Abstract
This 2004 Article IV Consultation highlights that United Kingdom’s real GDP growth is estimated at about 3 percent in 2004 and is expected to stay stable at about 2½ percent in 2005–06, in line with potential growth. Domestic demand remains the key driver of growth, underpinned by continued strong earnings growth and robust corporate profitability. Inflation expectations remain well anchored. Rising import prices are expected to push inflation toward the 2 percent target over the coming 2–3 years.
My authorities are most grateful to staff for their work and will take careful note of their comments. There is a broad measure of agreement between staff and the authorities on most aspects of economic policy.
Economic prospects
The economic fundamentals in the UK remain sound: 50 consecutive quarters of growth, the longest unbroken expansion on record; growth in 2004 of 3.1 percent; CPI inflation currently at 1.6 percent, short term interest rates at 4.75 percent, and employment at record levels of 75 percent. Growth is forecast (in the 2004 Pre-Budget Report) to remain at 3 percent to 3½ percent in 2005, before returning to trend (2.5 percent to 3 percent) in 2006; with inflation at or close to target. As staff note, there are risks: my authorities remain vigilant to these and agree with staff on the need for cautious macroeconomic polices, to which they are fully committed.
Monetary and fiscal policy
My authorities will continue to set policy on the basis of the policy framework established in 1997, and based on the principles of transparency, responsibility and accountability:
Fiscal policy set according to two fiscal rules:
the Golden Rule—over the cycle, the Government will borrow only to invest;
the Sustainable Investment Rule—over the cycle, public sector net debt will be held at a stable and prudent level, defined as 40 percent or less;
Monetary policy set by the Bank of England’s Monetary Policy Committee (MPC) to meet a symmetric inflation target.
My authorities agree with staff that the fiscal and monetary policy frameworks have served the UK well, anchoring expectations and sustaining stability. The fiscal framework is based on strict rules backed by cautious, audited assumptions. These rules are set over the cycle to allow the automatic stabilisers to operate freely and fully and fiscal policy to support monetary policy when the economy is below trend. My authorities feel that the current fiscal stance remains consistent with these rules and appropriate for this point in the economic cycle.
Fiscal policy will, as usual, be set in the Budget. The latest available projections (in the Pre–Budget Report) show a gradual reduction in the deficit to 1½ percent of GDP; with an average annual surplus on the current budget of 0.1 percent in this cycle, and ¼ percent from 2005-06 to 2009-10; and net debt stabilising at 37 percent of GDP. My authorities are thus on course to meet the fiscal rules in this cycle and the next.
Staff see downside risks to the revenue projections. My authorities are confident about these projections and note that they are based on deliberately cautious assumptions (e.g. growth at the lower end of the forecast range, and trend growth 0.25 percent below the neutral view). Data released since the IMF mission supports the view that there remains a significant output gap, and that above trend growth is continuing, with rising real incomes and a sizeable pickup in tax revenues including in corporation tax. They therefore do not agree with staff that there is a need for ‘an early correction’ and believe that the latest data confirms this view.
They have noted staff’s suggestions for minor modifications to the fiscal and monetary framework. They welcome the opportunity to discuss these issues with staff, but are not attracted to these specific proposals. In particular, they see considerable costs in the publication by the MPC of quantitative projections (and error bands) for a further set of variables; they doubt whether a probabilistic approach to fiscal policy would improve public understanding or confidence in the framework; and they regard the use of cautious (rather than central) assumptions as key to the prudent conduct of fiscal policy. They agree on the importance of external scrutiny of macroeconomic policy, a central objective of the policy framework, and believe this is achieved through independent auditing of key economic assumptions, high level of transparency in the fiscal framework through publications like the End of Year Fiscal Report and Long-term Public Finances Report, and the continuous and vibrant public debate around economic policy that this transparency engenders, including contributions from expert commentators such as the IMF.
Structural issues
Staff have rightly noted the legacy of under-investment in public services. Public sector net investment fell by 15 percent annually in real terms between 1991-92 and 1996-97 leaving the UK with the lowest level of public investment of any large EU country. To address this, and recognising the importance of public sector infrastructure for private sector productivity, my authorities aim to raise public sector net investment to 2¼ percent of GDP by 2007-08.
My authorities agree with staff on the need to ensure efficiency and value for money, and have set out a broad agenda for reform with a clear focus on outcomes, extra investment linked to reforms, civil service reform, and stretching efficiency targets. Improvements in central government procurement, for example, have delivered £2 billion of savings in 2003-04 alone; and my authorities have published plans to achieve £20 billion of efficiency gains (or 1½ percent of GDP) by 2007-08.
My authorities agree with staff on the central importance of raising productivity, and have set out a comprehensive programme of microeconomic reform to remove the barriers that prevent markets from functioning efficiently. These measures aim to improve competition, promote enterprise, support science and innovation, raise skills and encourage investment; and they are regularly monitored and assessed. A major review of regulation is underway, and the Budget will set out proposals to remove barriers that are not justified.
My authorities’ policy on membership of the single currency remains unchanged. The June 2003 assessment set out a reform agenda to promote convergence and flexibility, and progress on this will be reviewed in the Budget.
My authorities agree with staff on the importance of the work of the Pensions Commission; on the need to address housing market reform through implementation of the Miles and Barker Reviews; and on their overall assessment on the UK financial system.
Other issues
My authorities will continue to support trade liberalization, a successful completion of the Doha Round, and common agricultural policy (CAP) reform. They will increase ODA to 0.47 percent of GNI in 2007-08, with a timetable to reach 0.7 percent of GNI by 2013. They are seeking international agreement on a doubling of global aid flows through their proposal for an International Finance Facility; and greater debt relief for the poorest countries, with multilateral debt cancellation of up to 100 percent.