rate was 5.3 per cent (February to April 2006), up from 5.0 per cent over the quarter and up from 4.7 per cent over the year. The number of unemployed people increased by 77,000 over the quarter and by 199,000 over the year, to reach 1.61 million. The claimant count was 950,900 in May 2006, up 5,800 on the previous month, and up 96,700 on a year ago.
Chart 2.7: UK Employment and Unemployment Rates, 2000 - 2006
Source: ONS
2.2.3 Inflation and Monetary Policy
The Monetary Policy Committee ( MPC) of the Bank of England has the responsibility for setting interest rates to meet the UK government's symmetrical inflation target of 2 per cent. Subject to that, the MPC is also required to support the government's objective of maintaining high and stable growth and employment.
As Chart 2.8 shows, CPI inflation started 2005 at 1.6 per cent, before rising above the Banks' 2 per cent target rate in July, and staying there until December. This transitory movement above the inflation target was largely due to the impact of the rise in global energy prices. The latest data show that inflation in the year to April 2006 stood at 2.2 per cent. This relatively benign inflationary environment led the MPC to leave interest rates unchanged at 4.5 per cent in June 2006, for the tenth consecutive month.
Chart 2.8: UK Interest Rates and Inflation, 1998 - 2006
Source: HM Treasury
The Bank of England's latest Inflation Report 20 shows that the Bank expects inflation to move above 2 per cent over most of 2006 and 2007, before falling back to target by the end of 2007 - this forecast assumes that interest rates remain at current levels. According to the Bank, downward pressure on inflation stemming from spare capacity will be more than offset by upward pressure from higher energy prices. Towards the end of 2007, the Bank expects the effects of higher energy prices to diminish.
Box 2.1: Business Surveys and Official Data |
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State-of-trade surveys (more often called business surveys) provide prompt information on the performance of the private sector economy - both recent outturns and future prospects. The key advantages of business surveys are their timeliness - they tend to be available before official data are published - and the fact that they provide information on matters such as business optimism for which official data are not available. The key drawbacks of business surveys concern their relatively small sample sizes compared with the larger samples used to produce official statistics, and the qualitative nature of business survey responses ( e.g. firms are asked whether output is 'more', 'less' or the 'same'). On the first point, official GDP estimates for Scotland are derived from responses from around 5,000 businesses each quarter (data that are augmented by information from large corporations and trade bodies), while the NTC/ RBSReport on Scotland, for example, is based on an average response rate of around 600 firms. The concern with aggregating qualitative responses is that they may at times misrepresent actual changes in output, particularly when sub-sectors are experiencing large changes in output compared with the rest of the sector. The timeliness of business surveys ensures that they are widely used by the media, commercial organisations ( e.g. investors and forecasters) and economic policymakers such as the HM Treasury and the Bank of England. The Bank of England ( Quarterly Bulletin, Spring 2005), says that business surveys "often form an important input into the MPC's economic assessment", in particular at the "earlier stages of the ONS's data production cycle". The Bank has published several papers 21 that discuss their use of business survey information as a means to augment official statistics and their own sources of information ( e.g. Agent reports). This research outlines techniques that can be used to convert survey balance statistics 22 into quantitative estimates that can be compared directly with official statistics; it also describes the statistical relationship (derived from correlation and regressions analysis) that exists between particular business survey indicators for the UK economy and equivalent official data. Comparing the balance statistics for UK manufacturing activity from the CBI's Industrial Trends Survey and official estimates of quarter-on-quarter growth in UK manufacturing output, the Bank of England ( Quarterly Bulletin, Spring 2005) observe a correlation 23 of 0.40. Similar comparisons made using Scottish data yield a correlation value of 0.49. Using the CIPS survey for UK manufacturing activity, the Bank finds a somewhat higher correlation with official data of 0.54; the equivalent value derived from Scottish data ( NTS/ RBS report and Scottish GVA statistics) is 0.47. For service sector activity, the strongest correlation the Bank found in UK data was between the CIPS survey and quarter-on-quarter changes in services GVA (0.43). For Scotland, the highest correlation (0.3) with official estimates of services sector GVA growth involved the RBS/ PMI survey for services. The Monetary Policy Committee of the Bank of England meet every month to set interest rates, therefore, timely and accurate economic data is of particular value to them. To help inform the process, Bank officials use the best survey-based estimates and combine them with ONS's early GDP estimates, which are produced from a subset of survey responses, to produce a 'best guess' of actual changes in GDP. These calculations have been shown to reduce the uncertainty that surrounds ONS's preliminary estimates of GDP (produced seven weeks after the end of the quarter) compared with their later balanced estimates published in Quarterly National Accounts and the annual Blue Book. The Bank's research shows that the value of business surveys in reducing data uncertainty is greatest (a) in the short time span before official data are produced, and (b) between preliminary GDP and the later estimates in Quarterly National Accounts, which are produced around three months after the end of the quarter. |
2.2.4 Public Finances
The UK government's fiscal policy framework is based on the five key principles set out in the Code for Fiscal Stability - transparency, stability, responsibility, fairness and efficiency. The UK government's fiscal objectives are:
- Over the medium term, to ensure sound public finances and that spending and taxation decisions impact fairly within and between generations; and
- Over the shorter term, to support monetary policy and, in particular, to allow the automatic stabilisers 24 to help smooth the path of the economy.
