Transcript

Washington, DC, March 5, 2007
Teleconference call with Susan Schadler, Deputy Director of the European Department and Mission Chief to the United Kingdom
James Morsink, Division Chief for the United Kingdom in the European Department

MS. LOTZE: Thank you very much. Good morning everyone, well, and good afternoon and welcome to this conference call on the release of the documents of the IMF Article IV consultations with the United Kingdom.

My name is Conny Lotze with the External Relations Department. I am joined by Susan Schadler, Deputy Director of the European Department and Mission Chief to the U.K., and James Morsink, Division Chief for the U.K. in the European Department. Susan is actually joining us from all the way in Turkey.

As you know, the Public Information Notice, Article IV Staff Report and the Selection Issues Paper have already been released earlier today. This conference call is on the record. Before we open the floor to questions, Ms. Schadler will make some opening remarks. Ms. Schadler, please go ahead.

MS. SCHADLER: Thanks, Conny. Well, just to start things off, I would like to remind you that the objective of the Article IV consultation was to assess macroeconomic developments and policies in light of global and domestic risks and opportunities. Let me say a few words about what our broad conclusions were.

First, the recent record of strong and steady growth in the United Kingdom is likely to continue. We project GDP growth close to 3 percent in 2007-08 with inflation gradually going back to target by late 2007. Sterling has also been stable and strong, and though the current account deficit has risen slightly, we see no immediate concerns for competitiveness.

We largely agree with the authorities' recent policies and near-term policy plans. The fiscal deficit has come down entirely owing to increases in revenue so far. We applaud plans for further reductions to rely more on expenditure restraint after the Comprehensive Spending Review is completed later this year.

On monetary policy, it has had to deal with the recent spurt in inflation. We feel that the interest rate hikes of the past year were the right response to the threat of second round effects from energy price increases and the tightening of economic slack.

So because we have quite a high degree of agreement between ourselves and the authorities on the near-term prospects and policies for the economy, the mission focused mostly on whether the economy and policies are well positioned to respond to any domestic or global risks that might materialize going ahead.

The risks that we see as most significant for the U.K. are, on the upside, stronger than expected effects on demand or supply from immigration and, on the downside, a correction of house prices or global financial market turbulence that would push interest rates substantially higher. By and large, we believe that the U.K. is reasonably positioned to respond to such risks, though understanding the effects of any shock, if it were to occur, and acting on it quickly would, of course, be always a challenge.

Let me comment on a few different ways that we looked at the response to any possible materialization of risks that could occur. On interest rates, which we see as being broadly in a neutral range, we feel that they are well positioned to move in either direction should it become necessary. In fact, a major focus in our talks with the Bank of England was how to disentangle the increasingly complex influence of inflation from globalization. Here, the immediate concerns or considerations are the Asian productivity shock, immigration, and more generally, a possible decline in the responsiveness of inflation to interest rate changes as globalization becomes more pronounced.

The financial sector is strong and well supervised with a principle-based approach. The fiscal framework is good, and the mission focused on how to build fiscal cushions needed to respond to adverse shocks. In particular, looking ahead to the framework over future cycles, we noted that debt is likely to rise to just under 40 percent of GDP over the next few years. This in itself is not a concern, and it still constitutes one of the lowest debt ratios among G-7 countries, but it does call into question the ability to keep debt below 40 percent of GDP at all times in the event of adverse developments in the economy. So we recommend that the fiscal deficits be stabilized at about 1.5 percent of GDP, and this would allow the debt ratio to be brought back gradually to a level that would make it possible to recommit to keeping debt below 40 percent of GDP at all times while preserving space for fiscal policy responses to adverse economic developments.

More generally, I would really like to emphasize that we remain highly impressed by the openness and flexibility of the U.K. economy. This is one of its greatest assets in preserving strong performance and resilience in the face of any shocks in global or domestic conditions.

That is a brief summary of what we covered in the consultation and the substance of the IMF's Executive Board discussion of the U.K. Article IV consultation last Wednesday.

I think we could turn to questions now.

QUESTIONER: One area where it said in the report that your opinion differs slightly from the U.K.-from the Treasury-is that they are quite sanguine about the future path of house prices. You said, in this report and indeed in previous reports, that you were concerned that they are overvalued. I just wondered if you might be able to clarify to what extent you feel they are overvalued and whether you feel they have become more overvalued in the past year and also whether the chances of a sharper correction have increased?

MS. SCHADLER: For the past few years, the question of a possible overvaluation of house prices, of course, has been on our radar screen in the consultations. I would say that there is a little bit of a change this year, perhaps slightly, I don't want to say less concern but having lived with the situation for longer, it makes you a little bit more comfortable than when it first emerges. Of course, how you value house prices depends on interest rates, and so what seems appropriate at one level of interest rates could change if the level of interest rates were to change very sharply. So that is one of the reasons that we are concerned about how resilient the economy would be in the event of sharp and large changes in interest rates.

