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Productivity growth: the largest change we have made to our economy forecast in this
EFO has been to revise down trend or potential productivity growth, as foreshadowed
in our Forecast evaluation report in October.
As the remarkable period of post-crisis weakness extends and as various explanations pointing to a temporary slowdown become less compelling it seems sensible to place more weight on recent trends as a guide to the next few years. But huge uncertainty remains around the diagnosis for recent weakness and the prognosis for the future. We have assumed that productivity growth will pick up a little, but remain significantly lower than its pre-crisis trend rate throughout the next five years. On average, we have revised trend productivity growth down by 0.7 percentage points a year. It now rises from 0.9 per cent this year to 1.2 per cent in 2022. This reduces potential output in 2021-22 by 3.0 per cent. The ONS estimates that output per hour is currently 21 per cent below an extrapolation of its pre-crisis trend. By the beginning of 2023 we expect this to have risen to 27 per cent.
The net effect of these revisions is to reduce the estimated level of potential output in 2021-22 by 2.1 per cent compared to our March forecast. Growth in potential still picks up over the forecast from 1.3 per cent in 2018 to 1.5 per cent in 2022, but the average rate through to 2021 is now just 1.4 per cent a year, down 0.5 percentage points since March. 1.18 Increasing the current level of potential output, but reducing the rate at which it grows thereafter, leads us to revise down our forecast for actual GDP growth by 0.4 percentage points a year relative to March.
We now expect real GDP to grow by 5.7 per cent between 2017-18 and 2021-22 down from 7.5 per cent in March. Whole economy inflation is also expected to be weaker than we thought in March, largely because we changed our modelling of import prices to make it more consistent with our forecast for consumer prices. Taking the two sets of judgements together, GDP in nominal or cash terms is expected to grow by 12.6 per cent by 2021-22, down from 15.3 per cent in March. This implies slower growth in all the major sources of tax revenue.
Looking at the year-by-year profile, we expect real GDP growth to slow from 1.5 per cent this year to 1.4 per cent in 2018 and 1.3 per cent in 2019, as public spending cuts intensify and Brexit-related uncertainty continues to bear down on activity. The gentle improvement in underlying productivity growth and a small cyclical boost as spare capacity is brought back into use are expected to deliver slightly higher GDP growth in 2021 and 2022. The short term fiscal loosening announced in this Budget boosts growth by 0.1 percentage points in 2018 and 2019, but its withdrawal then reduces it by the same amounts in the following two years.
The uncertainty around the central projection is clearly very large. We expect CPI inflation to peak in the current quarter and then fall back for a while slightly below the Government's 2 per cent target over the subsequent year and a half, easing the squeeze on households' finances. Interest rates are expected to rise slowly, with markets expecting Bank Rate to reach 1% per cent in five years time, implying only three further quarter-point rises following the one announced earlier this month by the Monetary Policy Committee. House price inflation is expected to average just over 3 per cent a year.
The unemployment rate has fallen by 0.5 percentage points over the past year, despite real GDP growth slowing. We expect the rate to trough at 4.3 per cent of the labour force, its current rate, in the second half of this year, and then to edge up as GDP growth slows a little further and the National Living Wage prices some workers out of employment. Relative to our March forecast, we have revised unemployment down in every year. But we have also revised earnings growth down in line with the weaker outlook for productivity. We now expect it to pick up slowly from 2.3 per cent this year to 3.1 per cent by 2022.
Real earnings growth is forecast to average just 0.6 per cent a year in the six years to 2022. These are not subjective judgements about the extent of uncertainty, which for the reasons discussed above are greater than usual at present. The change in our central growth forecast since March, though material, is small relative to the uncertainty around either forecast implied by past forecast performance.
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