MACROECONOMIC STRATEGY AND PROSPECTS

Introduction

2.1  Recent world events have emphasised the need to promote stability. No country can expect to be immune from global developments; and this is especially true of the UK which is one of the most open economies in the world. In an increasingly interdependent world economy, the Government has a role to play in developing an economic framework - both domestic and global - that is able to cope with adverse developments.

2.2  Economic instability creates uncertainties and difficulties for individuals and businesses. It damages investment and long-term growth, wastes valuable resources and has significant economic and social costs. The key task for domestic macroeconomic policy is to create a platform of stability to allow people and firms to plan ahead with confidence. It is also important to address directly the causes of international instability to minimise the risks of disruption from external events.

2.3  In pursuit of economic stability, fiscal and monetary policies need to operate consistently, with clear objectives and to focus on the long term. If the objectives of high growth and employment are to be achieved, sound public finances and low inflation are essential. By setting in place a sound macroeconomic framework, supported by tough policy actions, the Government is steering a course of stability in an uncertain world.

The historical legacy

2.4  In each of the last two economic cycles, Britain's economic performance was poor compared with other G7 countries. During this period, the UK had one of the highest average inflation rates and below average growth. Fluctuations in output and inflation were higher than elsewhere, with growth ranging from around -2 to +5 per cent and inflation from 2 to 21 per cent. Interest rates and fiscal deficits were almost twice as volatile as those in France, Germany and the USA. All this damaged business' and consumers' ability to plan ahead effectively. It also contributed to Britain's poor productivity growth, which is examined in Chapter 3.

2.5  In the first half of 1997, as output approached and then moved beyond its sustainable level, the economy was in danger of repeating the boom and bust cycle. Momentum in the economy had built up and output was accelerating sharply, pushing GDP to an annualised rate of growth of nearly 5 per cent by the middle of the year - around double its sustainable rate. Growth had become unbalanced with household consumption rising sharply and was set to do so further on the back of a rising equity market and additional windfalls from building society flotations. Inflationary pressures were also building up, with private sector earnings growth reaching 6 per cent - a rate inconsistent with achieving the inflation target in the medium term. In addition, a large structural deficit in the public finances (of 3 per cent of GDP in 1996-97) needed to be tackled.

A framework for stability

The Government's response

2.6  The most pressing priority for the Government on arrival in office was to take swift action to prevent a return to boom and bust. Steps were therefore taken to develop a new long-term macroeconomic policy framework. Three elements lie at its heart:

• a new monetary policy framework to deliver low inflation: the Bank of England's Monetary Policy Committee (MPC) was given operational responsibility to set interest rates to meet the Government's inflation target of 2½ per cent annual growth in the Retail Prices Index excluding mortgage interest payments (RPIX). The Bank of England Act 1998 gave statutory effect to the new arrangements;
• a transparent fiscal framework set out in the Code for Fiscal Stability, underpinned by the 1998 Finance Act, and two tough fiscal rules to bring the public finances back under control; and
• a new regime for planning and controlling public spending, based on firm three-year public expenditure allocations: the plans announced in the Comprehensive Spending Review (CSR) in July provided better incentives for departments to manage their budgets efficiently and for the long term, reduced the bias against investment and locked in the tight fiscal position over the rest of the Parliament.

Consistently low inflation

2.7  The monetary policy framework now ensures that interest rate decisions are taken on the basis of the long-term needs of the economy and not on the basis of short-term political considerations. The MPC is tasked with achieving the inflation target set by the Government. The Bank of England's remit requires that deviations below the target level be treated just as seriously as outcomes above that level. As the Governor of the Bank of England has said: ģI give you my assurance that we will be just as rigorous in cutting rates if the overall evidence begins to point to our undershooting the target as we have been in raising them when the balance of risks was on the upsideī.

2.8  The new arrangements are among the most transparent in the world. MPC votes and minutes are now published two weeks after the monthly meetings; and a full analysis of inflationary pressures and developments, along with a forecast, is published in the Bank's quarterly Inflation Report.

Sound public finances

2.9  The primary responsibility of fiscal policy is to contribute to economic stability - which underpins high growth and employment - through sound public finances. As with monetary policy, transparency and accountability are central features of the new arrangements. The framework is defined in the Code for Fiscal Stability, a draft of which was published in March, and is being laid before Parliament today. The Code enshrines five key principles of fiscal management - transparency, stability, responsibility, fairness and efficiency. It also includes comprehensive reporting requirements to ensure Parliament and the public are well informed about economic and fiscal developments and requires that information is based as far as possible on best-practice accounting principles.

2.10  Within the framework, the Government's two strict fiscal rules define how sound public finances are to be delivered:

• the Golden Rule - on average over the economic cycle, the Government will borrow only to invest and not to fund current spending; and
• the Sustainable Investment Rule - net public debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level.

