I thank staff for a very productive mission and thorough Article IV report. My authorities broadly agree with the staff analysis, note that staff considers the overall policy mix is appropriate and, notwithstanding the steady growth the UK has experienced, agree with staff that they should continue to take action to ensure the economy remains resilient to ongoing domestic and external challenges.
As staff notes, the UK’s recent economic performance has been strong and considerable progress has been made in addressing underlying vulnerabilities. Growth has been robust, unemployment has fallen substantially, employment has reached a historic high, the fiscal deficit has been reduced and financial sector resilience has increased.
The economy continues to perform strongly with the recovery becoming more broadly entrenched. Even with the weaker global picture, staff expects growth to remain steady at 2.2 per cent this year and next. A tighter labour market and rising productivity growth is expected to support real incomes and consumption while business investment is forecast to grow at 7.4 per cent this year. The employment picture also continues to be positive, with unemployment falling from a peak of 8.4 per cent in 2011 to close to 5 per cent and the highest employment rate in the UK’s history.
Recent falls in oil and other commodity prices and weaker than anticipated wage growth (due in part to lower realised inflation) are contributing to a slower recovery in CPI inflation. The scale of the recent commodity price falls means that CPI inflation is likely to remain below 1 per cent until the end of the year, but it is expected to exceed the 2 per cent target slightly at the two year point, as drags from external factors unwind and domestic cost pressures build. Core inflation has picked up since the middle of last year and is now around its pre-crisis average, at 1.4 per cent in the latest data, and the Monetary Policy Committee (MPC) judges that inflation expectations remain well anchored.
Risks to the outlook
Against this broadly positive economic outlook, we welcome staff analysis of a number of key risks and challenges. These include global risks, from lower global growth and a slowdown in emerging economies, and domestic risks, arising from the housing market and lower than expected productivity growth.
Staff has also provided a helpful external assessment, supported by new analysis, of the current account deficit, which in recent years has been large by historical and international standards, and currently stands at 3.7 per cent of GDP. As the staff report notes, however, some of the weakness in the external position is expected to be temporary and should unwind as partner economies strengthen. Moreover, the nature of the capital flows financing the deficit does not suggest a particular vulnerability (in addition to its size), and the external balance sheet has become more resilient to shocks.
In a world where the global risks are increasing it remains of the utmost importance that the Government continues to work through its plan to build resilience and better prepare the UK for whatever lies ahead both externally and domestically. The Government’s strategy for doing so is built on four key pillars of: monetary activism; deficit reduction; structural reforms; and reforms to strengthen the resilience of the financial sector.
Monetary policy continues to play an important role in supporting economic activity. Since the global financial crisis, the MPC has reduced and held Bank Rate at its historically low level of 0.5 per cent and purchased a stock of assets amounting to £375 billion. The MPC continues to make clear that given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so only gradually and to a level lower than in recent cycles. The actual path that Bank Rate will follow over the next few years will depend on the economic circumstances.
Macroprudential policies and the housing market
The Financial Policy Committee (FPC) has been created with a remit to identify risks to financial stability and has already taken action to mitigate risks emanating from the housing market, traditionally a source of vulnerability for the UK economy, and a focus of the 2014 Article IV. In June 2014, the FPC judged that household indebtedness did not pose an imminent threat to stability, but that it was prudent to introduce two policies to insure against the risk of a marked loosening in underwriting standards and a further significant rise in the number of highly indebted households. House price growth subsequently eased somewhat, but with household debt to income still at high levels the FPC has judged that the insurance provided by the June 2014 Recommendations remains warranted.
The FPC is now looking at buy-to-let mortgages, where lending has continued to grow. In the year to 2015 Q3, the stock of buy-to-let lending rose by 10 per cent, compared to just 0.4 percent for lending to owner-occupiers. Assessed against relevant affordability metrics, buy-to-let borrowers appear more vulnerable to an unexpected rise in interest rates or a fall in income. The FPC is alert to financial stability risks arising from growth in buy-to-let mortgage lending and has made clear that it stands ready to take action if necessary to protect and enhance financial stability. Tax changes to the buy-to-let market announced last year are also expected to dampen demand from buy-to-let investors, although over time some of this may be offset by increased demand from existing and potential owner-occupiers.
