Economic context and outlook

The UK economy has demonstrated its resilience over the past 18 months. Growth has remained solid, extending the period of continuous growth to 20 quarters. Employment has risen by 3 million since 2010 and is at record highs, and over the past year, higher employment has reflected rising full-time work. The increase in employment has supported prosperity across the country and income inequality is at its lowest level in 30 years. The level of female employment is close to a record high at 15 million. The unemployment rate, which now stands at 4.3%, is at its lowest rate since 1975.

As the staff report notes, over the past year, higher inflation has weighed on household income, business investment has been affected by uncertainty, and productivity remained subdued. Productivity growth has slowed across all advanced economies since the financial crisis, but it has slowed more in the UK than elsewhere. If the UK can unlock productivity growth, there is an opportunity to increase growth, wages and living standards over the long term. In the near term, the government has pursued policies that provide support for households and businesses. Over the medium term, the government has set in train a plan to address the UK’s productivity challenge, by cutting taxes to support business investment, improving skills and investing in high-value infrastructure.

The staff forecasts are in line with those of the authorities. In November, the independent Office of Budget Responsibility (OBR) revised down its forecast for GDP growth in 2017 to 1.5%, reflecting slower-than-expected growth at the start of the year and revisions to recorded growth in 2016. Growth this year is expected to be 1.4%, with growth of 1.3% in 2019 and 1.3% in 2020, driven by a more cautious assumption for trend productivity. From 2020, growth is forecast to pick up and GDP growth rises to 1.6% at the end of the OBR’s forecast horizon in 2022.

Public finances

The government has made significant progress since 2010 in restoring the public finances to health. The deficit has been reduced by three quarters from a post-war high of 9.9% of GDP in 2009-10 to 2.3% in 2016-17, its lowest level since before the financial crisis.

The staff report notes the public debt ratio remains high by international standards. The OBR forecasts debt will peak at 86.5 % of GDP in 2017-18, its highest level for 50 years. The government agrees with staff that borrowing needs to be reduced further to maintain the UK’s economic resilience, improve fiscal sustainability, and lessen the burden on future generations.

The fiscal rules approved by Parliament in January 2017 commit the government to reducing the cyclically-adjusted deficit to below 2% of GDP by 2020-21 and having debt as a share of GDP falling in 2020-21.¹ The rules enable the government to take a balanced approach: returning the public finances to a sustainable position while helping households and businesses, supporting public services, and investing in Britain’s future. These rules will also guide the UK towards a balanced budget by the middle of the next decade. The OBR forecasts that the government will meet both its fiscal targets. By 2022-23, borrowing is expected to be at its lowest level since 2001-02 and debt as a share of GDP is forecast to fall next year and in every year of the forecast.

The government welcomes recognition in the staff report that the UK continues to set international standards with respect to fiscal transparency. In July 2017, the OBR published its first ‘Fiscal Risks Report’ (FRR), which provides a comprehensive assessment of risks to the public finances over the medium-to-long term. It also illustrates the potential fiscal impact of a number of these risks materialising at the same time through a fiscal stress test based on the Bank of England’s annual cyclical scenario (ACS). The publication of the FRR builds on the steps that the government has taken to improve fiscal transparency, including the creation of the OBR itself. The government’s response to the FRR will be published this summer.

Monetary policy

Following the vote to leave the EU, on 4 August 2016 the Bank of England’s Monetary Policy Committee (MPC) announced a monetary stimulus package to support economic growth and achieve a sustainable return of inflation to target. The MPC cut the Bank of England’s base interest rate from 0.5% to 0.25%, extended the quantitative easing programme, and introduced a new Term Funding Scheme to enable banks to pass on the Bank Rate cut to businesses and households.

The steady erosion of slack over the subsequent year reduced the degree to which it was appropriate for the MPC to accommodate an extended period of inflation above the target. Consequently, at its November 2017 meeting, the MPC judged it appropriate to tighten modestly the stance of monetary policy in order to return inflation sustainably to target. As the staff report notes, notwithstanding this tightening, monetary policy remains accommodative and continues to provide significant support to jobs and activity. At the most recent meeting, in December, the MPC voted unanimously to maintain the current monetary stance.

