The UK economy now appears to be progressing along a path that is just consistent with the economic objectives of the government. Inflation is currently slightly above the 2½ per cent target, but stands a reasonable chance of meeting it by the end of the year. Government borrowing in the most recent financial year was above expectations, but could still satisfy the Maastricht fiscal criterion next year without further tax cuts. The government does not have an explicit, quantitative objective for economic growth, but this too is broadly acceptable at a current rate of expansion of 2 per cent per annum. Fears of an early recession now appear to be disappearing and growth looks likely to improve over this year and next.

Economic growth slowed in most of the major industrialised countries over the course of last year. The slowdown has been particularly apparent in continental Europe, with GDP falling in the fourth quarter in Germany, France and Italy. Early indications suggest that activity has been subdued in the first quarter of this year, with industrial production declining in Germany, Spain and Sweden, the provisional UK figures recording the lowest per quarter growth since 1992, and a continued deterioration apparent in indicators of the general business climate in Europe. We have made a significant downward adjustment to our previous forecasts for Europe, with EU-wide GDP now projected to rise by only 1½ per cent this year, after growth of 2½ per cent in 1995. We expect growth to pick-up over the course of the year as the contractionary effects of ongoing inventory adjustment come to an end and as the effects from a more relaxed monetary stance begin to outweigh those from ongoing fiscal consolidation. Recent currency movements should help to stimulate external demand in Germany and France, with the D-mark having depreciated against the US dollar by around 7 per cent over the past four months. Private sector expenditure is also likely to benefit from the recent sustained appreciation of equity prices in most national stockmarkets, with prices at the end of April having risen by over 11 per cent in Germany, France, Italy and Spain since the beginning of the year.

Economic forecasts are usually presented as point estimates, despite the margin of uncertainty which surrounds them. In November 1995 the National Institute began to present estimates of the probability of the government's inflation target being met and of there being a fall in GDP. This article describes the methods that we use for calculating these probabilities. We show, by studying eight successive forecasts of the same event, how forecast reliability improves as the forecast horizon approaches and demonstrate that this can be explained in terms of the accumulation of information about the state of the economy.

Leading indicators are produced by both the OECD and the UK Office of National Statistics as tools for predicting turning points of the business cycle. An assessment on the basis of performance at turning points is frustrated by their scarcity. It is found that the indicators generally have significant (but not good) ability to predict changes in the direction of the variable they are intended to lead. When they are included in VAR models the standard error of quarter on quarter changes is generally lower than when pure autoregressions are used. However, the forecasting power of such equations is poor, and the general conclusion is that such indicators are not good forecasting tools.

What can the National Institute model tell us about the accuracy of forecasting inflation and growth? We make ‘point’ forecasts over the short to medium term, and assess the accuracy of those forecasts by examining past forecast errors (see Poulizac, Weale and Young, 1996). But the model itself can be used for the same purpose and can inform us better than historical exercises if a new policy regime has been adopted which is a major departure from past experience. In that case, the behaviour of the economy would be expected to be considerably different and so using a model which captures the structural effects of the changes may give a more accurate view of the likely behaviour of policy targets, policy instruments and other variables.

There are signs that the UK labour market has behaved differently in the most recent economic recovery. After the end of the recession in 1992 unemployment began to fall much earlier than expected, whilst wage and price inflation remained very low. Chart 1 plots unemployment and real wages in the first three years of the last two recoveries. In both cases unemployment rose in the first year of the recovery but thereafter the performance in the 1990s is much better. In the second year, unemployment began to fall significantly, much earlier than it had in the 1980s recovery. Three years after the low point in output the rate of unemployment was around 8½ per cent, 2½ per cent below the level pertaining at the equivalent point in the last cycle. At the same time real wages have shown little growth benefits compared with 4 per cent growth in the 1980s recovery.

The recent growth in higher education participation rates in Britain has been so sudden and so rapid that there is now intense public interest in its effects on graduate employment and salary prospects. Particular concern has been expressed about the development of certain phenomena associated with US-style ‘mass higher education‘, for example, an increase in the numbers of graduates who appear to be ‘under-utilised’ in jobs which have not traditionally been filled by degree-holders, and reports of apparent growth in variation in ‘quality’ of the graduates emerging from different kinds of degree course.

It is widely recognised that foreign direct investment (FDI) may have an important role to play in the transformation of the formerly centrally planned economies of Central and Eastern Europe. FDI provides a vital source of investment for modernising the industrial structure of these countries and for improving the quality and reliability of infrastructure. In addition new investments may also bring badly needed skills and technologies into the host economy. Evidence from joint ventures in Hungary (Lane, 1994) shows that such firms had a higher propensity to trade and invest than purely indigenous firms. Total FDI inflows into Hungary between 1991–93 were equivalent to 25 per cent of total fixed domestic capital formation (UINDTCI, 1995).