The economy forecast

Expenditure

This Forecast in-depth page has been updated with information available at the time of the March 2024 Economic and fiscal outlook.

The composition of GDP can be as important to the fiscal forecast as the headline measure, because some components will be more ‘tax rich’ than others. A forecast that alters the composition of GDP can therefore have a significant impact on the public finances, even if the path of GDP itself is unchanged.

The expenditure approach to measuring GDP, known as GDP(E), estimates the sum of all final goods and services purchased in the economy. Expenditure is split into household consumption, private investment, government consumption and investment, as well as exports and imports of goods and services. As with overall GDP, it can be measured both in cash (or nominal) terms and in inflation-adjusted real (or volume) terms.

  Household consumption

Household consumption is the largest component of expenditure, representing around two-thirds of GDP. The consumption forecast is an important determinant of the fiscal forecast, and VAT receipts in particular. Around 70 per cent of VAT receipts are derived from household consumption. These move largely one-for-one with changes in nominal consumer spending.

We generate our consumption forecast in two steps:

  • To forecast the next few quarters, we use high-frequency indicators such as card spending data and consumer confidence surveys. Data from UK retailers are also available on a timely basis and can indicate the likely near-term path for private consumption.
  • The medium-term forecast is informed by the prospects for real household disposable income and real financial wealth. These are assumed to represent households’ current and (expected) lifetime future resources. Real household disposable income is given by nominal labour income (as measured by compensation of employees plus mixed income) plus non-labour income (for example, dividend and interest income and welfare payments) less taxes paid, deflated by consumer prices. Financial wealth is affected by financial markets through equity and bond prices, which will reflect expectations of future income and may also affect behaviour now.

Once we have produced our forecasts for real household disposable income and consumption, we are able to calculate the household saving ratio – in effect, the proportion of total household income that is not consumed. This is a useful diagnostic – if the implied saving ratio is rising or falling over the forecast period, we will take a judgement as to whether such a path is plausible. When doing this cross-check we tend to focus on a measure of the saving ratio that excludes elements of pension saving that are a feature of the headline National Accounts measure of the saving ratio but are not particularly visible to households. Our latest forecasts for both are shown in the chart below.

Large but predominantly temporary shocks to the economy (such as the increase in energy prices following the Russian invasion of Ukraine) may be consistent with households reducing their saving significantly for an extended period to maintain their current levels of consumption. But if we were to judge that an event had a permanent effect on incomes, households would be expected to adjust their consumption plans accordingly. Of course, determining the distinction between an ‘extended but temporary’ effect and a ‘permanent’ effect is easier said than done.

Our macroeconomic model has an equation that has been estimated to predict household consumption based on real household disposable income, household wealth (deflated by the consumer expenditure deflator), the unemployment rate and interest rates. That equation is used to frame our thinking, but the consumption forecast itself will reflect BRC judgements that take into account the factors described above as well as any wider elements that the BRC considers to be relevant.

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  Investment

Investment is one of the most volatile of the main expenditure components of GDP. The data are also subject to large revisions, making it extremely challenging to forecast accurately, even at very short horizons (see Box 2.1 in our March 2017 EFO for a discussion of this feature of the data). Our forecast for investment is broken down into its three main components: business investment, residential investment (which includes some transfer costs that are counted as investment, such as estate agent fees associated with transferring the ownership of an asset) and government investment. The most important of these components is business investment, because it is the largest of the three and it boosts the productive capacity of the economy. For a recent discussion of how business investment has evolved since the EU referendum see Box 2.1 in our March 2020 EFO. For an analysis of the impact of corporation tax changes on business investment see Box 2.4 in our November 2023 EFO.

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  Business investment

The near-term outlook for business investment is informed by survey indicators and industry reports, such as the CBI Industrial trends survey, the Deloitte Chief Financial Officers survey and the Bank of England Agents’ summary of business conditions, all of which offer information on investment intentions.