These objectives are implemented through two well-established fiscal rules, against which the performance of fiscal policy can be judged:
- The golden rule - over the economic cycle, the government will borrow only to invest and not to fund current spending; and
- The sustainable investment rule - public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level. Other things being equal, net debt will be maintained below 40 per cent of GDP over the economic cycle.
Table 2.1 - from Budget Report 2006 - shows the latest projections for the UK's public finances. The table shows that the UK government expects to meet its golden rule, with an average annual surplus on the current budget over this economic cycle (defined as taking place between 1997/1998 and 2008/2009) of approximately 0.1 per cent of GDP. The cyclically adjusted surplus, which allows structural trends in the public finances to be assessed more clearly by removing the effects of the business cycle, shows a deficit of 0.3 per cent of GDP in 2005/2006, followed by a surplus of 0.4 per cent in 2006/2007 and higher surpluses from that point onwards.
The UK government also expects to meet its sustainable investment rule over the economic cycle. In 1996, public sector net debt stood at 44 per cent of GDP, before falling to 30 per cent in 2001/2002. It has grown since then, and is projected to reach 38.3 per cent by the end of the current cycle, and stabilising at this level for the remainder of the forecast period. The projection for core debt, which excludes the impact of the cycle, rises to 36 per cent by the end of the forecast period.
Table 2.1: Summary of Public Sector Finances (as a percentage of GDP) |
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| Outturn | Estimate | Projections |
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2004-05 | 2005-06 | 2006-07 | 2007-08 | 2008-09 | 2009-10 | 2010-11 |
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Fairness and Prudence |
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Surplus on current budget | -1.6 | -0.9 | -0.6 | 0.1 | 0.5 | 0.7 | 0.8 |
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Average surplus since 1997-98 | 0.2 | 0.1 | 0.0 | 0.0 | 0.1 | 0.1 | 0.2 |
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Cyclically-adjusted surplus on current budget | -1.3 | -0.3 | 0.4 | 0.7 | 0.7 | 0.7 | 0.8 |
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Long Term Sustainability |
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Public sector net debt | 35.0 | 36.4 | 37.5 | 38.1 | 38.3 | 38.4 | 38.4 |
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Core debt | 34.3 | 35.2 | 35.4 | 35.5 | 35.7 | 35.9 | 36.0 |
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Net worth | 29.0 | 26.0 | 24.8 | 23.3 | 22.9 | 22.9 | 22.8 |
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Primary balance | -1.7 | -1.3 | -1.1 | -0.5 | -0.1 | 0.1 | 0.1 |
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Source: HM Treasury
In April 2006, the public sector current budget was in surplus by £3.0 billion; this is a £1.3 billion higher surplus than a year ago, when there was a surplus of £1.7 billion. Public sector net lending was £1.4 billion; this is £0.5 billion higher net lending than in April 2005, when net lending was £0.9 billion. At the end of April 2006 public sector net debt was £457.1 billion (equivalent to 36.3 per cent of GDP). This compares to £418.4 billion (34.8 per cent) as at the end of April 2005.