However, the weakness in economic growth and rise in inflation over the last several months was unexpected. This raises the question whether it is time to adjust macroeconomic policies. The answer is no as the deviations are largely temporary.
Strong fiscal consolidation is underway and remains essential to achieve a more sustainable budgetary position, thus reducing fiscal risks. The inflation overshoot is driven largely by transitory factors, and hence maintaining the current scale of monetary stimulus is appropriate given fiscal adjustment and subdued wage growth.
This macroeconomic policy mix will also assist in rebalancing the economy toward investment and external demand. Bank balance sheet repair continues, but vulnerabilities remain and strong domestic measures and international coordination are needed to further bolster financial stability.
Indeed, the stability and efficiency of the UK financial system is a global public good due to potential spillovers and thus requires the highest quality of supervision and regulation.
Nonetheless, there are significant risks to inflation, growth, and unemployment. If they materialize, the policy response will depend on the nature of the shock.
The central scenario
1. The economy is expected to grow at a moderate pace in 2011. Growth was flat over the last two quarters, as the inventory cycle—which helped power growth through much of 2010—came to a close and with consumer confidence impaired by spiking commodity prices, a soft housing market, and headwinds from necessary fiscal consolidation.
Going forward, the latter two factors and the ongoing process of household and bank balance sheet repair will continue to weigh on growth. However, recovery should be buoyed by private investment, as it rebounds from unsustainably low levels and is supported by low interest rates and corporates’ strong cash positions.
In addition, net trade is improving along with global recovery and may benefit further if labor productivity—which has been depressed in part due to relatively high labor hoarding in the UK—rebounds and improves competitiveness.
Led by these forces, expansion is expected to resume in 2011, though real GDP growth will remain a moderate 1½ percent before accelerating gradually to around 2½ percent over the medium term.
2. Inflation is likely to remain above 4 percent for most of 2011, but then gradually return near the 2 percent target as transitory factors dissipate. Spiking commodity prices and large indirect tax hikes have temporarily boosted headline inflation.
However, core inflation excluding tax effects remains around 2 percent. With commodity futures indicating that oil and food prices will stabilize, inflation is expected to return near the target around the end of 2012 as the effects of recent shocks dissipate and as spare capacity keeps underlying inflation in check.
Leading inflation indicators support this outlook: growth rates of credit, broad money, and wages are all low, and inflation expectations remain contained.
Macroeconomic policies in the central scenario
3. The current settings of fiscal and monetary policy remain appropriate in the central scenario. The fiscal consolidation plan aims to stabilize government debt by FY14/15, thereby preserving confidence in debt sustainability.
Although consolidation will create headwinds for short-term growth, it will also assist disinflation and can thus be countered by looser monetary policy than otherwise.
In this context, the current accommodative monetary stance is appropriate, given the projection that inflation will return to target in a reasonable timeframe and the uncertainty regarding the strength of the recovery.
4. Such a policy mix will support economic rebalancing to a more sustainable equilibrium. Tight fiscal and accommodative monetary policy will help keep real interest rates low and sterling competitive.
This economic environment will assist public and private balance sheet repair while promoting expansion of investment and net exports. This is necessary if robust output and employment growth are to be achieved at the same time that private and public consumption are eased to more sustainable levels.
5. If growth resumes as expected in the coming quarters, the case for monetary tightening would increase. In this central scenario, the pace of monetary tightening should be gradual, given the extended period of fiscal contraction and the high sensitivity of house prices (and hence consumption and residential investment) to short-term interest rates.
Furthermore, the real interest rate consistent with stable inflation and full employment may remain low for some time, as it is likely that the financial crisis has shifted down the demand for investment and consumption at any given interest rate.
This view is supported by the low expected path for short-term rates over the next 2-3 years, as embedded in government bond yields. However, monetary tightening would need to be earlier and faster if leading inflation indicators, especially unit labor costs and inflation expectations, turn more worrisome.
6. On the fiscal side, the government has already made significant progress in implementing its consolidation plan, though challenges remain. Structural fiscal adjustment in FY10/11 is estimated at roughly 2½ percent of GDP, largely reflecting higher taxes and the reversal of fiscal stimulus.
Though the pace of adjustment will ease somewhat going forward, it will also become increasingly reliant on expenditure cuts, as specified in the Spending Review.
Evidence suggests that spending-led consolidations lead to longer-lasting budgetary improvements, but there may also be implementation challenges