Beyond the near term, we start with an assumption that firms will invest with the aim of achieving their optimal capital stock. Our macroeconomic model allows us to derive the optimal capital stock based on an estimate of the tax-adjusted cost of capital. The model’s business investment equation implies that in the short run, business investment is positively influenced by current output, but negatively influenced by greater uncertainty. We then make a judgement about how quickly firms will adjust their investment plans to achieve that optimal capital stock.

The output of the model is used to frame our thinking around business investment, but the forecast itself relies on judgements made by the BRC. As the business investment data are particularly volatile and subject to significant revisions, judgement can play a significant role in this case. To judge investment prospects, we look at the prevailing conditions in financial markets and the structure of firms’ balance sheets. Corporate profitability and retained earnings will influence the ability of credit-constrained firms to finance investment. We also consider other factors that would be expected to raise or suppress business investment, for example, by generating uncertainty or raising the cost of capital that might lead investment projects to be put on hold or even cancelled.

As with other components of GDP, we make adjustments to our forecast for business investment to reflect policy decisions that are expected to have an appreciable impact on firms’ capital expenditure. For measures that are expected to influence the cost of capital (like changes in the headline rate of corporation tax), we estimate the effect on the optimal capital stock and then determine a revised path for business investment to reach that new optimum. Some measures do not affect the long-run level of the cost of capital or capital stock but provide companies with an incentive to bring forward or delay spending from future periods to maximise profitability by investing when conditions are most favourable.

Our forecast for business investment has a significant effect on expected corporation tax receipts. because higher nominal business investment would directly reduce corporation tax payments as liabilities are reduced by the use of capital allowances (such as the Annual Investment Allowance).

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  Residential investment

Residential investment is composed of investment in new houses, investment in improvements to existing homes and transfer costs associated with moving between homes.

In our forecast, the new builds element is informed by our forecast for the housing stock. The improvements element is informed by a time-series econometric model where improvements are influenced by household consumption, housing market turnover, interest rates and the recent path of improvements. Our forecast for transfer costs is based on our forecast for property transactions. We sometimes apply a degree of top-down judgement about the prospects for the overall path of residential investment.

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  Government investment

Our forecast for government investment is largely determined by the Government’s nominal spending plans. In particular, the forecasts for nominal spending on gross fixed capital formation by central government and local authorities are estimated based on the Government’s latest policy decisions and any adjustments we make to reflect the extent to which we expect plans to be met in specific years. We generally assume that the government investment deflator grows broadly in line with its historical average and the rest of the growth in nominal government investment will be reflected in real government investment.

As with other parts of the forecast, if we were to judge that applying the methodology above to the Government’s fiscal plans implied an implausible path for the government investment deflator, with  consequences for the GDP deflator, we could move away from the above assumption.

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  Government consumption

Similar to government investment, our forecast for government consumption is largely determined by the Treasury’s public spending plans, which we adjust to reflect our own judgements about the extent to which plans will be met. Government consumption is broadly, but not entirely, equivalent to central government expenditure on public services and administration – known as ‘Resource Departmental Expenditure Limits’ (RDELs) in the Government’s spending framework. These plans are typically set in nominal terms, so to produce a forecast for real government consumption we also need to forecast a path for the government consumption deflator. In light of the way in which the ONS measures government consumption, for any given forecast for nominal spending growth, we assume that roughly half will be reflected in real spending growth and half in the implicit deflator (see Box 3.3. of the March 2016 EFO for more detail). However, we departed from this assumption during the covid pandemic, because of the significant changes in real output in the health and education sectors due to the halting of certain activities (explained in more detail in Box 2.4 of the March 2021 EFO).

Total government spending is the sum of government consumption and government investment. Our forecast for government investment is also largely driven by the Treasury’s spending plans. It is discussed further in the investment section.

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  Exports

The judgements which determine our exports forecast can be split into two categories:

  • Our expectations for UK export markets growth, which shows the amount that trade among the UK’s export markets is expected to grow over the forecast period.
  • The share of UK export markets growth that we expect to be satisfied by UK exporters. In recent years, the UK’s export market share has fallen and our recent forecasts for total exports have all been based on an assumption that that trend will continue. We also adjust our forecast to reflect exchange rate movements, which would be expected to alter the UK’s export market share as exporting from the UK becomes more or less profitable relative to supplying the domestic market.

