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At the conclusion of annual Article IV bilateral discussions with the authorities, and prior to the preparation of the staff's report to the Executive Board, the IMF mission often provides the authorities with a statement of its preliminary findings.
 
United Kingdom - 1999 Article IV Consultation

Concluding Statement of the Mission

November 24, 1999

1.  The performance of the U.K. economy in recent years has been remarkable. Real growth has been high, unemployment has declined steadily to very low levels, and inflation has remained subdued. Moreover, shocks to the economy have been absorbed more easily than expected, with the growth of the economy picking up strongly with the passing of the late 1998 slowdown in world trade. This strong performance is in good part owing to the improved policy framework which has fostered sound monetary and fiscal policies and significant structural reforms. The public finances, in particular, have clearly shifted into the "sound" range, from significant deficits to a small surplus. And monetary policy is clearly intent on delivering 2 percent inflation, as evident from the decisions first to tame inflationary pressures in early 1998 and later to reverse course when it became apparent that those pressures would be offset by deflationary forces from abroad. Looking forward, there is ample reason to expect this stability oriented framework of policies to continue to prevail--a prospect that augurs well for the tenor of economic prospects over the medium term.

2.  In the short term, however, the risks are predominantly on the upside even if these may be mitigated for a while by special factors and possible structural shifts in the economy. With output at about potential or trend levels, consumption demand buoyant, exports strengthening--notwithstanding the high level of sterling--and labor markets tight and seemingly set to tighten further, overheating pressures seem likely. Indeed, service sector prices already suggest as much. By the same token, pay settlements remain moderate, suggesting a possible downward shift in the structural rate of unemployment. The large number of settlements scheduled for early next year should permit coming to a firmer view. The near-term outlook for price inflation also looks benign, reflecting the lagged effects of sterling appreciation and declines in price-cost margins due to increased competition and deregulation. On balance, however, we expect output pressures to predominate in time so that the issue is when, not whether, to tighten. We thus expect official interest rates to increase further.

3.  Under these circumstances, there is no case for relaxing fiscal policy. To do so would exacerbate the upside risks and not fit well with the fiscal framework. Admittedly, the fiscal balance is turning out stronger than expected in the budget, but these gains are largely, if not wholly, transient in nature, and hence not grounds to relax policies. The bulk of the gains appears to be cyclical, reflecting the greater buoyancy of the economy. While a small part may reflect improved tax compliance and prove more enduring, such surprises have proven fleeting in the past. The United Kingdom's history of excessive optimism regarding the underlying strength of the public finances in good times, together with the need to safeguard the credibility of the government's newly-established fiscal framework, underscores the need for a cautious approach. For these reasons, we welcome the prudent approach espoused in the PBR and urge that next year's budget aim to preserve the structural gains achieved this year.

4.  As recent calls for increased expenditure and tax cuts suggest, public understanding of the fundamentals of the fiscal framework--to eschew the spending of buoyant receipts in good times so as to avoid painful cuts in bad ones--remains to be firmed up. This is notwithstanding the U.K.'s enviable record on fiscal transparency from an international perspective, including the significant steps taken over the past year. We welcome, in this regard, the efforts to clarify the effects of the business cycle on the budget forecast and to explain the methods of analyzing fiscal policy under the new framework, as well as improvements in the public finance statistical releases of the ONS. Looking forward, experience elsewhere suggests that public understanding could be enhanced by quarterly Treasury reports analyzing developments in the key fiscal expenditure, revenue, and balance indicators and how these compare with the expectations embodied in the budget plans. In addition, while the various budget reports have become increasingly useful, it would help to continue developing a standardized and consistent set of tables that would be appended to each budget report.

5.  The new monetary policy framework is working well at providing an anchor for inflation expectations. Indeed, not only have inflation expectations declined towards the announced target of 2 percent, but there is also clear evidence that market participants anticipate the changes in official interest rates that they believe are consistent with achieving these objectives. This points both to the central role of the symmetric inflation target and to the credibility of the framework. We also welcome the steps taken over the past year to reflect in the Inflation Report the diversity of views within the MPC. But more needs to be done, notably as regards how the risks and tensions embodied in the forecast might get resolved through future interest rate action. For instance, it is clear from the latest report that there is a tension between the risks of underlying inflationary pressures, on the one hand, and short-term uncertainties regarding the exchange rate, margins, and labor market developments, on the other. In the forecast, these tensions get resolved with inflation projected to speed through the target some eight quarters from now. This result, which is rooted in the procedures used--especially in the constant interest rate assumption--implies a progressive easing of real monetary conditions over the forecast period. The juxtaposition of accelerating inflation and easing real monetary conditions is surely not the Committee's intent. Thus, although we recognize that significant issues attach to central banks' revealing how policy interest rates might change, we continue to urge a more consistent and less constrained approach to the elaboration of the forecast--notably as regards the assumptions on interest rates--as well as to the forecast horizon. We also welcome the Bank of England's publication of its models, and look forward to their availability, along with the underlying data, in electronic form.

