Public Information Notice No. 05/27

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with the United Kingdom

March 8, 2005

On March 2, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Kingdom.¹

Background

Macroeconomic performance over the past decade has been strong and steady, owing much to structural reforms and improvements in macroeconomic policies and policy frameworks. Having slowed gradually over the past year, as higher mortgage interest rates and weaker house price appreciation dampened household consumption, real GDP growth is estimated at about 3 percent in 2004 and is expected to stay stable at about 2½ percent in 2005-06, in line with potential growth. Domestic demand remains the key driver of growth, underpinned by continued strong earnings growth and robust corporate profitability. Even though the unemployment rate fell to a 30-year low, wage growth stabilized and inflation remained subdued. Notwithstanding the recent cooling of the housing market, house prices are widely seen as overvalued.

The policy interest rate has been stable since August 2004, when it was raised to 4¾ percent, which is generally viewed as in a neutral range. Although headline CPI inflation edged up to 1½ percent at end-2004, core inflation remained subdued at 1¼ percent. The economy is widely seen as operating in the neighborhood of full capacity and, given the outlook for growth, is expected to remain so. The spread between nominal and inflation-indexed bonds suggests that inflation expectations remain well-anchored. Rising import prices are expected to push inflation toward the 2 percent target over the coming 2-3 years.

The fiscal position deteriorated sharply over the past five years, although the overall deficit is not large compared to other major industrial countries and the debt burden is relatively low. The widening of the deficit reflected an increase in government spending in response to the perceived demand for better public services and a decline in equity-bubble-related revenues. The December 2004 Pre-Budget Report projects that slower spending growth and a rebound in revenues will reverse this deterioration and ensure that the fiscal rules are respected now and in the future. However, there are questions about how much revenues will rebound in the absence of further policy measures.

The October 2004 Interim Report of the Pensions Commission suggested that many people are not saving enough for retirement. Based on a variety of assumptions, the Report found that some 9½ million people (about half of the working-age population over 35) have inadequate saving to meet their likely expectations about retirement incomes. The saving gap reflects several factors: the difficulty that most people face in making rational decisions about long-term saving; the complexity of the existing pension system; the high cost of selling and administering private pension products; and the lack of trust in the retail financial industry following a series of mis-selling scandals.

Executive Board Assessment

Executive Directors commended the United Kingdom authorities for their skillful macroeconomic management and flexibility in responding to changing economic circumstances, and welcomed the continued robust performance of the economy. Economic growth has been relatively rapid and stable, unemployment has fallen to one of the lowest rates among industrial countries, and inflation has been subdued. Directors noted that underlying this impressive performance have been clear and "state-of-the-art" policy frameworks underpinned by strong institutions, as well as a sizable countercyclical policy stimulus and a sharp increase in house prices. Looking ahead, Directors considered that the key challenge will be to ensure that the strong policy frameworks are sustained and supported by the right policy decisions.

The economic environment in the period ahead is expected to be benign, with strong growth supported by resilient domestic demand, and inflation moving toward the target of 2 percent. Directors noted, however, that this outlook is subject to significant short-term uncertainties. These include, first, how quickly the widely perceived overvaluation of house prices will be resolved and its effect on private consumption; second, how and when global imbalances will be unwound and their impact on the external sector and the value of sterling; and third, how to assess the economy's resource constraints, when standard yardsticks may be breaking down. Directors also acknowledged important uncertainties in the medium term about whether fiscal revenues will recover to their turn-of-the-century peaks, and whether private saving will be adequate to support the aging population in retirement.

Directors agreed that monetary policy is well positioned to maintain low and stable inflation and to respond to unexpected developments. They observed that the early but gradual strategy of increasing interest rates since late 2003 appears to have preempted the emergence of excess demand and helped cool the housing market. Directors also noted that, in response to easing demand growth and slowing house price growth, interest rates have been held constant recently, and appropriately so. With interest rates in a broadly neutral range and important but balanced uncertainties in the outlook, Directors noted that the next move in interest rates could be in either direction. They considered that the key challenges for monetary policy will be to judge incipient resource constraints, and to respond promptly to unexpected changes in aggregate demand in either direction.

Recognizing that the success of monetary policy stems in no small part from a strong policy and institutional framework, Directors welcomed the increased emphasis on inflation projections based on market expectations of future interest rates, and the extension of the projection horizon from two to three years. Directors considered the suggestion that the Bank of England publish numerical projections not just for real GDP and CPI but also for other key macroeconomic variables. Many Directors expressed reservations, noting the considerable costs this would involve. Directors also considered the pros and cons of publishing an illustrative path for interest rates consistent with the inflation target. Many Directors considered that this would be risky, as such forecasts could be misinterpreted as a policy commitment.