Since our November 2016 forecast, we have also made assumptions about the effects on trade of the UK leaving the EU. On 24 December 2020, the UK and the European Union concluded the Trade and Cooperation Agreement (TCA) governing their future trading relationship. As explored in Box 2.2 of our March 2021 EFO, Box 2.5 of our October 2021 EFO and Box 2.4 of our March 2024 EFO, the terms of the agreement and initial trade data following the end of the transition period are broadly consistent with our original assumption that the UK’s export market share would be lower by around 15 per cent after ten-years than if the UK had remained in the EU. The size of this adjustment was calibrated to match the average estimate in a number of external studies that considered the impact of a vote to leave the EU on the UK economy. We made a similar revision to import penetration so the downward revisions to gross trade flows were broadly neutral in their effect on the direct contribution of net trade to GDP growth. This contributes to our overall assumptions that the UK export market share will continue to fall over the forecast horizon. Our Forecast-in-depth page on EU exit has more information.

Our forecast for exports is published at an aggregate level but when constructing it we consider the paths for oil and non-oil exports. We produce a forecast for oil output because the production of this sector affects our North Sea revenues forecast. Oil exports are then estimated as a proportion of that forecast. Given that we take a top-down approach to forecasting total exports as described above and that the forecast for oil exports is derived from our oil output forecast, the remaining non-oil element of export growth is derived by residual.

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  Imports

The judgements that determine our imports forecast can be split into two categories:

  • Our expectation for import-weighted domestic demand, which is calculated by weighting the expenditure components of domestic demand according to their respective recent import contents. These weights are derived from detailed ONS data that estimate the inputs and outputs of all sectors of the economy. The forecast for import-weighted domestic demand is therefore derived mechanically from our forecasts for the other components of GDP.
  • The likely path for the import intensity of that demand over the forecast period. This could be affected by factors such as exchange rate movements, which will affect the relative prices of domestic goods and services compared with imported alternatives. Domestic demand in the UK has become more import intensive over time, consistent with world trade having grown more quickly than world GDP over a number of years, although this trend has been less evident more recently.

Our forecasts for total imports have previously been based on the assumption that the import intensity of domestic demand would continue to rise. However, following the vote to leave the EU, our November 2016 forecast assumed a reversal of that trend would occur for a number of years after the 5-year forecast horizon. We have so far retained this assumption in our subsequent forecasts. The size of the adjustment to import intensity was calibrated in the same way as the export market share adjustment described in the exports section.  Since the revisions to imports and exports growth were similar, the downward revisions to gross trade flows were broadly neutral in their effect on the direct contribution of net trade to GDP growth. Our Forecast-in-depth page on EU exit has more information.

As with exports, the forecast for imports is published at an aggregated level but when constructing this we also consider the paths for oil and non-oil imports. Oil imports are forecast as the residual between total demand (domestic oil demand and exports) and domestic supply (North Sea production). Again, stripping out this forecast for oil imports from total imports, the remaining non-oil imports growth is derived by residual.

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  Stockbuilding

Stocks, or ‘inventories’, are goods held by firms in reserve, rather than being immediately sold or used in the production process. These could include raw materials that are awaiting use by firms, or unsold goods that are held by wholesalers or retailers. The stock of inventories is an equivalent concept to the capital stock, so changes in inventories (stockbuilding) affect GDP in the same way that changes in the capital stock – i.e. business investment – affect GDP. An increase in the stock of inventories implies that firms have invested in their own inventories and this investment is therefore recorded as a component of GDP.

We look at the most recent outturn data to make a judgement about the most likely path of stockbuilding in the near term. Over the rest of the forecast period, we generally assume that inventories make no contribution to GDP growth, unless we expect some temporary macroeconomic conditions to cause firms to either build up or reduce their inventories in an unusual way.

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