Recent developments and prospects

2. The UK economy continues to enjoy sustained positive growth, with low and stable inflation and falling unemployment. A year ago, both staff and my authorities were forecasting robust growth for 2000 in the range 2¾ to 3¼ percent. Our latest official projection in November was for growth of around 3 percent. Since then, preliminary data for the fourth quarter of 2000 suggest growth slowed a little towards the end of last year, but this was mainly due to a large fall in the volatile oil and gas sector. Confidence indicators remain high, although, if the external environment deteriorates significantly, there will be implications for UK growth.

3. Strong export growth last year contributed to a much stronger net trade performance compared to previous years. Although imports also grew strongly, the current account deficit has levelled at around 1¼ per cent of GDP, Manufacturing output growth of 1.6 per cent in 2000 was the highest since 1994, but variation in performance within the sector remains marked and the sector overall continues to lag the much stronger expansion in services.

4. Further gains in employment last year took unemployment to its lowest level since the 1970s, ending 2000 at 5.3 per cent on the ILO-consistent measure and just 3.5 per cent on the claimant count basis. However, despite labour market tightening and some signs of skills shortages starting to emerge, growth in average earnings remained moderate at a little under 4½ per cent in the fourth quarter of 2000. Productivity growth rose to 2.6 per cent in the year to 2000 Q3, a considerable improvement over previous years, and helped to hold down unit labour costs. RPIX inflation averaged just 2.1 per cent in 2000, the lowest since the current series began in 1976, notwithstanding the sharp rise in oil prices during last year.

5. In recent months there has been a shift in the balance of risks to the UK’s economic prospects, reflecting weaker inflationary pressure in the UK and, in particular, the possibility of a further slowdown in the US. In response to these concerns the Bank of England’s Monetary Policy Committee (MPC) pre-emptively reduced interest rates by 25 basis points to 5¾ per cent on 8 February. Since then, inflation figures for January showed underlying inflation falling to 1.8 per cent.

Policy framework

6. The Government has put in place a macroeconomic framework based on the principles of transparency, responsibility and accountability to deliver economic stability for the long term. The monetary policy framework aims to deliver low and stable inflation, with the MPC setting the Bank of England’s policy rate to meet the Government’s inflation target. The fiscal policy framework is geared to ensuring, over the medium term, sound public finances and spending and taxation policies which are equitable both within and across generations; and, over the short term, to support monetary policy, in particular by allowing the automatic stabilizers to play their role in smoothing the path of the economy. The Government has set two fiscal rules: the golden rule - over the cycle, the government will borrow only to invest and not to fund current spending; and the sustainable investment rule -public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level.

7. My authorities’ position on EMU remains unchanged. Any government decision on EMU entry will be determined by whether the economic case for the UK of joining is clear and unambiguous, based on the five economic tests. The Government has said that an assessment of the five tests will be carried out early in the next Parliament.

Short-term issues

8. Looking forward, there continues to be little difference between the staff and my authorities on the prospects for the UK economy. The latest official forecast, prepared last November, was for growth this year of 2¼ to 2¾ percent. The staff forecast is at the top end of that range. Updated forecasts will be presented in the Budget on 7 March.

9. In last year’s report, staff said that the “March 2000 Budget should not use the margins built up by the over-performance of the previous year and instead aim to keep the structural fiscal balance unchanged”. The November Pre-Budget Report expected a cyclically-adjusted surplus for Public Sector Net Borrowing (PSNB) in 2000-01 which was 0.3 percentage points larger than projected in Budget 2000, which itself projected a 0.3 percentage points tighter position in 2000-01 than anticipated in the previous Budget. So the likely outturn for 2000-01 is for a much tighter fiscal stance than most -- including staff -- expected. This has contributed to a lowering of interest rate expectations, and will have beneficial effects on activity and inflation through 2001-02.

10. Again in this year’s report, staff have argued that the fiscal stance in the forthcoming Budget should be at least as tight as last year to avoid burdening monetary policy. My authorities believe that staff fears of inflationary pressures in the economy from the planned expansion in public spending during 2001-02 are not well-founded. The November Pre-Budget Report projected an on-going structural surplus in 2001-02. Moreover, the fiscal framework in the UK, based on prudence and caution, has restored the public finances to a healthy and sustainable position which has resulted in a decline in the ratio of net debt to GDP from 44 per cent in 1996-97 to a little over 30 per cent now. The sustained improvement has helped make possible the large investment in public services that was announced in last summer’s Spending Review 2000, while also supporting monetary policy in the short term. The government has increased investment in key priorities such as health, education and transport, thereby addressing years of under-investment in the public sector, which staff agree is necessary. Staff also concur that the planned move from surplus to small deficit consistent with our fiscal framework and our two fiscal rules does not threaten medium-term sustainability of the public finances.

11. Meeting the inflation target is the job of monetary policy. The MPC had raised interest rates to 6 per cent in February 2000, but then left rates unchanged throughout the rest of the year as consistent with achieving the inflation target, taking full account of the public spending plans set out in the Budget and Spending Review 2000. Indeed, as the report highlights, by the end of 2000 the balance of the debate on the MPC had shifted to whether the policy stance should be eased. Interest rates were then cut by 25 basis points two weeks ago on the basis of the expected effect of weaker prospects for the US economy coupled with the fact that price and cost pressures in the UK have remained benign. The MPC’s view is that the risks to growth and inflation are clearly on the downside of the central projection published in the February Inflation Report. That central projection implied that the planned increase in public expenditure was consistent with meeting the inflation target.

