Outlook and recent developments

The UK economy faces significant global challenges. There is evidence that, following extensive structural reforms and the development of strong macroeconomic frameworks, it has become more resilient in recent years. This, together with a long period of stability, provides a platform from which to manage the severe adverse shocks it is facing. But my authorities are highly alert to the risks and strongly committed to maintaining sound policies and strengthening policy frameworks where appropriate. In this context my authorities have proposed reforms to the financial stability framework.

Since the last IMF Article IV report, published in March 2007, the UK has recorded GDP growth of 3% in 2007. However, growth in advanced economies is slowing in 2008. Whereas all forecasting judgements are subject to uncertainty, the Treasury’s Budget forecast was made in March against a backdrop of considerable uncertainty relating to the duration, intensity and effects of the ongoing disruption in financial markets. Specifically, credit conditions were assumed to ease during the second half of 2008 and normalise by mid–2009. Contingent on our assumptions for credit conditions, and in the absence of any further shocks, the Budget forecast was for quarterly growth to pick up in the second half of 2008, with year–on–year growth rates picking up in 2009. The Treasury will update its forecasts in the Pre Budget Report in the Autumn, as normal. In the latest Treasury–compiled Comparison of Independent Forecasts, published in July, forecasts of GDP growth averaged 1.6 per cent in 2008 and 1.3 per cent in 2009.

There are clear downside risks to growth should credit conditions deteriorate further, or for longer, than assumed, constraining consumer spending and business investment by more than forecast. Furthermore, continued cost pressures from rises in global agricultural commodity and energy prices are helping to push up headline inflation, impacting negatively on households’ real incomes. Weaker real household disposable income growth would likely further constrain consumer spending.

Global cost pressures temporarily raised inflation above 3 percent in March 2007, but inflation returned close to target from mid–2007, averaging 2.3 per cent in 2007/08. Following an increase to 3.3% in May 2008, the Governor of the Bank of England wrote to the Chancellor of the th Exchequer on 16 June 2008 on behalf of the Monetary Policy Committee, as required by the MPC’s remit. In his letter, the Governor stated:

“Inflation has risen sharply this year, from 2.1% in December to 3.3% in May. That rise can be accounted for by large and, until recently, unanticipated increases in the prices of food, fuel, gas and electricity. These components alone account for 1.1 percentage points of the 1.2 percentage points increase in the CPI inflation rate since last December”.

After rising 10% in the year to July 2007, house prices have now shown some falls and the housing market is experiencing significant challenges as a result of the disruption in the international financial markets. With the securitisation markets effectively closed, mortgage approvals are now down over 60% compared to a year ago and mortgages, particularly for those with small deposits, are increasingly difficult to find. House–builders are also experiencing difficult business conditions after years of favourable conditions. However, demand underpinning the housing market is still strong and is likely to remain so as our population ages and grows and more people live alone; this will support house prices in the long–term.

My authorities agree with the IMF assessment that the UK faces little threat to external stability, but they will continue to monitor the external balance closely. The current account deficit in 2005 was around 2½ per cent of GDP. Since 2005 investment has risen strongly, by nearly 2 percentage points of GDP, while gross national savings has fallen by a similar amount. This left the current account deficit at around 5 per cent of GDP in the third quarter of 2007. The deficit has since fallen to 2.4 per cent of GDP. Although most of this improvement is due to the value of derivative positions of American and European owned investment banks in the UK being marked down following turmoil in financial markets, the underlying current account deficit is forecast to fall as investment and savings rebalance.

The continued turbulent conditions in global financial markets are posing challenges for the financial sector in the UK, as they are around the world. Actions taken by central banks to ease liquidity concerns, along with action taken by financial institutions to raise additional capital, will improve the resilience of the financial system to shocks. However, prospects for the UK and world economy are subject to considerable uncertainties relating to the present adverse shocks from ongoing disruption in financial markets and rising global commodity prices.

