Outlook and recent economic developments

At the time of the last UK Article IV in summer 2009, the UK, along with other advanced economies, was undergoing a severe contraction with risks to the outlook from rising unemployment, falling house prices, deleveraging, tight credit conditions and losses in the financial system. Since then, conditions have stabilised and the economy has returned to growth. Real GDP has now grown for four consecutive quarters to a level 2.8 per cent higher than in the last quarter of falling output (Q3 2009).

The economic forecast that underpins the UK budget is now the responsibility of the newly created and independent Office for Budget Responsibility (OBR). Its central economic forecast is for the recovery to gather pace - 1.2% this year, 2.3% next - rising to above trend rates from 2012 as the private sector recovery strengthens and the economy becomes more balanced. Growth in the second and third quarters of 2010 was higher than the OBR forecast in June. The reasons for the OBR’s slightly stronger growth projections for 2011 as compared with staff are explained in the staff report, and include a larger contribution from net exports and stronger fixed investment. Global demand, however uneven, is necessary to sustain the UK recovery, and domestic demand is likely to be supported by some gradual moderation in private savings.

As staff mention in their report, labour market performance has been better than envisaged at the time of last year’s assessment. Although output fell by more than 6% during the recession, employment fell by less than 2%. Employment increased by 178,000 in the 3 months to August, and is now at the level projected to be reached by mid 2012 in the OBR forecast.

Significant uncertainties remain, especially around the strength of the global recovery. My authorities’ strategy is to mitigate risks and address the underlying economic imbalances that contributed to the crisis in order to promote sustainable, private sector-led growth. Alongside the consolidation of fiscal policy they have introduced measures to support investment and growth. They have avoided sharply raising taxes on capital and labour, focusing instead on reforming corporation tax to reduce the cost of capital and promote investment. Welfare reforms are designed to encourage and reward work while protecting the most vulnerable in society. Efficiency savings are sought across the public sector.

On the inflation outlook, my authorities agree with the staff that the forthcoming VAT increase means that inflation is likely to remain above the 2% target until the end of 2011. While there is some risk that a prolonged period of above target inflation may cause medium-term inflation expectations to increase, we expect inflation to fall back below the target, given the spare capacity in the economy and labour market.

Fiscal policy

In their 2009 Article IV assessment of the UK, staff sought a stronger commitment to fiscal consolidation and a more ambitious medium-term fiscal adjustment path. Staff urged greater clarity on specific adjustment measures with a focus on expenditure reduction. The new Government, which took office in May 2010, agrees with this advice. Tackling the fiscal deficit in a way that will help promote growth is the most urgent task facing the UK economy.

The Government’s June Budget therefore set out an accelerated plan for fiscal consolidation, which at around 2% of GDP by 2014-15 was toward the upper end of outside expectations. This has been received positively by the markets. Around three quarters of the consolidation will come from spending restraint, in line with staff advice and international evidence on what determines an effective and lasting consolidation.

Following the June Budget, the October Spending Review set out £81 billion of spending reductions to deliver the consolidation plan, while at the same time seeking to protect priority areas of expenditure, including those that promote economic growth. Key transport and infrastructure projects have been supported, and areas of resource spending that are important for growth have also been prioritised, including through a real terms increase in the core schools budget of 0.1% a year, spending on science being maintained in cash terms and a £1.4 billion regional growth fund. My authorities are also committed to protecting the UK’s budget for overseas development assistance from expenditure cuts and to delivering the target of ODA at 0.7 per cent of GDP.

A particular focus of policy has been to achieve the consolidation in a way that helps address longer-term fiscal pressures. Therefore my authorities are reforming State Pension provision by bringing forward the equalisation of State Pension Age for men and women at 65 to November 2018, and accelerating subsequent increase to 66 by 2020. This will significantly offset the cost to the public sector of increasing longevity, and my authorities are also considering bringing forward further planned pension age increases. Public sector employees’ pension contributions will rise, leading to additional savings of £1.8 billion a year by 2014-15. Further savings will be those delivered through reforms to social benefits and transfers from central to local government.