Certainly, if we look at standard measures of overvaluation that are done not only in the IMF but in other places, there is a huge range of opinion about the degree of possible overvaluation ranging from pretty close to zero to something considerably higher. I have seen figures of 30 percent or so.

I think anyone has to say there is just a lot of uncertainty related to any kind of estimate based both on the parameters of the system-the interest rates that are present at the time-and the supply response looking ahead and so forth. Those things are not going to be set in stone.

But the second thing that has happened over the past years is that there was this period of stability during 2005 followed by a renewed more moderate increase during 2006. The fact that very rapid pace in 2004 calmed down and then reverted to somewhat of a slower increase makes us a little bit more comfortable about the prospects for stability in house prices, but this clearly remains an area where there is a large divergence or large range of opinions.

QUESTIONER: I am just wondering, could you take us a little bit more in detail about the state of the public finances on why do you think that this 40-percent barrier is now under threat and how confident are you about the measures that the U.K. has outlined to you so far regarding its comprehensive spending review, that those measures will indeed rein in the deficit to the extent that this barrier won't be reached.

MR. MORSINK: On the 40-percent ceiling, net public debt to GDP has been rising for the past few years and is now at about 37.5 percent of GDP, and on current policies and current projections, we would anticipate that it would keep rising for the next couple of years before stabilizing. So that is why we are more concerned now than we have been in the past about the 40-percent ceiling.

Turning to your second question about how confident we are in the measures, I would say that the government has thus far demonstrated its commitment to spending restraint in the spending plans that it has already reached agreement with several ministries. I believe with the home office, it has reached an agreement for zero-percent real growth, and with some smaller ministries such as the Department for Work and Pension, the HM Revenue and Customs, and the Treasury itself, for actual declines in real terms over the period covered by the forthcoming comprehensive spending review.

I think we also saw last week, the initial bargaining with some of the labor unions in the health sector. That also shows the government's determination to make sure that pay increases are affordable and consistent with the 2-percent inflation target over the medium term.

QUESTIONER: I guess what you are saying is the evidence you have so far suggests that this will be a manageable target.

MR. MORSINK: I guess what I am saying is that we have seen, thus far, that the government has taken actions in line with this commitment. I don't, by any means, want to suggest that this is going to be easy. I think that reining in the growth of public spending is going to be a challenge, coming after a period when public spending has risen quite sharply. Moving to a situation where public spending on the whole is going to be rising less than nominal GDP growth is a challenge, and so we look forward to the plans that will be announced in more detail as part of the comprehensive spending review to flesh out the details of these more general projections.

QUESTIONER: I just have something to follow-up to the question just previously about the fiscal situation. I remember about two years ago when the IMF was saying that the Chancellor needed to take action on the fiscal situation, that he needed either to raise taxes or to cut spending. At that stage, Gordon Brown, I remember, stood up in Washington and said, well, we don't agree with the IMF's projections.

Since then, it seems that you both kind of agree with each other a lot more. I mean the current report seems slightly more conciliatory. I was wondering in hindsight, who was wrong, the IMF or the Treasury?

MR. MORSINK: I would say we were both right.

QUESTIONER: You are not allowed to say that. [laughter]

MR. MORSINK: Okay, well, let me just give you some evidence for my answer. On the one hand, I think we were right in the sense that the government did raise taxes somewhat. There was the increase on taxes on North Sea Energy Corporations. There were also some smaller tax increases such as the increase in air passenger duties and other smaller measures. So, on the one hand, taxes have gone up slightly. There have been measures that have raised tax revenue.

On the other hand, tax revenue has come in, I would say, stronger than even we expected, and this we largely attribute to the strength of the financial sector and also to relatively high energy prices.

I would say we were both right, and I think I will leave it at that.

QUESTIONER: Can I ask a follow-up question? There was one interesting line in the report which I am just trying to search out at the moment, which talked about, here we are, it says current plans to focus.

It is about the spending, tax and spending plan. It is paragraph 41: Current plans to focus this consolidation on spending restraints are appropriate, given that further increases in tax rates would risk adversely affecting incentives to work and invest.

I don't remember that from the previous report, and I wonder whether the message of this is that we have now hit a level of the tax burden, the tax GDP, where it is no longer really appropriate to increase taxes and any changes in the fiscal situation have to come through spending cuts. I mean is that a fair assessment?

MS. SCHADLER: Well, no, I think that is a little bit of a misreading. I mean the language changes from year to year. So I think you are probably reading more into it than what should be there.

We have, for the past several years, pointed to the need for reduction in the fiscal deficit, and we have continuously said that this should be done through measures on the expenditures side. That is the best way to do it. Now, it is true, as Jim just said, there have been some measures on the tax side in the past couple of years, and so revenues have gone up. There has also been additional buoyancy, revenue increases that have come not because of tax measures but because the economy has just produced more tax revenue in the process of growing more rapidly. It is true that the revenue ratio has moved up a little bit over the past couple of years, and that probably heightens, a little bit, the message that moving ahead, the fiscal adjustments should come on the spending side.

