The most significant development in the British economy over the past year has been the sharp and sustained reduction in inflation. Retail price inflation has fallen to around 4 per cent., close to the German level, while underlying producer price inflation is at its lowest level for a generation.
Average earnings, too, are rising at the lowest rate for 25 years, suggesting that, after a decade of supply-side reform, the British labour market is operating far more effectively than before. This augurs well for employment prospects in the longer term. But, as elsewhere in the world, activity and demand in Britain have been weak. The rapid increase in demand in the late 1980s, fuelled by a sharp fall in saving and large increases in indebtedness, made a period of adjustment inevitable. Companies and households that borrowed extensively have reined in spending and repaid debt in response to higher interest rates.
Following a substantial reduction in interest rates, there were clear signs of renewed growth in the late summer and early autumn of last year—not just in confidence surveys, but also in the figures for retail sales and economic activity more generally. But, as in the United States, the recovery here was not sustained.
The effect on the British economy of recent world developments, and particularly those in the United States, cannot simply be measured by the adverse consequences for British exports. British firms have factories and offices abroad—indeed, our investment in the United States is higher than that of any other country. Conditions in one country can and do affect business confidence elsewhere. So unexpected weakness in the rest of the world has taken its toll on confidence in Britain, discouraging investment and stockbuilding. Over the year as a whole, GDP fell by nearly 2½ per cent., ½per cent. more than my forecast of a year ago.