Policy frameworks

We welcome staff’s assessment that sustained low inflation and rapid economic growth over the last decade has been achieved thanks to strong policies and policy frameworks.

Fiscal

The UK Government’s fiscal policy objectives are:

• over the medium term, to ensure sound public finances and that spending and taxation impact fairly within and between generations; and

• over the short term, to support monetary policy and, in particular, to allow the

automatic stabilisers to help smooth the path of the economy

As noted by staff, the Government’s two fiscal rules, designed to implement these objectives, have served the economy well. Discipline imposed on the public finances through the framework has seen debt cut over the economic cycle which began in 1997–98 from 43.3 per cent of GDP at the end of 1996–97 to 36.6 per cent in 2006–07. Budget 2008 also forecasts that net investment, protected by the fiscal framework, will grow as a share of GDP to rates not seen since 1979–80, helping to address the historic underinvestment in infrastructure.

The UK’s 2008 Budget set out a path for fiscal policy that provides support to the economy in the short term, while taking action to maintain sound public finances in the medium term. My authorities welcome the staff’s assessment that “the 2008 budget judgment was appropriate, as was its commitment to fiscal tightening over the next few years.” This judgement was in line with the Government’s fiscal policy objectives, and the design and implementation of the fiscal framework is based on these objectives. My authorities wish to stress their firm commitment to ensuring that public finances remain sustainable in the long–term. As part of this, a comprehensive assessment of long–term fiscal sustainability was published alongside Budget 2008.

The staff report makes an interesting contribution to the ongoing debate about the role and design of fiscal frameworks, building on the constructive discussions that the team had with my authorities during the mission. My authorities’ utmost priority is to continue to ensure that the fiscal framework supports the overarching fiscal policy objectives described above.

Monetary

The UK Monetary Policy Framework seeks to ensure low and stable inflation as an essential precondition for achieving the Government’s central objective of high and stable levels of growth and employment.

The framework is based on four principles:

• Clear and precise objectives– the primary objective of monetary policy is to deliver price stability;

• Full operational independence for the MPC in setting interest rates to meet the Government’s inflation target;

• Openness, transparency and accountability, which are enhanced through, for example, the publication of MPC member’s voting records, prompt publication of the minutes of monthly MPC meetings, and the open letter system; and

• Credibility and flexibility—the MPC has discretion to decide how and when to react to events, within the constraint of the inflation target.

Since its introduction in 1997, the monetary policy framework has successfully delivered a long sustained period of low and stable inflation. The Government fully supports the Monetary Policy Committee of the Bank of England in the difficult decisions it is facing.

In previous years staff has praised the inflation–targeting framework for its overall design and consistently strong implementation and we welcome the conclusion of this year’s report that it should remain unaltered.

In setting the Bank Rate, the MPC has been aiming, as always, to bring UK CPI inflation back to the 2% target in the medium term. In recent months, the Committee has been balancing two major risks to the inflation outlook. On the upside, there is a risk that rising CPI inflation will lift medium–term inflation expectations and thereby lead to a more prolonged period of above–target inflation. On the downside, the risk is that weaker incomes and tighter credit will lead to a sharper and more prolonged downturn in the economy that would pull inflation below the target further out. Both risks have become more pronounced since the Bank of England’s MayInflation Report was published. The MPC judges that some measure of spare capacity will be required to reduce the risk of medium–term inflation expectations rising; the question is what level of Bank Rate is consistent with the appropriate slowing in growth. As usual, the Committee will decide month by month on the basis of the latest data.

Financial

My authorities believe that the UK has strong fundamental arrangements in place for financial stability. The framework, with a principles– and risk–based regulatory regime, with the Financial Services Authority (FSA) as single regulator at its centre is right, though it has been tested over recent months, and shortcomings in its execution have been identified and are being addressed by the FSA. The FSA has outlined a comprehensive supervisory enhancement programme to ensure that its supervision is effective across all the organisations that the FSA regulates. In response to market developments since last August, the FSA has intensified its engagement with individual banks. My authorities are committed to strengthening the existing overall framework with its clear roles and responsibilities for the Treasury, the FSA and the Bank of England, and with a Standing Committee of the three authorities to ensure proper communication and coordination.

