• ensuring that, once the short-term impact of the economic cycle is taken into account, the public finances are placed on a sound and sustainable long-term footing; and



• providing an estimate of the amount of spare capacity in the economy so that fiscal policy can play a role in supporting monetary policy through the economic cycle.

Trend growth is also important to other decision makers. Interest rate decisions made by the Monetary Policy Committee need to be based on the best possible view of the economy's sustainable productive capacity. This will ensure that monetary policy is neither too tight nor too loose, consistent with the symmetric specification of the Government's inflation target. In effect, it allows policy-makers to aim for the highest level of growth and employment consistent with keeping RPIX inflation at 2½ per cent. Business people also need to take into account growth in the economy when making their long-term investment decisions.

The Government inherited public finances which were in substantial structural deficit. In keeping with its prudent approach to fiscal policy, the Government took the decision to adopt, for the purposes of projecting the public finances, a deliberately cautious assumption for annual trend growth. This assumption of 2¼ per cent was audited and endorsed as prudent by the National Audit Office. There is no reason to change this judgement. Therefore, the projections of the public finances in the forthcoming Pre-Budget Report, Budget and 2000 Spending Review, will continue to be based, as in the past two years, on an assumed annual trend growth rate of 2¼ per cent.

At the time the Government entered office the economic outlook was also highly uncertain due to significant emerging macroeconomic imbalances which needed to be tackled. Against this background, the Government judged that it was sensible to present its forecasts for economic growth in the form of opportunity ranges. This illustrated the potential for supply-side improvements to deliver stronger growth above the prudent 2¼ per cent per year assumption used for the fiscal projections.

Two and a half years on, the Government now believes that - on the basis of a careful and balanced assessment of past and future trends - it is possible to give a firmer indication of the outlook for trend growth. This assessment does not fall into the trap of assuming productivity improvements as a result of new policies before clear evidence emerges.

The Government believes that a neutral estimate of the UK's annual trend growth rate over the coming period is 2½ per cent. Following significant reforms to the macroeconomic framework and a number of important structural measures, the UK economy has shown clear signs of improved stability and a decline in the sustainable rate of unemployment. This evidence suggests strongly that the contribution of growth in the employment rate to overall trend growth will be greater than during the 1990s.

There is also good reason to believe that productivity growth - promoted by the Government's policies - may also turn out somewhat higher than in the last economic cycle. But it is too early to conclude that the economy's underlying productivity performance has improved. Therefore the underlying rate of productivity growth over the period ahead is assumed to be identical to that experienced during the 1990s.

To summarise, over the period ahead:

• employment growth is expected to contribute ½ per cent per annum to trend growth, due both to growth in the working age population and an increase in the employment rate; and



• productivity growth is expected to contribute 2 per cent per annum to trend growth. This reflects an underlying trend labour productivity rate of 2.1 per cent, moderated slightly by the impact of changes in the employment rate.

This assessment therefore assumes some further increase in the employment rate, but does not rely on any improvement in underlying productivity performance. In this sense the Government's neutral estimate of trend growth is subject to upside risk. The Government is determined to take a prudent approach by erring on the side of caution when uncertainties exist. Thus the potential exists for even stronger non-inflationary growth. Given the evidence, the economic forecast in the forthcoming Pre-Budget Report and Budget will assume a annual trend growth rate of 2½ per cent. In keeping with the Government's past approach, the projections will also illustrate the implications of sustaining a slightly higher rate of growth. Such a scenario is well within grasp if the most is made of opportunities available.

The UK's recent history - particularly in the late 1980s and early 1990s - points to two key lessons for setting fiscal policy:

• projections of the public finances are inherently uncertain, and would still be so even if the economic cycle could be estimated accurately. So policymakers need to take into the account the possibility of errors when setting fiscal policy; and



• for a number of reasons, it is usually more difficult to tighten fiscal policy in the face of worsening trends in the public finances than it is to ease fiscal policy if events turn out somewhat better than expected. This implies that policymakers should base their fiscal projections on prudent assumptions, thus allowing a margin to deal with this asymmetry.

Heeding these lessons, the Government will continue to plan the public finances on a prudent basis. Therefore, the projections of the public finances in the forthcoming Pre-Budget Report, Budget and 2000 Spending Review, will continue to be based, as in the past two years, on an assumed annual trend growth rate of 2¼ per cent.