12. Staff have also argued that, if domestic private spending and external demand remain strong, the planned public spending increases would contribute to pressure for an interest rate increase and possible further real appreciation of sterling. My authorities are not convinced that a short-term and temporary shift in the balance between monetary and fiscal policy would have a significant and predictable effect on the exchange rate, given that the appreciation in the real exchange rate since 1996 coincided with a tightening of the fiscal stance totalling almost 5 per cent of GDP.

Medium-term issues

13. Staff argue in the report that, given the degree of caution built into the public finance projections, it would be better to fund public investment in the UK through offsetting measures on current spending or revenue rather than through borrowing, preferring a broadly balanced budget over the cycle instead of the golden rule. However, the golden rule supports intergenerational fairness by helping to ensure future generations contribute to the costs of today’s investment where benefits accrue to them in the future. Current spending is at least matched by current receipts over the cycle. Sound public finances are also assured by the sustainable investment rule. The Pre-Budget Report projects public sector net debt falling to around 30 per cent in 2001-02, which is amongst the lowest in the EU and G7.

14. Moreover, my authorities strongly believe that in order to meet the fiscal rules there is no room for complacency. Hence, the public finance projections are based on prudent and cautious assumptions. For example, the public finance projections are based on an assumed growth in potential output of just 2¼ per cent.

15. My authorities agree with the staff’s assessment that more public spending is required on priority areas–health, education, and public infrastructure -- while maintaining a sound overall fiscal position. Increased spending on these priorities was announced in last summer’s Spending Review. Over the next three years net investment is planned to more than double, rising to a share of 1.8 per cent of GDP by 2003-04. An annual £43 billion of additional funding has been allocated for significant improvements in key public services by the end of this period. The priority areas of education, health, transport and housing and law and order will account for more than three-quarters of the rise in spending.

16. As the staff point out, the UK’s long-term record on productivity growth has over decades been disappointing. The productivity gap between the UK and its major competitors is substantial and longstanding. My authorities recognize that improving productivity performance is key to achieving higher long-term growth and sustained increases in living standards. My authorities are therefore committed to improving productivity performance and have put in place a long-term strategy built around macroeconomic stability and microeconomic reforms targeted at market failures, with a focus on five priority areas:

• promoting competition and better regulation;

• encouraging enterprise and innovation;

• raising investment;

• improving skills levels; and

• raising public sector productivity

17. The staff investigation into whether the UK is beginning to benefit from the “new economy” is welcome and timely. This issue is the focus also of much research in the UK. There have been large investments in ICT in the UK over recent years, and there is some evidence of productivity increasing in the ICT sector. However, whole economy productivity growth was, on average, relatively weak through the second half of the 1990s as a result of muted gains between 1995 and 1999. So, while productivity growth has picked up significantly since then, and we think there are good reasons to be optimistic about future improvements, we do not believe it is prudent at this stage to build significant improvements in productivity growth into our forecasts.

18. My authorities welcome the staff’s positive comments on our pension reforms, particularly in recognising the balance that needs to be struck between improving savings incentives for the current generation of workers, especially for low income groups, whilst reducing poverty amongst current pensioners. As with our general approach to fiscal policy, my authorities have been determined to ensure the UK pension system is built on a prudent and sustainable basis.

Financial issues

19. When the Financial Services and Markets Act (FSMA) 2000 is implemented in the second half of 2001, it will provide the legal underpinning for the Financial Services Authority (FSA) as the single regulator for financial services in the UK. The new legislation will allow the FSA to move to an integrated and more transparent approach to regulation, taking into account the principles of good regulation and based on an assessment of the risks to its statutory objectives:

• maintaining confidence in the UK financial system;

• promoting public understanding of the UK financial system;

• securing an appropriate degree of protection for consumers; and

• reducing the scope for financial crime.

20. The UK has been active on the international front in a variety of ways. It is an active member of the Basle Committee on Banking Supervision (BCBS), the Basle Committee on Payment and Settlement Systems (CPSS), the International Association of Insurance Supervisors (IAIS), and the International Organisation of Securities Commissions (IOSCO), it has followed-up work on incentives for implementing international codes and standards of regulation and has participated in the Financial Action Task Force’s (FATF) exercise to identify those countries and territories considered to be uncooperative in the global fight against money laundering. On the domestic front, the FSA works, along with other Government departments, to ensure that the recommendations of the review on financial regulation in the UK’s Overseas Territories are implemented fully.

21. Finally, the Chancellor of the Exchequer has committed the UK to undergo an IMF Financial Sector Assessment Program (FSAP) assessment. This detailed examination of the stability of the UK financial system and the UK’s adherence to internationally accepted financial sector codes and standards will be conducted by an IMF team after the FSMA has been in force for several months.

Conclusion

22. The benefits for the UK economy from the comprehensive program of enhancements to the framework for policy-making introduced in recent years are starting to be seen in sustained macroeconomic stability and better economic performance. A sound and sustainable fiscal position, coupled with a credible and effective framework for monetary policy, are setting the environment in which the private sector can take decisions with more confidence and the necessary improvements in public services can be afforded.

23. The challenge remains, however, to move to a significantly higher level of sustainable growth, the benefits of which are widely spread through the domestic economy, and which allows the UK to play a full part in maintaining a healthy world economy.