"While recognizing that our individual circumstances may vary, we share a common commitment to a medium-term economic strategy: Credible fiscal consolidation programs, successful anti-inflationary policies and as a consequence low interest rates and strengthened structural reform."
The United Kingdom has undertaken an extensive program of government restructuring, market reforms and fiscal restraint over the past few years. The result is a sixth year of increasing real GDP growth and a reduction in the fiscal deficit.
The successful taming of the deficit has allowed the UK to enjoy stable price inflation in the range of 2.6 to 2.9 % over the past three years close to the stated government goal of 2.5%.
Unemployment has consistently declined from 8.2% in 1995 to approximately the 6% range today. Behind Japan and the United States, the UK has the lowest unemployment rate in the G-7. Interest rates both short and long-term are very stable varying less than a full percentage point over the past three years on both counts.
Although overall government expenditure is expected to rise in fiscal 1997-98 increased revenues has reduced the deficit. The fiscal debt is forecast to be eliminated by year 2000-01 along with borrowing requirements.
The pound sterling has been strong and stable and the announcement by the new government of new independence for the Bank of England has lent credibility and a sense of security that fiscal responsibility and low inflationary policies will be continued by the new government.
Britain had made significant headway in keeping with this commitment. After three years of accelerating inflation from 1993 to 1995, CPI inflation dropped in 1996 to 2.4% from 3.4% in 1995. However, as the general elections approached, the year over year inflation rate picked up to around 2.7% in the early months of 1997. The Bank of England has raised rates twice since the May general elections but there are concerns that this has come too late to ease inflation in 1997. CPI inflation is now expected to pick up again in 1997, perhaps reaching 2.8%. Britain is given a full score for this commitment because the new Labour government has clearly indicated its commitment to price stability by granting the Bank of England autonomy.
In October 1992, the Bank of England adopted inflation targets which specified the lower half of the 1-4% range by spring 1997 and 2.5% or less thereafter. The relevant price index targetted is the retail price index excluding the large mortgage interest payment component.
As in Canada, the Bank of England actually targets a narrower price index than the CPI. In Britain, the targetted retail price index excluding mortgage payments will likely meet the target if only just. The performance of the benchmark retail price index excluding mortgage payments (RPIX) has been at variance with the CPI because of movements in mortgage rates. RPIX inflation stayed flat at 2.9% in 1996 but is expected by the IMF to drop in 1997 to 2.6% in 1997.
Until May 1997, the Bank of England has conducted monetary policy under the direction of the central government. The central government issues real indexed bond which provides a useful measure of the market consensus on expected inflation and consequently on the credibility of the inflation targets. Immediately following the general election in May, the new Labour government announced its intention to grant greater autonomy to the Bank of England in the conduct of monetary policy. The precise details of the autonomy have yet to be decided on. The central government issues real indexed bond which provides a useful measure of the market consensus on expected inflation and consequently on the credibility of the inflation targets.
Britain has not committed itself to entering the EMU and so is not bound to meet the inflation target set out in the Maastricht agreement. However, the central government has nonetheless adopted a policy of shadowing the Maastricht target. The matter remains undecided under the new Labour government.
The inflation criterion is that inflation should be less than the average of the three lowest inflation rates plus 1.5%. The average of the three lowest inflation rates - in Finland, Sweden and France - was about 0.5% in 1996 which implies a Maastricht target of not more than 2.0%. However, according to the IMF, the reference for 1997 has now probably increased to about 3.1%. Barring any crisis, it appears likely that Britain will now meet the inflation target.
---The economy and inflation---
The performance of the British economy is in sharp contrast to the mainland European G7 economies and more in line with the US economy. The British economy, like the major European economies, has also passed through a period of both inflation and deficit reduction that has weakened the economy. However, Britain postponed these measures until the economy had more clearly recovered from the prolonged recession in 1990-1991 and the recovery was buttressed by the sharp depreciation of the currency in 1992. But perhaps more importantly, the British economy has benefited from the structural reforms of the economy enacted under the Conservative government, especially in the labour market. In contrast to the EU partners, the British economy has therefore been better placed to weather the more recent inflation and fiscal deficit reduction. Economic growth has remained resilient averaging 2% over 1992-1996, and the unemployment rate by early 1997 had fallen to almost 6%. The stronger performance of the British economy is reflected in the IMF 1.9% estimate of the output gap for Britain in 1996. This is above that in the US but far below that in the other G7 countries which are nearer 3%. The relatively small negative output gap and the relatively low unemployment rate in Britain implies that Britain is closer to the point in the business cycle when inflationary pressures can be expected to build up again.
