SCOTTISH EXECUTIVE

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Scottish Economic Report: January 2000

1.5 The UK Context

1.5.1 UK Macroeconomic Policy

The UK's macroeconomic policy framework aims at promoting economic stability, while enabling policy to respond to economic shocks. Based on the principle that stability in macroeconomic conditions facilitates both growth in output and growth in employment, it forms part of an overall economic strategy which also incorporates raising productivity, increasing employment opportunities and promoting a fairer society.

The macroeconomic policy framework has two key components in the monetary policy and fiscal policy frameworks.

Fiscal Policy

The UK Government's Code for Fiscal Stability was issued in March 1998 and set out five key principles for the formulation and implementation of fiscal and debt management policy:

• Transparency in the setting of fiscal policy objectives, the implementation of fiscal policy and the publication of the public accounts.
• Stability in the fiscal policy-making process and in the way fiscal policy impacts on the economy.
• Responsibility in the management of the public finances.
• Fairness, including between generations.
• Efficiency in the design and implementation of fiscal policy and in managing both sides of the public sector balance sheet.

In line with the principle of transparency, the Government's fiscal rules were set out in the July 1997 Financial Statement and Budget Report, and are as follows:

• The Golden Rule: that is, over the economic cycle, the Government will borrow only to invest, not to fund current spending.
• The Sustainable Investment Rule: that is, net public debt (as a proportion of GDP) will be held over the economic cycle at a stable and prudent level.

The UK Government's fiscal approach draws a clear distinction between current and capital expenditure, and this underpins the Government's commitment to the Golden Rule. Departmental spending allocations will include a firm split between the two types of spending, with a presumption against moving funds from capital to current, except in certain defined circumstances. Previously, decisions did not accurately reflect how future generations would have to pay for current public spending and the arrangements tended to encourage cutbacks in capital rather than current spending.

In order to monitor compliance with these rules, the new format for public finances focuses on three measures:

• Surplus on current budget, or the difference between current receipts and current spending, which relates to the Golden Rule.
• Net borrowing, or the difference between net investment and surplus on current budget, which is a measure of the Fiscal Stance.
• Net public sector debt ratio, or public sector debt (net of certain liquid assets) as a percentage of GDP, which is relevant to the Sustainable Investment Rule.

Monetary Policy

UK monetary policy focuses primarily on the establishment of low and stable inflation through the management of the interest rate instrument. The Government's monetary policy framework gives the Bank of England's Monetary Policy Committee (MPC) operational responsibility for setting interest rates to meet the Government's inflation target of 2.5 per cent. The inflation target applies continuously, so it is necessary to consider interest rate decisions in a forward-looking context. Decisions take account of a wide range of information, typically about the international economy, monetary and financial conditions, demand, output and labour market conditions, reports by the Bank's regional agents, and various pieces of market intelligence.

In setting rates, the MPC recognises that there are time lags in the effects of interest rate changes on the real economy, and, in turn, on monetary conditions. Box 5 provides some background on the relationship between interest rates and inflation, and on the types of time lag which are involved and lengths of such lags.

One consequence of the delayed effect of monetary policy changes, and the need to ensure that inflation is on target over the Bank's two-year forecasting period, is that current policy must be set in anticipation of the macro-economic conditions that may prevail over this time horizon. Thus, current interest rates may be changed even though the current rate of inflation is within the target. The quarter point increases in base rates in September and November 1999 - taking the rate to 5.5 per cent - took place in such a context. More generally, rates will tend to be cut when the Bank judges that there are substantial risks of a future undershoot in inflation, or increased where it believes there are risks that inflation will go beyond the target level.

Some of the background to the Bank's approach to monetary policy was set out in more detail in a recent paper by its Deputy Governor ¹⁷. The paper points out that:

• Interest rate decisions focus on the economy-wide inflation target;
• To maintain stability, interest rates will go up or down, depending on the Bank's assessment of prospective supply and demand;
• The Bank's approach to monetary policy is 'pre-emptive', based on the view that early action can be beneficial. Hence, in explaining the rise in rates in September 1999, the paper points out that the early action could serve to lower the level of interest rates which might otherwise be needed.

Implications for Scotland of monetary and fiscal stability

These elements of UK monetary and fiscal policy are intended to lay the foundations for long run sustainable growth in UK output and employment. If UK policy achieves these objectives, the Scottish economy should stand to benefit in various ways. For example, UK GDP growth rates and Scottish GDP growth rates have historically been closely correlated (see Box 6 and Chart 1.7b). A high correlation in aggregate GDP is not an unexpected result as Scotland and the rest of the UK have shared both the same monetary and fiscal policy over the period and many similarities in overall economic and institutional structure. The high correlation is also likely to be greatly affected by the fact that the rest of the UK has been a major export market for Scottish goods and services; under such circumstances, growth and demand conditions in UK markets tend to have strong spill-over effects on Scottish growth, and vice-versa. In addition, of course, Scotland is a sub-set of the UK in statistical terms.