But it has very much been a theme. The group of us who you are talking to now, who have been working on this, this is our third year working on the U.K., but I think even before our time, there was a fairly consistent line that expenditure has accelerated very rapidly during that period, 2001, well, even up through 2005, and then going ahead the retrenchment that was needed was going to have to come on the expenditures side. So I don't see this as anything outside the framework of what we have been talking about, although the point is reinforced because the revenue ratio is a little higher now than it has been in recent years.

QUESTIONER: It just seems slightly more explicit this time around. I remember previous ones, and I know that it has been the policy to talk about cuts in spending rather than increasing taxes. It just seems slightly more explicit this time around. That is my opinion.

MS. SCHADLER: Well, I am not sure that there is anything intentional there, and I think that the real point here is that the government has started making provisions for containing the growth of spending and has a Comprehensive Spending Review in which it is committed to restraining spending growth going ahead, that is just about to come out.

I think we want to make sure that we strongly support those national intentions to rein in spending, both through the actions that Jim just discussed and through the Comprehensive Spending Review. So I think, if anything, it is only to reinforce what the government is saying it plans to do is exactly what we believe it should be doing.

QUESTIONER: I had a question regarding the inflation projection. There was some mention that it is expected to fall back towards the target by the end of 2007. The table in the back shows it being steady at 2.3 percent for the CPI in 2007 and 2006. Could you explain the apparent difference there and also can you discuss a little bit the factors that would lead to an easing of inflation?

MS. SCHADLER: This is an average CPI and not an end-of-period CPI. But, yes, Jim, go ahead.

MR. MORSINK: That is exactly right. The numbers in the table are annual average numbers over the previous year's annual average whereas the CPI figures, the headline CPI figures are the change over 12 months. So those two numbers are not strictly comparable. On a 12-month change basis right now, we have CPI at about 2.7 percent, but that is very much consistent with the projections that you see in the table.

Going forward, the main factor that is going to bring headline inflation back down to 2 percent is the fading of the very sharp energy price increases that we had through mid-2006. Since mid-2006, energy prices have fallen a little and more recently gone up a little, but broadly speaking, the big increases that we saw between end of 2003 and mid-2006, those big increases are going to be passing out of the CPI in the next few months. Therefore, we expect that by the end of this year, year on year CPI inflation will fall back to the target.

QUESTIONER: Just one thing on interest rates, you talked about the evolution of wage growth as really being the swing factor, and I guess what you just said about energy prices pulling down headline CPI would emphasize that. Do you have any earlier considerations or conclusions as to how the prospects of wage growth are indeed evolving?

Are you confident that things seem to be relatively on track on wage growth or are there early concerns that this may indeed necessitate tightening? Thanks.

MS. SCHADLER: So far, wage growth has been very contained over recent months. In many senses, the signs are good. I think the concern is that with inflation now above the target and having been above the target for some time, it could begin to affect inflation expectations and then feed into wage increases, but there isn't anything obvious at the moment, any actual developments at the moment that would give rise to major concerns so much as our concerns about our understanding of the wage formation process going ahead and the risks that are in that.

I don't know. Jim could give you perhaps more numbers on what wage increases have been recently.

MR. MORSINK: Yes, I would just add that private sector average earnings growth excluding bonuses, which is our sense of underlying private sector wage growth, has been flat at 3.8 percent year on year for the past few months. So I would just echo what Susan said which is that, thus far, we have not seen signs of wage growth picking up but that there is a risk that it might do so and that is what we need to watch out for.

QUESTIONER: Sorry, if I could follow-up on just the interest rates again, when you look at the housing market, where do you guys stand on this question of whether there should be a leaning against the wind or whatever the right analogy is in order to prevent, to address the very high housing prices?

Is it something that the Bank of England should be trying to tackle as part of its inflation targeting mandate or is the housing market really not an issue in terms of their work?

MS. SCHADLER: You know an inflation target, strictly speaking, is targeting inflation. To the extent that house prices feed into inflation, they need to be, strictly speaking, taken into account and factored into interest rate decisions. Should the interest rate be targeting the level of house prices? The best practice on inflation targeting is not to target things other than inflation, and house prices would be one of those things. Especially, as I said earlier, there is a huge amount of uncertainty about whether house prices are overvalued, if they were overvalued, how much if would be and so forth. It would become a very speculative thing for monetary policy to do more than take into account the impact of increases in house prices directly on inflation.

MS. LOTZE: If there are no more questions, then we will complete the conference call here. Thank you very much, Susan in Turkey, and thank you very much everybody for participating in this call. Goodbye.

[End of conference call.]