Public Information Notice No. 00/17

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

March 6, 2000

On March 1, 2000 the Executive Board concluded the 1999 Article IV consultation with the United Kingdom.¹

Background

The economy has bounced back from the effects of last year's global slowdown which led to a temporary pause in the U.K.'s output growth in late 1998 and early 1999. Exports and related movements in inventories accounted for most of the decline in growth. Domestic demand, and especially consumer spending, remained strong throughout and contributed to making the slowdown in economic activity shorter and shallower than originally expected. Growth picked up strongly in the last three quarters of 1999 to an average annualized rate of about 3 percent, reflecting both buoyant consumption expenditures and, more recently, an increase in exports. Resource utilization has remained high and the economy is now estimated to be roughly at potential output. Unemployment declined further from its peak at about 10½ percent (on a claimant count basis) in the early 1990's to a 25-year low of 4 percent.

Inflation pressures have remained largely latent owing mainly to the lagged effect of the sterling appreciation, declines in price-cost margins due to increased competition and deregulation, and enhanced efficiency of labor markets. RPIX inflation has been below the 2½ percent policy target. House prices and mortgage equity withdrawals, however, have picked up since the beginning of 1999. Indications of price pressures in the labor market have been mixed, with earnings growth increasing to the 4½-5 range, outstripping productivity, while pay settlements trended down to about 3½ percent.

The real exchange rate appreciated sharply in 1997, reflecting both nominal appreciation and an increase in unit labor costs, and has remained strong since. The current account shifted to a deficit of 1¼ percent of GDP in 1999, with net exports contributing negatively to growth. However, exporters appear to be adjusting to the high level of sterling and there has been little evidence of a sustained decline in the U.K.'s share of world or European markets. The export slowdown in late 1998 appears to have been driven mainly by the decline in demand in Europe and Asia, with the subsequent export rebound being associated with recovery in these markets.

The Bank of England's Monetary Policy Committee (MPC) continued lowering the policy rate during the first three quarters of 1999 to address the ongoing decline in activity. However, it reversed policy direction in September-as the recovery firmed and medium-term risks of higher-than-targeted inflation began to emerge-and, by February 2000, had increased the rate by a total of 100 basis points to 6 percent. The budgetary outturn in fiscal year 1998/1999 and the current year 1999/2000 have been stronger than originally envisaged. The November Pre-Budget Report revised the projected fiscal path upward to reflect the ongoing overperformance which has been prompted by the stronger-than-expected economic recovery and some structural fiscal improvements. Both the monetary and fiscal policy frameworks-with their medium-term orientation and emphasis on transparency and accountability-have delivered a high degree of policy credibility and private sector confidence.

Given the improved macroeconomic performance and high levels of resource utilization, policies have increasingly focused on achieving long-term goals: a more equitable sharing of economic gains-particularly through the alleviation of poverty and inroads into long-term unemployment; pension reform; closing the sizeable productivity gap between the United Kingdom and other major industrial countries; and strengthening the structural underpinnings of the economy, in part with a view to clarifying the implications of any eventual decision whether to join EMU.

In this regard, the Government's recent efforts in the welfare and labor market area (particularly the New Deal, the Working Families Tax Credit and the National Minimum Wage) are focused on enhancing work incentives and alleviating poverty. The recent proposals on pension reform are aimed at increasing the public pension benefits of the lowest paid and bolstering the role of privately funded pensions for others. On the productivity gap, shortfalls in the U.K.'s labor productivity seem to reflect, among other factors, sizable gaps in its human and physical capital stock. The authorities' strategy to boost productivity thus features both increasing public sector physical and human capital investment and improving the climate for private investment, in part through efforts to increase competition, improve deregulation, and encourage enterprise and innovation. Since an efficient and stable capital market is also an essential element in this regard, Bank of England has been given responsibility for the overall stability of the financial system and the Financial Services Authority has been charged with ensuring the effective and efficient regulation of the increasingly integrated financial services industry.

Executive Board Assessment

Directors commended the authorities for the United Kingdom's impressive economic performance over much of the 1990s, during which growth has been strong and sustained, and both unemployment and inflation have declined to enviable levels. Recently, the economy had weathered the slowing of global demand in late 1998, and growth was resuming based on buoyant domestic demand, and more recently a pickup in exports. While the strength of sterling was a source of uncertainty, Directors believed that the authorities' strong policy frameworks and their track record of skillful policy management would be conducive to a continuation of sustained growth and low inflation. At the same time, a number of Directors expressed concern at the real appreciation of the exchange rate, noting that the effects of exchange rate changes on trade are typically lagged, and suggested that the authorities will need to remain alert to the implications of sterling's strength for competitiveness.

Looking ahead, Directors considered that short-term risks were mostly on the upside, with the main challenge being to prevent overheating. The immediate prospects for inflation remained benign owing to favorable, but most likely temporary, factors. However, most Directors thought that resource pressures were likely to increase over time, given that above potential growth had resumed with the economy at or close to full employment. Some Directors noted the additional inflation risks stemming from a potential depreciation of sterling as the euro strengthened. On the other hand, several Directors underscored the possibility of more favorable inflation outcomes stemming from favorable structural shifts in the economy.