Moreover, because Scotland is an open economy, comparative inflation performance is important to international competitiveness. Continued low inflation would keep the domestic costs of goods and services down and tend to aid Scotland's relative price position. Similarly, provided low inflation is seen to be locked into the UK economy, private sector inflation expectations - in output, labour and financial markets - would be subdued, contributing to lower actual inflation in the future and lower long-term rates of interest. Finally, the avoidance of short-term economic instability should assist continuity in business planning, aid investment decisions, and refrain from imposing longer-term structural obstacles on Scottish economic performance.

1.5.2 UK Economic Strategy: Other Elements

Raising productivity

In the global context, considered in sections 1.1 and 1.2 above, the enhancement of competitiveness through continuing and significant productivity improvements remain the central challenges for both Scotland and the UK. The effect of productivity growth is to help raise the level of sustainable output growth, so allowing a higher level of aggregate economic welfare to be attained. Box 7 provides a useful summary of recent thinking on productivity and the accounting of growth.

The UK Government's Pre-Budget Report, November 1999, illustrated substantial productivity gaps between the UK and the US, and also between the UK and France and Germany (measured by output per worker). Scottish Executive estimates of productivity are shown in Box 8, including those for Scotland. The key finding here is that Scottish productivity appears to differ little from that of the UK and is, if anything, slightly inferior. Thus, against this back-drop, raising productivity is one of the central elements in the thinking of both the Scottish Executive and the UK Government.

The UK strategy has identified five key drivers of future productivity growth that underpin microeconomic policy formation to promote productivity. These are investment; innovation and enterprise; education and skills; competition and regulation; and public sector productivity. A number of measures have been taken to facilitate growth in productivity, including a reduction in corporation tax, and an extension of capital allowances for small and medium-sized enterprises¹⁸.

Promoting employment opportunities

The promotion of employment opportunities - and, particularly, the role of government in such promotion - has become a primary policy issue in many economies. The fundamental issues in this area, affecting many countries in varying degrees, have been the changing nature of work, the way taxes and benefits systems affect the incentives to work (unemployment trap) and to progress in work (poverty trap), and the incidence of inactivity or structural unemployment among different groups of workers. A key problem facing economies is essentially about how to provide non-working state benefits while minimising the disincentives to work, thereby fostering higher growth rates and enhancing the overall distribution of the benefits from growth.

The UK Government's economic strategy includes the promotion of employment opportunities. Two central aspects of the strategy are helping people back into work and introducing reforms to improve the rewards from work. Thus, for example, the reforms to the UK tax and benefit system and the UK minimum wage have been introduced to increase the rewards from work and improve labour supply incentives. Increasing the labour supply is designed to allow the economy to expand in a sustainable way; that is, without the same pressures on inflation and, with more people in work, encouraging the benefits of growth to be distributed more broadly across society.

Key aspects of UK policy measures include the 10p starting rate of income tax, introduced in April 1999, the lowering of the basic rate of income from 23 per cent to 22 per cent from April 2000, and the structural changes in the system of national insurance contributions (NICs) announced in the last UK Budget, which are designed to take large numbers of people out of paying NICs. The low starting rate of income tax benefits the low paid most in proportionate terms and is intended to reduce the incidence of the unemployment and poverty traps. Similarly, the national minimum wage, introduced in April 1999 and set at £3.60 an hour for most workers, is intended to help the low paid and increase labour supply incentives at the low end of the pay scale.

The UK Government also replaced the Family Credit system with the Working Families Tax Credit (WFTC) in October 1999. It is aimed at improving the rewards from work for people with families (whether couples or single parents), where the tax and benefit system can significantly reduce incentives to work. The WFTC is a tax credit and is designed to sharpen the link between work and overall rewards through the pay packet. Treasury estimates at the time of the last Budget suggested that around 1.4 million families in the UK would benefit from WFTC by 2001, around 500,000 higher than the numbers who would have received Family Credit.

A further major UK initiative in this area is the New Deal, which is aimed at groups where there have been significant levels of inactivity or structural employment obstacles, with the objective of helping them enter the labour market. For example, New Deal programmes are operating for young people (aged 18-24 years old), the long-term unemployed, and lone parents, and further programmes are being developed for people over 50 years
old and other groups. In Chapter 2, Box 3 examines the impact of the New Deal in Scotland.