2.11  This framework is based firmly on achieving sound public finances and long-term economic stability. Within the framework, there is an inbuilt capacity to respond to changing economic circumstances by allowing the automatic stabilisers to operate (as discussed later in this chapter). The Government is also able to support monetary policy with appropriate fiscal policy settings, as with the fiscal tightening introduced in the July 1997 Budget (see Table 2.1), consistent with meeting the fiscal rules. In this way, the framework sets a long-term goal for policy without imposing inappropriate restrictions on the flexible operation of policy.

Table 2.2: Summary of UKforecast

2.29  Much as expected, the main driving force has been the deceleration in domestic final demand and, in particular, a slowing of growth in household consumption. Nevertheless, the labour market has remained strong with employment now having risen by around 400,000 since May 1997.

CHART HERE

2.30  Independent forecasts for UK growth changed little between March and late summer, remaining in line with the Budget forecast. However, two broad strands of recent evidence point to more moderate short-term growth than anticipated in March:

• underlying trade performance has been weaker than expected, accounted for by a worsening in net trade with countries outside the EU and particularly in Asia; and
• business surveys, especially in manufacturing, have indicated lower trade, output and confidence in the second and third quarters of 1998.

2.31  On the assumption of no further deterioration in the world economic outlook, GDP is now forecast to grow between 1 and 1½ per cent in 1999: ¾ percentage points lower than anticipated in the March Budget.

2.32  The lower projection can be more than accounted for by the effects of the deterioration in the world economy on UK exports, financial markets and other economic activity. UK export markets are now expected to grow more slowly than forseen in March. As UK exports represent around one third of GDP, this effect alone reduces GDP by around ½ per cent in 1999. In addition, global instability has, for example, contributed to a significant fall in UK equity prices since July, which is likely to impact on domestic spending.

2.33  As output growth slows further, and the level of output falls below trend, downward pressure will be exerted on domestically-generated inflation and reflected in lower business margins and, later on, slower growth of unit labour costs. Over time, however, import price inflation is likely to increase as the effects of exchange rate movements unfold. RPIX inflation is therefore expected to dip temporarily just below the Government's target in the first half of 1999, before returning to 2½ per cent by the end of the year.

2.34  The scale of the cyclical slowdown, combined with a forward-looking policy approach that provides an inbuilt capacity to respond to developments, is expected to permit a somewhat stronger subsequent cyclical recovery in output from early in the year 2000, with output returning to its trend level in 2002. GDP is expected to grow by 2¼ to 2¾ per cent in 2000 and by 2¾ to 3¼ per cent in 2001. As domestically-generated inflation falls, offset by receding external downward pressures on prices, RPIX is expected to remain on target.

2.35  Prospects for a stronger cyclical recovery are also supported by currently robust household balance sheets. This contrasts with the downturn in the 1990s which was preceded by a strong increase in household borrowing, particularly in secured loans, leaving households extremely vulnerable to the subsequent housing market downturn. In addition, the financial position of the corporate sector is far more secure than in the late 1980s. Firms have spent much of the 1990s

repairing their balance sheets following earlier sharp increases in gearing. The current lower levels of corporate gearing mean that firms are at less risk of running into financing difficulties.

2.36  The slower pace of the overall economy will make it even more important that the labour market functions effectively, both enhancing incentives to work and tackling long-term unemployment. Chapter 4 discusses the wide range of Government policies designed to achieve this aim.

Smoothing the economic cycle

2.37  The Government's new macroeconomic framework has helped the UK economy to become more resilient and provides a defence against the risk of a return to 'boom and bust'. The new framework provides not only the means to avoid unnecessarily large fluctuations in activity caused by excessively short-term policy decisions, but also allows responses that limit the adverse effects of external shocks.

2.38  The UK's relatively large cyclical behaviour reflects, in part, the consequences of policy mistakes as fiscal and monetary decisions were taken without a clear framework and with changing objectives. Required corrective action was typically not forthcoming until it was too late, resulting in greater than necessary problems and excessive corrective action.

2.39  The coherent and transparent framework now in place offers assurance that short-term political factors will no longer interfere with proper and timely policy action required to maintain stability and that there will be a more informed policy debate in which risks and options are discussed openly. This means that business, investors and the public can take effective decisions and plan with confidence on the basis that economic policy will promote stability, not the opposite.

2.40  In the context of the current economic cycle, a number of developments are already evident.

• Monetary policy was tightened much earlier in this cycle than in the previous cycle. This has meant that despite rises since May 1997, the present level of interest rates - 7¼ per cent - is less than half the peak of the previous cycle - 15 per cent.
• Fiscal policy was tightened as the economy moved above its trend level in 1997. The £20 billion fall in public sector net borrowing in 1997-98 has not only dealt with the structural problems in the public finances but it has also meant that fiscal policy has been supporting monetary policy in countering the inflationary pressures that had built up.
• The MPC has acknowledged the new global downside risks to the outlook for output in industrial countries and has made it clear that this is a factor they take into account in assessing the prospects of meeting the UK's inflation target.
• Addressing long-standing under-investment in the public sector at this stage - by doubling the capital budget over the next three years - should help promote steady growth by raising the productive capacity of the economy over time.

