Economic Prospects for the UK and Policy Recommendations
Weale, Martin, Young, Garry, National Institute Economic Review
Since the General Election much the most important economic event has been the introduction of a new structure for monetary policy based round an independent Bank of England. We have also seen Mr Brown's first budget, which has increased taxation as the National Institute and others had recommended.
Recently fear has grown that the economy is overheating. Of the monthly indicators, retail sales in May were 5.3 per cent above their level of a year ago. On the other hand, industrial production appears to be stagnant. If a tight grip is being maintained on public spending it is also likely that the output of the public sector service industries cannot be growing fast. Those private sector services which supply the slow-growing public and industrial sectors should be experiencing the knock-on effects of slow growth in their markets. This suggests that the scope for runaway growth in the residual service sector to affect the growth rate of the whole economy can be exaggerated.
Taking everything together GDP grew at an annual rate of 3 1/2 per cent per annum in the first quarter of the year and there is no doubt that such a growth rate is not sustainable, particularly when there is no evidence of significant spare capacity in the economy. The policy question to be faced is not whether a reduction in the growth rate is desirable but whether the policy measures already in hand have done enough (or possibly too much) to achieve a 'soft landing'.
A number of comparisons can be made with the economic situation Mrs Thatcher inherited in 1979. The economy was growing rapidly in the first half of 1979 just as it is now. The exchange rate rose before both elections. The rise since the [TABULAR DATA OMITTED] 1997 election is of similar magnitude to that which occurred in the first three months of Mrs Thatcher's government but this time it has happened without the support of oil price increases and 'petrocurrency' status. Interest rates are, of course, much lower and the inflation rate is around 2 1/2 per cent per annum as compared with the rate of 10 per cent which Mrs Thatcher inherited. On the other hand real interest rates, after adjustment for inflation are higher than they were in 1979. Fiscally too, there are similarities. The budget deficit in 1979 was too large and a programme of fiscal consolidation was needed, but the tightening built into current plans is larger than it was in 1979.
In 1979 the government adopted a new monetary policy targeting of the money stock. This proved impossible to run satisfactorily because the link between the money stock and inflation was so flexible that it was impossible to choose a sensible monetary target. However the new tight monetary policy did lead to a surge of foreign confidence which continued to boost sterling for 18 months or so after the election. In the early stages the rise in sterling was, as now, hailed by some as a vote of confidence and an indication that the markets believed things were changing fundamentally. With this background we review Bank of England independence and Mr Brown's budget. We then summarise the prospects for the British economy.
Bank of England Independence
By making the Bank of England independent, the new government has made an absolutely fundamental change to the operation of economic policy in the United Kingdom. The move was welcomed by financial markets with a sharp rise in the price of government stock, probably because the opportunity to manipulate economic policy for short-term political purposes at the expense of subsequent inflation is much reduced.
The Bank of England has the job of delivering an inflation target set by Parliament and has to explain deviations of the inflation rate by more than 1 per cent from that target. This is intended both to make statements about intended inflation more credible and to ensure that the high inflation rates experienced in the 1970s and 1980s do not recur. …