Consistent with the staff assessment, the MPC remains of the view that, were the economy to follow the path expected, further modest increases in Bank Rate would be warranted over the next few years. Any future increases in Bank Rate are expected to be at a gradual pace and to a limited extent. The MPC will monitor closely the incoming evidence on the evolving economic outlook, including the impact of the increase in Bank Rate, and stands ready to respond to developments as they unfold to ensure a sustainable return of inflation to the 2% target.

Financial sector risk overview

In its most recent decision, the Bank of England’s Financial Policy Committee (FPC) judged that, apart from those related to leaving the EU, domestic risks were at a standard level overall. In line with their published strategy, they agreed to raise the UK countercyclical capital buffer (CCyB) rate from 0.5% to 1%, with binding effect from 28 November 2018. The FPC will reconsider the adequacy of a 1% UK CCyB rate in light of the evolution of the overall risk environment.

The FPC has been monitoring the risks highlighted in the staff report and has already taken action, for example, to guard against a loosening of underwriting standards in the owner occupied mortgage market and in relation to the rapid growth of consumer credit. The Committee has also judged risks from global debt levels and asset valuations and risks from misconduct costs to be material.

The ACS results gave the FPC an updated indication of the risks to banks’ capital from this overall risk environment. The UK economic shock in the scenario, in aggregate, reduces banks’ capital by around 3.5% of their relevant UK risk-weighted assets. Based on a fully-phased-in capital conservation buffer of 2.5%, this suggests that a UK CCyB rate in the region of 1% would deliver a sufficient regulatory buffer for the banking system to absorb a domestic stress of the severity embodied in the test.

Raising productivity

Staff identify the need for sustained policy focus on raising productivity in order to increase living standards. Average output per hour growth between 2008 and 2016 was 0.1%, well below its pre-crisis trend of 2.1% in the decade before. Evidence suggests the UK should prioritise upgrading infrastructure, improving skills, helping businesses to invest, and reforming the housing and planning systems.

The government has already made significant progress in these areas and has announced reforms to go further. The National Productivity Investment Fund (NPIF), announced at Autumn Statement 2016 and extended at Autumn Budget 2017, targets investment at areas crucial for improving productivity, namely housing, R&D and infrastructure. Tax cuts will support business investment and the government is improving skills through a significant increase in apprenticeships and the introduction of “T level” qualifications, to transform technical education. Delivering high value infrastructure projects like the Mersey Gateway Bridge, the Northern Hub in Manchester and Crossrail will also support productivity.

The government’s plans mean that by the end of this Parliament public investment in economic infrastructure will have doubled in a decade, from £12 billion in 2012-13 to at least £24 billion in 2022-23, in real terms an increase of more than 60%. This includes a 50% increase in transport investment, funding the biggest road investment programme in a generation, and the biggest rail transformation in modern times.

Productivity is a long-term issue and these reforms will take time to have an impact. However, taken together, the government believes the action it is taking represents a significant step towards improving the UK’s productivity, in order to boost wages and enhance people’s living standards.

Impact of the UK’s decision to leave the EU

As the staff report highlights, developments regarding the UK’s withdrawal from the EU and the reactions of households, businesses and asset prices remain the most significant influence on the economic outlook and a continued source of uncertainty.

The government is approaching the EU exit negotiations anticipating success. It does not want or expect to leave without a deal, but while it seeks a new partnership, it is planning for a range of outcomes, as it is the responsible thing to do. To support the preparations, nearly £700 million of additional funding has been provided to date and the 2017 Autumn Budget set aside a further £3 billion spread evenly over the next two years to ensure that the government can continue to prepare effectively for EU exit.

The authorities are also cognisant of the risks. For example, the FPC assessed the resilience of major banks to a highly unlikely combination of severe risks in its annual stress test, judging that the extent of the stress test scenario meant that it encompassed a wide range of macroeconomic risks that could be associated with leaving the EU. Furthermore, on the basis of the results of the ACS, the FPC judged that the UK banking system could continue to support the real economy even in the unlikely event of a disorderly exit.