Directors agreed that the rules-based fiscal framework has served the United Kingdom well by underpinning fiscal discipline and assuring scope for automatic stabilizers to operate freely. They noted that the fiscal support provided to growth has contributed to a weakening in the fiscal position over the past four years, but that, in the current cycle, the sizable initial current and overall surpluses virtually ensure that the rules will be met, or will be missed by an insignificant margin. Looking ahead to the next cycle, Directors took note of the authorities' view that slower spending growth and a rebound in revenues would reverse the past fiscal weakening and ensure that the fiscal rules were respected, and welcomed their intention to take remedial measures if the envisaged improvement did not materialize. However, many Directors viewed the authorities' projections, based on a substantial rise in revenues relative to GDP, to be somewhat more optimistic than warranted. They considered that more realistic projections of the level of potential output and of the scope for higher corporate tax revenues would point to a need for fiscal adjustment if the United Kingdom were to continue to meet the fiscal rules. On the appropriate policy response, Directors noted the authorities' commitment to take measures should they prove necessary. However, many Directors recommended that a mild fiscal adjustment be started expeditiously, in the current favorable economic conditions, to allow the consolidation to be spread over time.

Directors considered that fiscal adjustment measures should be designed to minimize any adverse effects on efficiency, work effort, and growth. With this in view, they suggested restraint in current spending, in order to reduce the risks of running into limits on absorptive capacity and to allow more time to assess value for money. Several Directors also favored the wider application of user fees as another good way of raising efficiency and revenue. Directors concurred that, if more reliance on revenue measures were desired, broadening the tax base would be preferable to raising tax rates, given potential adverse effects on supply.

Directors considered some suggestions on possible ways to modify the authorities' fiscal framework as the economic cycle comes to a close. First, Directors discussed the pros and cons of publishing fiscal projections based on central (rather than cautious) assumptions, with an explicit margin for adverse developments through the cycle or with a fan chart of fiscal outcomes. Many Directors doubted whether a probabilistic approach to fiscal policy would improve public understanding or confidence in the framework. Second, while recognizing that fiscal projections already receive extensive scrutiny and that U.K. economic policy more generally is subject to vibrant public debate, a few Directors saw merit in the suggestion that consideration be given to broadening the scope of independent assessment of the fiscal projections by the National Audit Office. Finally, Directors welcomed the recently established efficiency targets at the departmental level. In this regard, they underlined the inherent challenges in ensuring the efficiency of public spending, especially given the rapid increase in recent years.

Directors noted that the challenges of population aging, although less severe than in most other industrial countries, were moving to the forefront of public debate in the United Kingdom. They welcomed the current debate about the government's role in ensuring adequate retirement income, including the Interim Report of the Pensions Commission, which provides strong evidence that a sizable swathe of the middle-class is not saving enough to ensure retirement income that will meet their aspirations. Directors acknowledged that addressing the problem of under-saving raises difficult questions, and concurred that simplifying the now-complex pension system and encouraging longer active participation in the work force make sense. Directors stressed that, in general, the costs of motivating or forcing higher private saving must be weighed against risks of future demands by pensioners on public resources.

Directors supported the authorities' multi-pronged strategy for raising productivity. At the same time, Directors emphasized the importance of systematic monitoring and evaluation of ongoing programs, including through the recent introduction of specific performance indicators. Directors welcomed the authorities' intention to address structural rigidities in the housing market by making further progress in implementing the recommendations of the Miles and Barker reviews.

Directors concurred that indicators of the health of the financial sector remain quite favorable. Noting that capitalization, credit quality, and profitability in the banking sector continue to be strong, Directors nevertheless cautioned that slower credit growth will likely dampen profitability and that there are downside risks stemming from unsecured lending to households, lending related to commercial property, and the ongoing search for yield. Directors welcomed the signs of improved health of the life insurance sector over the past year, and the introduction of risk-based capital measures in insurance firms and of broker regulation in the non-life insurance sector. They also noted the strengthening of the supervisory and institutional aspects of payment and settlement systems. Finally, Directors welcomed the strengthening of the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) regime in line with Financial Sector Assessment Program (FSAP) recommendations.

Directors praised the United Kingdom for its leadership role in promoting trade liberalization, especially with respect to agricultural trade, and looked forward to further progress in this area. They commended the United Kingdom's commitment to increasing aid flows and welcomed the increases in official development assistance, aimed at reaching the goal of 0.7 percent of GNI by 2013.