The United Kingdom’s macroeconomic performance over the past decade has been enviable. Not only has it secured the highest per capita GDP growth among the Group of Seven major industrial countries (see Chart 1), but it has done so with the lowest volatility while maintaining low and stable unemployment and inflation.
In many respects, the recent U.K. experience is an example of preparation meeting opportunity. The economy has managed to harvest the fruits of two decades of sustained labor and product market reforms to reap the rewards of globalization in recent years (see table). Anchored by sound monetary and fiscal policy frameworks, the United Kingdom has also been able to respond to shocks in a flexible manner. But globalization is an ongoing process, and its future currents are hard to predict. This presents clear challenges for the country because, given its openness and integration with the world economy, global shocks can have immediate and sizable effects. Against this backdrop, macroeconomic and financial policies will need to be ready to help cushion the economy from future shocks.
Conditions are in place for continued robust growth and stability. Following a mild slowdown in 2005, growth has rebounded in the past year, driven largely by domestic demand. Consumption has rallied on the back of solid employment and wage increases, alongside rising housing wealth, while investment has responded to high net rates of return. Economic slack has diminished accordingly. At the same time, energy price increases have boosted inflation, which in turn has pushed up survey measures of inflation expectations to their highest level in years. In light of these developments, the Bank of England tightened monetary policy starting in mid-2006, raising the policy interest rate to a broadly neutral 5¼ percent by early 2007. Absent any major shocks, the outlook for 2007-08 is good: growth should fall back in line with potential, reflecting recent monetary tightening, and inflation should return to target by end-2007 as the impact of past energy price increases fades. If second-round effects of last year’s energy price increases were to push up pay deals, further increases in the policy interest rate could be needed. And, although the current account deficit will widen further in 2007, it should remain steady after that.
Chart 1Outperforming the G-7
The United Kingdom’s growth in national income per head during the past decade has been the highest among the major industrial countries.
Source: IMF, World Economic Outlook database.
Positioning to face risks
Despite these favorable fundamentals, there are risks. Some of them are on the upside, most notably from the possibility that immigration enhances productive capacity more than currently envisaged. On the downside, external risks dominate, especially in light of recent turbulence in global financial markets. A reversal of uncharacteristically low risk premiums, a rise in global interest rates, or an abrupt realignment of major currencies would increase credit and market risks in the U.K. financial system. On the domestic front, the likely overvaluation of house prices increases the risk of an abrupt downward adjustment. And the fallout would be greater if domestic and external risks crystallized at the same time. Positioning macroeconomic policies to be responsive to these types of developments will be critical to ensuring continued strong performance.
Monetary policy would be on the front line in the event of a shock to aggregate demand. The Bank of England should stand ready to lower the policy rate if the outlook deteriorates, because of either a sharper-than-expected global growth slowdown or an abrupt adjustment in house prices. More generally, globalization will continue to complicate the conduct of monetary policy in the coming years. For a start, increased immigration—including from new European Union member states—makes it more difficult to assess slack in the labor market. Uncertainty about future immigration further complicates this task. Second, it is possible that the deflationary impact of the Asian productivity boom will wane, either because the underlying boom itself peters out or because people come to anticipate wealth gains from falling prices. The same holds true for the deflationary effect of efficiency gains in the distribution sector. Third, some combination of globalization (specifically, more cross-border labor mobility, which dampens the link between wage setting and domestic labor market conditions) and more credible monetary policy appears to have weakened the relationship between domestic economic slack and inflation. The implications of these developments for monetary policy are not straightforward. While the Bank of England can worry less about short-term fluctuations in economic slack, it must also heed the increasing persistence of deviations of inflation from target, which would necessitate maintaining a tight stance for a longer period of time.
Creating a cushion
Given the downside risks to the outlook, fiscal policy should also play its role in securing macroeconomic stability, especially by building a cushion that would allow policymakers to respond to adverse shocks. After a few expansionary years, fiscal policy is now on a consolidation path; the deficit is expected to fall back to about 1½ percent of GDP by 2011/12. But such an adjustment will undoubtedly prove challenging, particularly because the government plans to rely mainly on reining in current expenditure growth. In this vein, the upcoming Comprehensive Spending Review will be crucial. Beyond the five-year horizon, it will be essential to keep the deficit at about 1½ percent of GDP to gradually reduce debt sufficiently below 40 percent of GDP to permit the government to maintain this as a ceiling at all times (see Chart 2). As these adjustments occur, the fiscal framework, undergirded by the two fiscal rules—the golden rule, requiring current balance over the cycle, and the debt ceiling—will guide the process and be a useful brake on discretion. To enhance the transparency of the government’s fiscal projections, the independent National Audit Office could be granted greater responsibility to audit a broader array of fiscal assumptions.
The U.K. economy is anchored by sound monetary and fiscal policy frameworks.
|Real GDP (percent change)||3.3||1.9||2.7||2.9||2.7|
|Unemployment rate (percent of labor force)||4.8||4.8||5.4||5.3||5.1|
|General government balance (fiscal year, percent of GDP)||-3.2||-2.8||-2.5||-2.1||-1.8|
|Consumer price index (percent change)||1.3||2.1||2.3||2.3||2.0|
|Current account balance (percent of GDP)||-1.6||-2.4||-2.9||-3.1||-3.2|Chart 2Beneath the ceiling
The fiscal deficit needs to be cut to keep public debt below 40 percent of GDP
Source: U.K. Treasury.
The financial sector will also play a crucial role in safeguarding stability, especially given the nature of the dominant risks and the United Kingdom’s position in the global financial system. Although the U.K. banking system is among the strongest in the world, certain vulnerabilities could come to the fore if some of the global risks were to materialize. Mounting leverage, especially among commercial property companies and parties to leveraged buyouts, is one source of vulnerability, and household debt trending upward is another. The linkages between the United Kingdom and other financial systems, while fostering risk transfer, mean that adverse shocks could hit widely and rapidly. These issues are at the heart of the authorities’ continuing efforts to improve the resilience of the financial system to shocks. Plans to enhance stress testing and international crisis prevention and management arrangements are especially welcome.
In conclusion, to sustain success in the United Kingdom, macroeconomic and financial policies must remain attuned to the changing global environment. Monetary policy will need to walk a tightrope amid competing risks, including those that emanate from globalization trends. Fiscal policy should be geared toward building a cushion to cope with possible shocks. And financial sector policies need to keep a close eye on vulnerabilities.
Anthony Annett and James Morsink
IMF European Department