Table 2.5: Cyclically-adjusted budget balances¹

2.49  Past experience shows the danger of letting cyclical movements in the public finances disguise changes in the underlying fiscal position. For both the current budget and net borrowing, cyclically-adjusted figures, which abstract from the temporary effects of higher or lower growth, therefore give a clearer view of the underlying fiscal position expected over the remainder of the Parliament. Table 2.5 shows that a nearly 1 percentage point improvement in the structural position this year has led to a recorded structural surplus on current budget and structural net borrowing being close to balance. These cyclically-adjusted measures1 also indicate stronger underlying public finances over the next few years than is evident in the unadjusted numbers.

2.50  Net public sector debt is projected to continue to fall relative to GDP. Despite the changed outlook for growth, keeping public borrowing at low levels means that the debt ratio is projected to be reduced consistently over the medium term.

Meeting the fiscal rules

2.51  For the reasons explained earlier, an important feature of the two fiscal rules is that they are set over the economic cycle. This means that any current deficits recorded during an economic slowdown must be offset by current surpluses during a period of stronger economic growth. In this way, the framework provides the basis for long-term economic stability, but allows some flexibility within the economic cycle.

2.52  The framework provides an inbuilt capacity to respond to changing economic circumstances by allowing scope for the automatic stabilisers to help reduce output fluctuations (see
Box 2.5). Furthermore, it does not rule out fiscal policy supporting monetary policy, as appropriate, as it did last year when fiscal policy was tightened and public sector net borrowing was reduced by £20 billion. Consistent with this, meeting the fiscal rules over the cycle must remain the primary objective of fiscal policy.

2.53  The current budget projections in Table 2.4 suggest that the average surplus from 1997-98, the first year of the present cycle, to 2002-03, when the economy is projected to be back close to trend, is around ½ per cent of GDP. This is consistent with meeting the golden rule over this economic cycle plus some margin.

2.54  The Government explained in the EFSR why it believes that it is desirable to reduce net public debt below 40 per cent of GDP over the economic cycle. Chart 2.2 shows that, consistent with this view, the projected net public sector debt ratio is forecast to fall to 40 per cent by the end of this financial year and to continue falling over the medium term. This reflects very low levels of government borrowing - even in the face of slower than expected growth - and compares with a peak in the net debt ratio of around 44 per cent of GDP in March 1997.

2.55  The projections in Table 2.4 show that UK government borrowing and the debt ratio remain well below the Maastricht reference levels for general government net borrowing of less than

  3 per cent of GDP and general government gross debt below 60 per cent of GDP. Borrowing in 1998-99 is also well below the levels in the other major EU countries and is close to balance in the medium term; the debt ratio is currently lower than all other EU countries with the exception of Luxembourg. The fiscal prospects are consistent with the terms of the European Union Stability and Growth Pact.

Dealing with uncertainty

2.56  As noted above, the public finance projections are based on a prudent and cautious approach. This prudent approach reflects not only the fact that growth in any given year is to some extent uncertain, but that the cyclical path of the economy is also uncertain. If the profile of growth were to differ from that assumed, the short-term outlook for the public finances would be affected. However, as the fiscal rules apply over the whole economic cycle they will tend to be robust to errors in short-term growth forecasts. For a given path of trend output, higher or lower growth in the short term will be followed by correspondingly lower or higher growth later, and the public finances may be little affected on average over the cycle.

2.57  Whereas errors in short-term growth forecasts may have only a temporary effect on the public finances, errors in estimating the current cyclical position of the economy - the output gap - will have a permanent effect on prospects. If output were higher relative to trend than had been assumed, the prospects for the public finances would be less favourable, as lower economic growth would be implied on average over the remainder of the cycle.

2.58  In previous forecasts, the effects of uncertainty over the cyclical position of the economy have been illustrated by showing cyclically-adjusted measures based on a pessimistic, but possible, assumption that the output was 1½ per cent further above trend than in the central assessment. Substantial revisions to output data, following rebasing and introduction of ESA95, have increased - by approximately ½ per cent - the estimate of the extent to which the economy was above trend. In addition, higher than expected output growth in the third quarter of 1998 means that output is thought to have been around ¾ per cent above trend in mid-1998 rather than at trend as implied by the Budget forecast - this represents ¾ percentage points of the 1½ per cent pessimistic case.

2.59  Chart 2.3 illustrates a pessimistic case which, on top of the prudent assumptions, assumes trend output to be 1 per cent lower than suggested by the present assessment. In light of the revised assessment of output relative to trend, this case is therefore marginally more pessimistic than the previous pessimistic case, illustrated in the EFSR. As before, it also takes account of the effects of uncertainty from a variety of influences. In this scenario, the cyclically-adjusted current budget is in deficit in the early years of the cycle but this is broadly balanced out by surpluses in later years. Even on this more pessimistic view, the Government remains on track to meet its fiscal rules over the economic cycle. The sustainable investment rule would also be met in this case by a good margin.

Other pre-budget information