The long term answer to the country’s housing problems is to build more homes and in the Budget and Autumn Statement the Chancellor announced a doubling of the housing budget to over £2 billion per year. As a result the UK is embarking on the biggest home-building programme by any government since the 1970s. Further reforms to the planning system have also been announced to improve supply, and public and commercial land is being released for house-building.
Another key risk identified by staff is the high levels of public borrowing and debt. Reducing the deficit has been central to the Government’s strategy since 2010, when it was set to be 11.1 per cent of national income, a peacetime record. This year it is set to fall to close to a third of that, 3.9 per cent, but at over £70 billion this year, borrowing is still far too high. The UK currently has the second largest fiscal deficit in the G7 as a share of national income, alongside its large current account deficit.
The recent Spending Review sets out spending plans that will see the deficit and debt fall every year, and we are expected to reach a surplus by the end of the Parliament. The deficit reduction plan is based on simple rules set out in the new Charter for Budget Responsibility, which commits the Government to reducing the debt to GDP ratio in each and every year of this Parliament, to reaching a surplus in the year 2019-20, and to maintaining that surplus in ‘normal times’ in order to rebuild buffers. Within the new framework, the surplus rule will be suspended if the economy is hit by a significant negative shock, defined as real GDP growth of less than 1 per cent on a rolling 4 quarter-on-4 quarter basis. This provides flexibility to allow the automatic stabilisers to operate freely when needed.
In line with the IMF’s Fiscal Transparency Code, the new Charter also requires the Office for Budget Responsibility to produce a fiscal risks statement setting out the main risks to the public finances, including macroeconomic risks and specific fiscal risks. This will be produced at least once every 2 years, and the OBR plans to produce the first such report within the next two years.
Productivity continues to be a challenge for the UK, with output per hour still 15 per cent below its pre-crisis trend. In 2015, the government published a plan for strengthening productivity growth over the next decade, setting out a number of concrete policy measures. These are designed to encourage long-term investment in economic capital (including infrastructure, skills and knowledge) and promote a more dynamic economy that encourages innovation and helps resources flow to their most productive use. The government is also committed to boosting productivity by investing in human capital. A new Apprenticeship Levy was announced in the summer Budget of 2015 that will come into effect in April 2017, and the government has committed to an additional 3 million apprenticeships in England by 2020.
At the end of 2015, the government set up the National Infrastructure Commission to determine Britain’s infrastructure priorities and hold governments to account for their delivery. The Commission will produce a report at the start of each five-year Parliament, offering recommendations for priority infrastructure projects. At the Spending Review the Government also committed £100 billion of spending by 2020 for new roads, rail, flood defences and other vital projects.
Reform of the Financial System
The resilience of the banking system had continued to strengthen in recent years, reflecting the introduction of higher regulatory requirements. The aggregate Tier 1 capital position of major UK banks was 13 per cent of risk-weighted assets in September 2015. In its most recent stress test, the Bank of England assessed the resilience of the banking sector to a deterioration in global financial market conditions and the macroeconomic environment, including in emerging market economies. The stress-test results and banks’ capital plans, taken together, indicate that the banking system would have the capacity to maintain its core functions, notably lending capacity, in a stress scenario.
The FPC has judged that the appropriate equity requirement for the banking system was broadly in line with internationally agreed Basel III requirements, which would be fully phased in by 2019, and has clarified that it is therefore not seeking further structural increases in capital requirements for the system as a whole. The FPC has also announced its intention to make active use of the time-varying countercyclical capital buffer that will apply to banks’ UK exposures, and is actively considering the appropriate setting.
The Fair and Effective Markets Review was established in June 2014, to conduct a comprehensive and forward-looking assessment of the way wholesale financial markets operate, help to restore trust in those markets in the wake of a number of recent high profile abuses and influence the international debate on trading practices. In June 2015, the review published its final report and the recommendations are currently being taken forward.
Looking ahead staff is currently undertaking the UK’s Financial Sector Assessment Program that is expected to come to the Board in July 2016.
As staff highlight in the report, the UK is currently seeking reforms to address the concerns of the British people over its membership of the European Union. A date for a referendum will be set as soon as the Prime Minister gets a substantial agreement for reform in the EU, and will be at the latest by the end of 2017. We welcome the Managing Director’s commitment to look at this issue in more detail in the 2016 Article IV.