Building a Fairer Society

A further plank of the UK Government's economic strategy is building a fairer and more inclusive society, in which everyone can contribute to and benefit from economic prosperity. In Britain, poverty and inequality have increased significantly since the late 1970s. The proportion of people living in households with relatively low incomes (proportion below 40, 50 and 60 per cent of mean income) more than doubled between the end of the 1970s and the beginning of the 1990s. A particular target is child poverty, which the Government is committed to abolishing within 20 years. As well as improving the lives of these children in the immediate term, the Government's aim recognises that Britain's long-term economic potential requires investment in the next generation. Opportunity for all: Tackling poverty and Social Exclusion was the first annual UK poverty report, published in September 1999. It identified key indicators of poverty and social exclusion and the main policy milestones which will be published in future and used to monitor progress. These indicators include measures of worklessness, low incomes, health and poor housing, reflecting the fact that poverty is a multi-dimensional problem.

The UK Government has introduced a raft of policies designed to reform the tax and benefits system in order to support all families with children, and to help make work pay. The Working Families Tax Credit, referred to above, is designed to integrate the tax and benefit systems to help low and middle income working families. It is intended to improve the incentive to work by alleviating the poverty and unemployment traps. The Pre-Budget Report discussed the possibility of an Integrated Child Credit to provide a seamless and transparent system of support for children, but acknowledged that this would be a major structural reform for the longer term with a number of operational and policy challenges.

1.5.3 UK Economy: Recent Economic Developments and Prospects

Overview

• The UK inflation rate is within the inflation target.
• Fiscal balances have improved in recent years.
• Base rates were increased by a quarter point both in September and November 1999 to stand at 5.5 per cent.
• The UK 10-year bond yield has fallen in the second half of the 1990s and the differential with corresponding yields for the G7 is currently small.
• GDP grew faster than expected in 1999, and the Treasury forecast was revised up from 1-1¹/₂ per cent at the time of the Budget to 1³/₄ per cent in the November 1999 Pre-Budget Report.
• The outlook for 2000, both according to Treasury and independent forecasters, is for a stronger GDP performance, with the inflation target continuing to be met in the fourth quarter of 2000.

UK Output and Demand

Following the deep recession of the early 1990s, UK economic growth resumed in the second half of 1992 (see Chart 1.8). Between 1992 and the end of 1998, growth averaged around 3 per cent a year. Following an increase in GDP of 3.5 per cent in 1997, growth slowed to 2.2 per cent in 1998. Growth in domestic demand, and particularly household consumption, slowed to more sustainable rates as fiscal and monetary policy was tightened, and export growth weakened as the effects of sterling's earlier rise worked through.

The Government's expectations at the time of the 1999 Budget were that the slowing in growth would be relatively short-lived. The Treasury forecast for output was for growth of 1 to 1¹/₂ per cent in 1999, compared with an average among independent forecasters of 0.6 per cent. Subsequent developments have broadly confirmed the more optimistic Treasury assessment and, with strong growth in domestic demand, GDP has grown faster than expected.

chart 1.8

Source: Office for National Statistics, Gross Value Added at basic prices.

The estimate of GDP for the third quarter of 1999 showed a rise of 0.7 per cent on the previous quarter, compared with growth of 0.8 per cent in the second quarter. Compared with the third quarter of 1998, the preliminary estimate of growth was 1.8 per cent.

Data for the third quarter of 1999 show that consumption growth continued, though at a lesser rate than in the previous quarter. Growth was 0.5 per cent in the third quarter compared with 1.1 per cent in quarter 2. There was also a contribution from net exports, with exports of goods and services rising by 6.2 per cent over the quarter while imports rose by 4.9 per cent. Stocks showed a substantial decrease for the second successive quarter.

The UK's deficit on trade in goods and services was £3.3 billion in the third quarter of 1999, comprising a deficit in trade in goods of £6.2 billion and a trade in services surplus of £2.9 billion. This compared with a deficit of £3.7 billion on trade in goods and services in the previous 3 months. The ONS estimates of trends in the value of trade in goods (based on data to September 1999) suggest that the UK trade deficit is narrowing.

The third quarter of 1999 saw export volumes rise by 8 per cent whilst imports grew by 5 per cent on the previous quarter. Exports of goods had been weak from late 1998 onwards, but have recently shown some recovery. Some of the adverse factors which had been affecting exports have begun to improve and strengthening growth in both Asian markets and EU economy is now apparent. The strength of sterling has also been of concern to exporters. Sterling's Exchange Rate Index has risen by over 25 per cent since the beginning of 1996.

Current UK monetary and fiscal indicators.

Box 9 discusses some of the indicators which may be used to assess the effectiveness of macroeconomic policy.

Table 7, together with charts 1.9 and 1.10, show recent trends in a number of monetary and fiscal variables.