According to OBR projections, these measures taken together should eliminate the cyclically-adjusted current deficit by 2014-15 and place public sector net debt on a downward path in the same year.

Fiscal Framework

The staff report describes well the steps my authorities have taken to strengthen the fiscal framework and provide greater transparency and credibility to the UK’s official economic and fiscal forecasts in particular by creating the new independent Office for Budget Responsibility (OBR). The need for a reform on these lines has been a theme of staff advice to the UK in several previous Article IV cycles. The OBR will produce independent macroeconomic and fiscal forecasts on which all budget decisions will be based, judge the consistency of the Government’s fiscal policy with its fiscal mandate, and assess the sustainability of the public finances. The OBR has been operating on an interim basis since May 2010, and legislation was introduced to Parliament on 21 October to establish the OBR and its core functions in statute.

The fiscal mandate my authorities have adopted to guide policy decisions over the medium term is to set policy to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period. This fiscal mandate is supplemented by a target for public sector net debt as a percentage of GDP to be falling at a fixed date of 2015-16. On current plans, the UK is forecast by the OBR to meet the mandate and supplementary debt target a year early.

Monetary policy

With fiscal policy constrained, and the recovery still fragile, the Bank of England has maintained a supportive monetary stance with policy rates at the lower bound and additional stimulus provided through large scale asset purchases. As shown in the staff report, the programme of asset purchases have had a significant impact on financial markets and particularly gilt yields, and its effects should continue to be felt on the wider economy for some time to come.

The current weakness in broad money growth is likely to be related to continued adjustment of bank balance sheets, and could be seen as a corollary of bank deleveraging. The Monetary Policy Committee (MPC) judges it appropriate to maintain Bank Rate at 0.5% and the stock of assets financed by reserves at £200bn; the Committee will continue to assess month by month whether a change in policy in either direction is warranted (the MPC’s next decision will be this Thursday, 4 November). When and if it feels it is appropriate to begin tightening policy, this is most likely to occur through a rise in Bank Rate with asset sales being conducted later in an orderly programme over a period of time.

Financial policy and framework

Conditions in the UK’s financial sector are much improved with higher bank capital ratios, increasing bank profitability and a successful conclusion to CEBS stress testing for UK banks. This has helped build resilience to further shocks.

However, my authorities remain vigilant and mindful that funding challenges remain, exacerbated by renewed uncertainty over the macro outlook. UK banks envisage (realised and prospective) balance sheet reduction as central to helping meet this funding challenge. Central to addressing all these issues is the need for appropriate risk management – with close monitoring of firms’ governance, culture, policy, processes and systems.

As explained in the staff report, the case for structural reform in the UK banking sector is currently being assessed by an Independent Commission on Banking which will report in September 2011.

Systemic risk in the financial system is being addressed through regulatory and institutional reform. The staff report and Selected Issues paper (chapter VI) explain the Government’s wide ranging programme, an important part of which is to give the Bank of England responsibility for macro-prudential regulation and oversight of micro-prudential regulation. As part of this, a new Prudential Regulatory Authority will be created, as a subsidiary of the Bank, and a separate, independent Consumer Protection and Markets Authority (CPMA) will also be established. The Government will also legislate for the creation of a new Financial Policy Committee with macro-prudential oversight.

My authorities are committed to full implementation of the recently agreed Basel III requirements and UK banks appear well placed to meet these new requirements in a timely manner. My authorities intend to continue to play a full role in international and EU discussions on strengthening the financial sector, and enhancing international cooperation. They are fully cognizant of the risks as well as benefits posed by interconnected global markets and firms, and are supportive of the drive to build a strategic global approach to regulation, enabling effective risk management through coordinated macro-prudential analysis, harmonised prudential rules, effective supervision of cross-border firms and fair, and orderly global markets.

As staff note, my authorities look forward to exploring many of the issues relating to the financial sector in more detail in the forthcoming Financial Sector Assessment Programme which will be conducted during the first half of 2011 and be discussed by the Board alongside the 2011 Article IV report, in conjunction with a pilot Spillover Report for the UK.