Absent external deflationary shocks, most Directors agreed that policies-in the first instance monetary policy-would likely need to tighten further over the course of this year. In this regard, they took note of the Bank of England's record in taking prompt, forward-looking action, including the rate increases that had already taken place.

Given cyclical considerations and the strong real exchange rate, Directors underscored the need to ensure that the fiscal stance remains supportive of monetary policy. While welcoming the stronger than anticipated budgetary outturn likely for fiscal year 1999/2000, which implies attainment of an overall surplus on a Maastricht basis, they urged that the March 2000 budget preserve the margins built up by the overperformance during the previous year. Some Directors went further to suggest that a strengthening of the real exchange rate would warrant a discretionary tightening of fiscal policy.

Many Directors also stressed the importance of consolidating the credibility of the government's newly established fiscal framework by abiding by the existing three-year budget plans.

Directors considered that the remarkable performance of the U.K. economy in recent years owes much to the strengthening of policy frameworks. These frameworks had helped foster sound macroeconomic and structural policies and-through their emphasis on transparency and accountability-had given a high degree of credibility to policies and had bolstered private sector confidence. Many Directors also pointed to the key role that earlier structural reforms, particularly in labor markets, had played in allowing the supply side to respond flexibly.

Directors praised the effectiveness of the inflation targeting framework in the United Kingdom, commending in particular the forward-looking, transparent, and preemptive aspects of the approach. They considered it emblematic of the success of the framework that the United Kingdom had the lowest inflation rate in the European Union at the end of last year, and some of the lowest long-term bond yields in the world in early 2000. Directors noted in this regard the potential tension between the need to be both forward-looking, including about possible future policy actions, given present prospects, and the need to be transparent. In considering the staff argument that the Monetary Policy Committee's modeling framework should include a policy reaction function rather than assume a constant interest rate, all Directors agreed that policies need to be considered dynamically, and that in fact policies are formulated in a forward-looking manner in the United Kingdom. Moreover, most Directors believed that, as the transparency of the U.K. monetary policy framework is already among the highest internationally, attempts to incorporate a forward-looking view of interest rates into the published forecast could risk misleading markets and the public. Several Directors noted that these concerns should not be interpreted as precluding further progress in improving the forecasting framework by endogenizing future policy responses.

Directors considered that the fiscal framework provided a significant measure of assurance both that needed infrastructural investments would be carried out and that the public finances would be managed prudently on a sustained basis. Some Directors felt that, while the golden and debt sustainability rules provided useful guides to fiscal policy, these rules did not adequately constrain policy at present and left scope for sizable spending initiatives. They noted that there was room for adopting tighter rules, for instance, to require overall balance over the cycle. Some other Directors, however, considered that tighter fiscal rules, while perhaps helpful in the medium term should current measures prove inadequate, are unnecessary given the current cautious stance of fiscal policy. While welcoming the efficiency gains and improved public resource allocation arising from the strengthened fiscal framework, Directors cautioned against increased resort to indirect means of funding new initiatives such as tax expenditures. Some Directors also noted that, while fiscal transparency was high by international standards, it could be further strengthened by improvements in the area of budget reporting.

Directors praised the authorities for focusing long-term policies toward achieving greater equity and strengthening productivity. They commended the government's recent welfare and labor market reforms that were aimed at strengthening incentives to work, particularly among jobless households. A few Directors expressed concern about the recently announced increase in the national minimum wage, noting that it had been introduced in exceptionally propitious economic circumstances, and that adverse effects on unemployment might become evident only during an economic downturn. Directors welcomed the intention underlying the proposed pension reforms to increase the savings and coverage of those who at present are not adequately covered. They cautioned against any risk that the reforms could substantially enlarge future fiscal liabilities or increase the costs of employing low-income workers.

Many Directors agreed that closing the productivity gap vis-à-vis other major industrialized countries was an important long-term challenge for the United Kingdom, which would require increased private and public investment on a sustained basis. Given the already strong real exchange rate and the risks of relying excessively on foreign savings, they considered that the most effective means to achieve this expansion in investment would be to increase public saving.

Directors commended the authorities' initiatives to increase competition, encourage innovation, and put in place appropriate regulatory regimes. They noted that the new financial structure seemed to be performing satisfactorily, with the key role of the Financial Services Authority (FSA) being that of regulating the increasingly integrated and complex financial services industry, and the role of the Bank of England being that of ensuring the overall stability of the financial system. It was suggested that a further examination of the experience of the FSA would be useful, especially for countries considering institutional reform of their own financial supervisory functions.

Directors agreed that entry into EMU remains a key medium-term decision for the United Kingdom. They considered that, while many considerations would influence the decision whether to join, an overriding economic case for or against entry could not be made at the present time. However, many of the factors affecting this decision, such as differences between the United Kingdom's and the euro area's relative cyclical positions, and concerns over wage flexibility in the United Kingdom, were likely to change over time. The Fund must continue to focus on this critical policy issue in its ongoing surveillance activities.

Directors praised the authorities' initiatives to relieve the debt burden of the poorest countries and their commitment to increase overseas aid spending, and in this connection, they welcomed the recent increases in such assistance. They encouraged the authorities to accelerate progress toward the UN target for overseas aid spending of 0.7 percent of GNP from the 1999 level of 0.27 percent of GNP.

The United Kingdom publishes data on a sufficiently timely and comprehensive basis to permit effective surveillance.