Economic Outlook

Over the last year, the UK economic recovery has continued to be subdued and uneven but the economic news has been better in recent months.

GDP growth was only 0.2 per cent in 2012. Domestic demand was actually stronger than forecast, with much of the weakness attributable to net trade, which in turn reflects weakness in the UK’s key export markets. Independent analysis by the Office for Budget Responsibility (OBR) explains that “the unexpectedly poor performance of exports is more than sufficient on its own to explain the shortfall”.

In March, the OBR forecast a steady return to growth of 0.6 per cent of GDP in 2013. Since then, the economy has shown signs of improvement and the average of independent forecasts for GDP growth has now risen to 0.9 per cent. GDP growth in Q1 was 0.3 per cent and recent official and survey data for the services, construction and manufacturing sectors leads most external forecasters to anticipate stronger growth in Q2. Overall, this gives some indication that momentum is building.

Crucially, private sector jobs are still being created. According to the OBR, the picture on employment “continues to surprise on the upside”. Employment is now at record levels, 432,000 higher than a year ago, while unemployment has fallen further and currently stands at 7.8 per cent. Since early 2010 an additional 1.3 million private sector jobs have been created, more than offsetting the fall in public sector employment of 423,000. Given these trends, the risks of hysteresis should not be overstated.

CPI inflation rose to 2.7 per cent in May, up from 2.4 per cent in April, but is still down to roughly half the level it was at its peak in September 2011. In May, the Monetary Policy Committee (MPC) judged that inflation was likely to remain well above the 2 per cent target for the rest of the year, reflecting external price pressures and administered and regulated prices. That said, inflation is still expected to fall back to target over time, as external price pressures fade and a gradual revival in productivity growth curbs increases in domestic costs.

There is some way to go before we see a strong and sustainable recovery. This reflects the ongoing domestic and external challenges, and the fact that the UK was hit harder than most countries by the financial crisis, following a decade of unbalanced and unsustainable growth. The Government’s strategy is designed to protect the economy through this period of global uncertainty, maintain market confidence and lay the foundations for stronger, more balanced growth. As recommended by the IMF, my authorities are taking a multi-pronged approach. This is focused on: monetary activism; deficit reduction; structural reform; and reform of the financial sector.

Monetary activism

Monetary policy continues to play a critical role in supporting the economy and provides the first line of defense against external shocks. The MPC has maintained Bank Rate at 0.5 per cent over the past year. Given the potential impact on bank and building society profitability, the view continues to be that further rate reductions could be counterproductive, potentially inhibiting their ability to lend and impairing the functioning of money markets. The stock of asset purchases also remains unchanged since mid-2012 at £375bn. The MPC will continue to review this position in light of the latest developments.

In March, the Government reviewed the monetary policy framework and updated the MPC’s remit. The new remit reaffirms the MPC’s primary objective of a 2 per cent inflation target within a flexible inflation-targeting framework. Moreover, it clarifies the Government’s expectation of the Committee in terms of the judgements it must make in forming and communicating the trade-offs that are inherent in setting monetary policy to meet a forward-looking inflation target while giving due consideration to output volatility. It also makes clear that the use of all necessary unconventional policy tools to maintain price stability and secure the recovery is available to the MPC, if judged necessary. The Chancellor has also requested that the MPC provides an assessment of the merits of using intermediate thresholds in its August 2013 Inflation Report.

In addition to pursuing a highly accommodative monetary policy, the Funding for Lending Scheme (FLS) was launched in July 2012 to reduce banks’ funding costs and boost their lending to households and businesses. Since its introduction banks’ funding costs have fallen, and by more than their European counterparts. There is also evidence that this is being passed on to consumers: interest rates have come down on mortgages, unsecured personal loans, and loans to businesses of all sizes. And while the improvement in credit conditions will take time to feed through to lending volumes, net lending is expected to pick up modestly in the remainder of this year. In contrast, the expectation prior to the introduction of the FLS was for a net decline in lending over this period.

In April, the FLS was extended by a further year to the start of 2015 to give banks and building societies confidence that they will be able to continue to access funding on reasonable terms. And given improvements in credit conditions have been less pronounced for SMEs than for secured household borrowers and larger businesses, the incentives for lending to smaller businesses have been strengthened.

Deficit reduction

In 2010 the UK had a budget deficit of 11.2 per cent, forecast by the IMF at the time to be the largest budget deficit of any G20 country. Since then, the deficit has been reduced by about a third, but it remains one of the largest in the G20 at 7.4 per cent of GDP. As a result, gross debt is continuing to rise and is forecast to peak in 2016-17 at over 100 per cent of GDP.

The Government’s fiscal strategy is anchored by the tax and spending plans set out in the June 2010 Budget. Subsequent implementation and ongoing commitment to these plans has ensured fiscal credibility. However, implementation has taken place within a flexible medium-term fiscal framework. Sizeable automatic stabilizers have been allowed to operate in full and the pace of structural adjustment has been allowed to slow in the near-term, with the Government choosing not to take corrective action to meet its debt target. As a result, the planned period of consolidation has been extended from 5 to 8 years.