As part of this process, my authorities propose to provide the Bank of England with a new statutory objective for financial stability and new policy tools to ensure it can fully deliver against this new objective. Reforms are also proposed to extend the range of tools available to the authorities in the rare situations where a bank is judged to be failing, including a special resolution regime. Changes are also being proposed to the operation of the UK’s deposit compensation scheme to ensure customers fully understand, and have confidence in, the arrangements which will deliver swift and adequate compensation should a bank fail. These proposals continue to be subject to further public consultation and refinement with a view to starting implementation this year including through legislative reform¹. The UK Authorities acknowledge the staff report’s conclusion that the proposed reforms are sound.

As the financial market risks are global in nature it is key that there is adequate response at the global level in–cluding the implementation of the recommendations of the FSF which the UK strongly supports. We also support efforts to enhance the IMF’s early warning capabilities to improve awareness of risks to the global financial system and responses to mitigate these risks through joint FSF–IMF work reporting to the IMFC.

The Bank of England has responded to strains in money and financing markets by using the flexibility built into its money market operating framework. Since August 2007, the Bank has provided 61% more reserves to banks, in line with an increase in the voluntary targets set by banks at the start of each monthly maintenance period for the reserves they hold on account at the Bank. In addition to this, the Bank has used other tools in its published framework.

First, in September 2007 and March 2008 in response to heightened pressures in short–term money markets, it offered to supply additional reserves, above the amount required to meet the targets set by banks. Subsequent to each operation, short–term market rates traded closer to Bank Rate. In order to accommodate that additional supply (and subsequently to provide banks with extra flexibility to manage their day–to–day liquidity), the Bank of England has widened the ranges around banks’ reserves targets within which reserves are remunerated. The Bank has also increased the ceilings on the reserves targets individual institutions can choose. In addition, the Bank increased the size of its scheduled long–term repo operations held in December and January, lending more at three months against a wider range of high–quality collateral, including AAA residential mortgage–backed securities and covered bonds. These operations were offered again at their maturity in March and April and again in June and July. The Bank has also provided reserves through drawings by Northern Rock on the liquidity facility available to it.

In April 2008, the Bank announced and implemented a Special Liquidity Scheme, to allow banks to swap temporarily their high–quality, but currently illiquid, mortgage–backed and other securities for UK Treasury bills. The scheme’s aim is to improve the liquidity position of, and hence confidence in, the UK banking system.

The SLS has three main features:

• 1. The asset swaps will be for long terms. Each swap will be for a period of one year and may be renewed for a total of up to three years.

• 2. The risk of losses on the securities remains with the banks.

• 3. It is designed to provide financing for legacy illiquid assets existing at the end of 2007.

In addition, a number of UK banks have been active in raising significant amounts of new capital in the market to strengthen their solvency ratios.

Looking ahead

My authorities are grateful to staff for a wide ranging consultation which addressed some very pertinent issues. The opportunity to engage with staff on the forecast and to test forecast judgments at such a challenging time was valuable. The extra focus on the external balance in the mission, consistent with the 2007 Decision on Bilateral Surveillance, was welcome and provided useful insights to both sides. We welcome staff’s endorsement of the budget judgement and the UK’s fiscal stance, and of the overall approach to reforms designed to promote financial stability. My authorities believe that strong policy frameworks and extensive structural reforms, which support openness, promote flexible markets, and liberalise the economy leave the UK economy well placed to withstand economic shocks. However my authorities certainly do not underestimate the severity of the shocks or the uncertainty around their duration and impact. As global shocks require global responses, my authorities strongly support the work of the IMF with all its membership to address financial instability, and the impact of high food and oil prices.