Following the sharp increase in short term interest rates to over 15% in 1990 and the ensuing recession, CPI inflation in Britain plunged from around 10% in 1990 to 1.6% in 1993. In contrast to the major EU partners, Britain eased monetary policy and monetary conditions quite considerably at the end of 1992 and lowering interest rates allowed the pound to plummet versus the DM and out of the ERM. The build up in inflation to over 3.4% in 1995, obliged a tightening of monetary policy that was accomplished through higher interest rates in 1995 and 1996 and subsequently the appreciation of the pound versus the DM in 1996. Monetary conditions in Britain remain tight. Although the 3-month T-bill rate has declined to around 6% - a level last seen in the early 1970s - it remains high relative to the low inflation rate. The tightness in monetary conditions is accentuated by the strong appreciation of the pound through 1996 and into early 1997.
The British economy has started to show some considerable strength at the tail end of 1996 and into 1997 with annualized growth topping 4%. The IMF now expects the annual average growth to reach 3.3%. This has been accompanied by strong gains in the unemployment rate which by March has dropped a full percentage point from six months earlier. This has prompted the Bank of England to raise interest rates twice since the May elections. The rate hike is expected to dampen growth through the year and, supported by further gains in the pound, the worst of the build up in inflationary pressures has probably passed. Consequently, the CPI inflation rate is expected to ease and the annual growth in the CPI will likely remain flat at 2.4%. RPIX inflation in 1997 will probably drop to 2.6%
Britain has made significant progress in reducing the deficit as a share of GDP. However, there are concerns because the Conservative government failed to address the risk of missing the Maastricht deficit target in its pre-election budget. And the new Labour government has not yet given any sign of announcing supplementary measures.
The central government deficit which almost entirely accounts for the general government deficit has declined from 8.0% of GDP in 1993 to 4.5% in 1996. The IMF expects a further drop 3.2% of GDP in 1997. This significant improvement is only partially the result of a structural reduction in the deficit and the strength of the economy has made a significant contribution.
Britain has not committed itself to the meeting the fiscal deficit target of the Maastricht agreement. The matter remains undecided under the new Labour government. However, the central government has nonetheless adopted a policy of shadowing the Maastricht target. The Maastricht fiscal criteria call for the general government deficit and debt to fall below 3% and 60% of GDP respectively. Since the Maastricht fiscal criteria refer to the general government account and not just to the federal government, this should be a consideration in the assessment of the central government's compliance with the Lyons commitment towards fiscal consolidation.
Successive budgets since the 1990-92 recession have aimed at reducing fiscal deficits through a revenue based program of controlling expenditures and raising tax revenues through non-distortionary tax reform (i.e. by shifting the tax burden from direct to indirect taxes) . Despite the significant decline in the deficit since 1993, the reduction was less than expected because of revenue leakage. But the main cause has been the failure to address current expenditures.
---Neutral 1996/97 budget---
The 1995/96 budget had presented measures to target deficit reduction in line with the Maastricht deficit target. Consequently, the 1996/97 budget was fiscally neutral reducing both expenditures and revenues equally. The main tax measures ere a one penny cuts in the personal income tax rate, a reduction in the employer national insurance contribution tax, increases in tobacco and gasoline taxes offset by cuts in liquor and natural gas taxes. Increased expenditures on health , education and the police were offset by cuts to administration and public investment. However, as matters turned out, the 1995/96 deficit at 5% of GDP was a full percentage point worse than expected, primarily due to an overly optimistic economic outlook and significant revenue slippage.
---Political budget for 1997/98---
Despite the deficit overrun and because of the impending general election, the 1997/98 budget announced in November 1996 failed to take the adequate fiscal measures required to meet the Maastricht target.. , The budget did impose a small degree of fiscal tightening by increasing revenues more than expenditures. Expenditures on health, education and the police were again increased at the expense of administration. Tax measures included another one penny cut in basic personal income tax rate, an increase in the personal income tax exemption ceiling, an increase in air passenger duties. The new budget projects a reduction in he general government deficit from 4.1% of GDP in fiscal 1996/97 to 2.6% in 1997/98 for a projected average of just under 3% in calendar 1997.
Most of the gains in the deficit are based on optimistic real GDP and hence revenue growth projections. Consequently, the deficit is expected to remain just above 3% of GDP in 1997. The new Labour government has not to date announced any new fiscal measures.
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