The Government has continued to improve the composition of consolidation, recognising the benefits of further switching from current to capital spending. Over the past two years, plans have been revised to increase capital spending by around £20bn. And in recent weeks, the Government has set out plans to deliver a further £3bn of capital investment in 2015-16 in areas with the highest economic returns (transport, science and innovation and education) and £100bn of specific infrastructure projects over the next Parliament.

In addition, recognising the fact that a significant proportion of infrastructure investment in the UK is delivered by the private sector, the Government is using the credibility of its balance sheet to provide further support to the economy through guarantees for investment in infrastructure. While the government cannot control the timing of this investment, these guarantees are designed to support investment in major projects that may have stalled due to adverse credit conditions. This will also support the rebalancing of the economy towards sustainable private-sector led growth.

In summary, my authorities continue to believe that the fiscal policy stance and projected pace of consolidation implied by its tax and spending plans, remain appropriate, given the economic outlook, risks and continued global uncertainty. In turn, fiscal credibility has allowed the government to use its balance sheet to support investment through guarantees and credit easing policies, and support the economy with the free operation of sizeable automatic stabilisers. Credibility has also reduced the risk of adverse feedback between weak public finances and the strained and systemically important financial sector, which staff acknowledge is a “global public good”. Revising the fiscal plans in an attempt to fine-tune the consolidation path would risk undermining credibility and could have consequences for global, as well as domestic, financial stability.

Structural reform

A comprehensive programme of supply-side reforms is underway to boost competitiveness and improve the business environment, as set out in the Plan for Growth, and the National Infrastructure Plan. A wide-range of reforms have been identified across government, including: infrastructure investment; deregulation; measures to boost trade and investment; root and branch reform of the planning system; and radical reforms to every stage of education and skills provision.

At the 2013 Budget, the Government complemented planning reforms by launching the Help to Buy scheme to support the housing market. This is a temporary scheme to make it easier for first time buyers to purchase homes and existing homeowners to move home. After three years, the Financial Policy Committee (FPC) will assess its impact and advise whether it should be continued.

Separately, the Government also set out further reforms at the Budget to devolve significant local funding to Local Enterprise Partnerships to enable them to tackle barriers to growth, which hold back private investment at the local level.

Financial Sector Policy

The healing process in the UK financial sector has continued over the last 12 months. Bank liquidity and funding positions have improved and capital ratios of major UK banks and building societies have increased. However, confidence in the financial system remains fragile and credit growth is still weak. The outlook is still clouded by the ongoing risks associated with a weak and uneven global recovery, and imbalances in the euro area. More still needs to be done to improve the resilience of the UK banking system and ensure that lending to the real economy is maintained. To meet these challenges, the Government is continuing to implement its ambitious financial sector repair and reform agenda.

On 1 April 2013, the Financial Services Act came into force, fully establishing the new regulatory and supervisory architecture in the UK. The Financial Policy Committee (FPC), Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) are now all up and running. The view of my authorities is that the issues raised by staff in the 2011 FSAP, concerning the mandates and independence of these institutions, have been fully addressed and, while it is still early days, there is a sound basis for effective coordination.

Given the uncertain outlook for financial stability, a number of steps have been taken to ensure the capital adequacy of UK banks and building societies in line with FPC recommendations. The PRA has conducted an asset quality review to ensure that banks have credible plans in place to meet identified shortfalls, either by issuing new capital or restructuring balance sheets in a way that does not hinder lending. The PRA will also ensure that credible plans are in place for the transition to tougher prudential standards in 2019. In order to assess capital adequacy on a forward-looking basis, the Bank of England, including the PRA, is continuing to develop its stress testing framework and a discussion paper will be published in the autumn. The PRA will also ensure that UK banks comply fully with Enhanced Disclosure Task Force (EDTF) recommendations when they publish their 2013 annual reports.

Structural banking reforms are now going through Parliament in the Banking Reform Bill. Key measures include the ring-fencing of retail banking from wholesale and investment banking and an additional 3 per cent of equity on top of the Basel III minimum for the largest ring-fenced banks. These reforms will improve the safety of banks, protect taxpayers and ensure a more stable financial sector. The Government also intends to give the FPC the power to vary the leverage ratio for deposit takers and investment firms above the international baseline requirement in 2018, though this will be reviewed once this baseline is implemented in 2017. More broadly, the UK continues to press in European negotiations for the full and faithful implementation of the Basel III binding minimum leverage ratio baseline. In addition, the Government has asked the Office of Fair Trading to conduct a review of competition in small business banking, recognising that competition remains an important structural issue in the UK banking sector.

The IMF recommended in May that the Government urgently develop a strategy for returning its shareholdings in the Royal Bank of Scotland (RBS) and Lloyds Banking Group (LBG) back to the private sector. The Chancellor has announced that he is actively considering options for beginning the sale of LBG and is urgently investigating the case for breaking up RBS and creating a “bad bank” of risky assets - a review will be completed by autumn. The Government strategy will be guided by three objectives: maximising the banks’ ability to support the UK economy; getting best value for money for the UK taxpayer and returning the banks to private ownership.