In the context of the new UK macroeconomic framework, the data are instructive. They show that inflation is within the MPC target range and comparatively low by historical standards. During summer 1999, the rate fell below the target, reflecting the influence of weaker import prices and a squeezing of retail and producer margins. Influences in the opposite direction have been an increase in the oil price since the beginning of 1999 and strong growth in domestic unit wage costs. Fiscal policy remains relatively tight with net borrowing having fallen and expected to be in surplus in the current financial year. The surplus on the current budget has improved markedly since 1996-97 when there was a deficit of 3 per cent of GDP. By 1998-99, this had been transformed into a surplus of 0.8 per cent of GDP. While interest rates have been increased by 25 basis points in September and November 1999 to reach 5.5 per cent, the official short-term rate of interest remains at comparatively low levels. Moreover, the current 10 year bond yield is now around 170 basis points below its 1997 average and 250 basis points below its 1996 average. Furthermore, the positive differential on 10-year bond yields against G7 countries has fallen significantly. Box 10 examines long-run trends in UK Total Managed Expenditure.

Source: HM Treasury, Pocket Databank and Pre Budget Report, November 1999.

Notes:
1. 1999 figures RPI(X), base rates and bond yields are the latest data available for the year.
2. The net borrowing and current surplus figures are for the financial years 1995-96, 1996-97, 1997-98, 1998-99, and 1999-2000. All figures exclude windfall tax receipts and associated spending. The 1999-2000 figure is a forecast from HM Treasury's Pre-Budget Report, November 1999.
3. Base rates are the last official rate applying in each year, except 1999 which is that of November 1999.

Prospects and Forecasts: Real Economy

The most recent Treasury forecasts for the UK economy were set out in the November 1999 Pre-Budget Report and are summarised in Table 8.

Projections for GDP growth are given as ranges, based on alternative assumptions about the supply-side performance of the UK economy. The mid-point of the ranges is based on the assumption of 2¹/₂ per cent a year for the trend rate of growth, which is the Government's neutral assessment of the economy's growth potential over the medium term. The public finances projections are based on the low end of the ranges, consistent with a cautious assumption of 2¹/₄ per cent a year trend growth. The surplus on the current budget is projected to rise slightly over the years to 2001-02, and net borrowing is expected to show a small surplus in all years to 2001-02. Box 11 provides background details on the considerations underlying the assessment of the economy's trend rate of growth.

Source: HM Treasury, Pre-Budget Report, November 1999.
Note: Forecasts for the surplus on the current budget and net borrowing are for the financial years 1999-2000 to 2002-03. Both exclude the windfall tax and associated spending.

Outside views on economic growth have strengthened recently - the consensus for growth in 1999 was 1.6 per cent in November 1999, up from 0.6 per cent in March 1999. There is a clear consensus that the economy is likely to grow at a much stronger rate in 2000. The average of outside forecasters, in November 1999 was for growth of 2.8 per cent (see Table 9).

Forward-looking business survey indicators have strengthened from the low levels of a year ago, with improvements in global economic prospects and continued low interest rates. Business survey indicators had deteriorated sharply in Autumn 1998, with a 20 year low for the CBI manufacturing optimism on balance in October 1998²³. The latest CBI Quarterly Industrial Trends Survey (October 1999) suggests that manufacturers' business confidence has strengthened since July 1999, rising at its fastest rate since April 1995. Optimism about export prospects for the year ahead remains weak, but less so than at any time since January 1997.

Source: HM Treasury, Pre-Budget Report, November 1999 and HM Treasury, Forecasts for the UK Economy: A Comparison of Independent Forecasts, November 1999.

Outlook for the UK monetary indicators

The Bank of England's Inflation Report, November 1999, assessed the most likely outcome for inflation in 2000 to be 2 per cent, and 2.5 per cent by the end of its two-year inflation forecast, following a build-up of pressures from above-trend growth. On the basis of both extrapolations of the current exchange rate and expected interest rate differentials, its central projection for sterling is a depreciation of 3.6 per cent over the same period. Based solely on expected differences in interest rates, the depreciation would be about 7.2 per cent, while econometric modelling, as described in Box 12, would imply a depreciation of about 2.6 per cent.

Table 10 sets out the average of independent forecasts for 1999 and 2000 for some of the main monetary indicators.

Source: HM Treasury, Forecasts for the UK Economy: A Comparison of Independent Forecasts, November 1999.
1 Sterling index: 1990 = 100

Based on the average of the independent forecasts, the outlook for 2000 is for a stronger GDP performance, with the inflation target continuing to be met in the fourth quarter of the year. Short-term (3-month) market rates of interest are expected to be around half a point higher in the fourth quarter of 2000 than they were in Q4 1999, and the sterling index is expected to fall. There is a broad agreement between the average forecasts of the city institutions in the survey and those of all of the panellists taken together. On the whole, the city forecasts tend to suggest slightly higher GDP growth, slightly higher short-term interest rates, and a slightly lower level of the exchange rate.

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