6.  With the economy seemingly set on a course of sustainable growth with low inflation and reasonably high levels of resource utilization, policies have increasingly focused on wider social goals, notably strengthening the situation and prospects of the poor and increasing the overall efficiency of the economy. The case for these policies is clear: the poor have been disadvantaged by the turbulences of the past and by adverse incentive structures that perpetuate poverty; and the productivity of the U.K. economy has not compared favorably with that of some of its main trading partners due mainly to lagging skill levels and rates of capital formation. The policies being designed and implemented to address these issues are in many ways as ambitious as those in the macroeconomic area and are to be welcomed, at least in terms of their broad thrust and direction. Nonetheless, we would underscore some cautions, as there are aspects that will need to be thought through fully, e.g. in the context of the upcoming spending review.

7.  First, although less binding than heretofore, resource constraints remain a fact of life, and the challenge for policy is to establish a strategy that enables the best use of the national resources in pursuit of the goal of raising productivity and long-term growth. Specifically, there is a persuasive case for seeking and sustaining quite high rates of private and public investment, including human capital investment, over the medium term if the United Kingdom is to make up some of the productivity gap vis--vis its main partners. In this vein, an important part of the Government's fiscal strategy is aimed at protecting planned increases in public investment from pressures for higher current spending. This is very welcome and far sighted. But it is also possible that more public investment will lead to a crowding out of private investment. Moreover, unless domestic saving rises, increases in total investment will need to be financed from abroad. Is this optimal, particularly in light of the potential implications for the real exchange rate? To minimize these risks, is there a case for curbing current spending? These are complex questions, all the more so since strong cases can be made for increases in many of the more growth-enhancing forms of current spending, notably education. But, at the end of the day, the search for policies that lastingly raise the potential rate of growth of the economy will need to consider the balance between domestic and foreign saving. Given the U.K.'s history, we would err on the side of caution in relying on foreign savings and place greater emphasis on raising domestic, particularly public, savings.

8.  The foregoing implies a need for vigilance in the public finances not only in the short term, but in the long term as well. As regards spending, the new budgetary structures seem to be working out reasonably well. It will be important to sustain these plans through the next spending review and indeed prioritize even more strongly within current spending. As regards tax policy, the envelop is becoming more binding. One way forward is to cut the many tax expenditures that remain embedded in both the direct and indirect tax system. To the authorities' credit, progress continues to be made in this direction, notably with the elimination of the mortgage interest relief (MIRAS). However, there is room for more, especially since tax expenditures remain a popular way of dealing with narrow issues and funding new initiatives. In our view, a more neutral tax system remains the best approach to improving the overall functioning of the economy.

9.  A warranted exception in this regard is the Working Families Tax Credit (WFTC). The Government's welfare reforms, including the New Deals and the WFTC, are aimed at alleviating well-known and documented externalities, and hold great promise for combating poverty and reducing the number of jobless households. While the initial results of the New Deals for Youth have been encouraging, more time is needed to fully assess the effects of the various programs on labor force participation and income distribution. In particular, the programs clearly have a strong redistributional and long-term cast, and it is too early to assume that they will generate significant positive macroeconomic effects in the near term as well. The positive net effects on participation may be moderate since the tax measures entail disincentives for second earners in a household. This is not to detract from the considerable possibilities for achieving the principal goal of breaking the intergenerational cycle of poverty perpetuated by the relatively high incidence of households with no working adults. Progress is likely to prove more challenging as the New Deal is expanded to the larger group of older unemployed or inactive workers, worthwhile as such initiatives are from a social or longer term point of view.

10.  We would also urge an equally cautious approach to evaluating the benefits of the introduction of the National Minimum Wage. We are pleased to note that it has not so far had any discernible employment effects, but hard information on that score is scant at best. More fundamentally, it will also be essential to analyze the effects in periods of economic weakness. Until such time, it is important to maintain the minimum wage and the lower rate for youth and trainees at their present levels.

11.  The pension reforms proposed by the Government have potentially far-reaching implications for the pension system as well as for the long-term fiscal position. The present U.K. system has the major advantage over typical industrial country pension schemes in that it is largely private and funded, with a limited future fiscal burden stemming from demographic pressures. However, the current scheme may not provide an adequate social safety net, particularly for the low-income segment of the labor force. We would encourage a clearer articulation of the Government's intentions with regard to pension reform and clarification of key issues such as the respective roles and responsibilities of the government, individuals, and private financial institutions; whether the administrative costs of stakeholder pensions can be kept low enough to make them a feasible option for low-income groups with volatile employment histories; and potential increases in labor and fiscal costs. The future fiscal cost will need to be carefully and transparently assessed since given the pay-as-you-go character of the state pension system, decisions today can cumulate over decades to a sizeable fiscal burden.

12.  The consolidation of supervision under the Financial Services Authority has proceeded smoothly. Prudential regulation is being streamlined and strengthened, and we fully expect that the FSA will continue to meet the challenges of supervising the increasingly integrated and complex multi-sector domestic and international financial institutions.

13.  As regards EMU, the United Kingdom clearly satisfies the fiscal and inflation elements of the Maastricht criteria and is undertaking preparations for entry should a decision to do so be made. We welcome the publication of the Government's contingency changeover plans which aim to ensure that procedural aspects of joining are anticipated and addressed accordingly.

14.  We commend the authorities for their efforts and contributions to relieve the poorest countries' debt problem and for their commitment to increasing U.K. overseas aid spending. We encourage the authorities to accelerate progress toward achieving the U.N. target of 0.7 percent of GDP.