RPIX

• From 1992 until 1997, and for much of the period since 1997, the key measure of inflation in the UK was RPIX, the Retail Prices Index, less mortgage interest payments (MIPS).
• The target which Gordon Brown set the Monetary Policy Committee was to keep the rate of inflation as measured by this index within one percentage point either side of 2.5%.
• Between 1997 and end of 2003, this was achieved, with RPIX ranging from a high of 3.2% (in May 1998) to a low (in June 2002) of 1.5%.

CPI

• In January 2004, however, the Chancellor changed the rules. The target for the MPC dropped to 2% (+/- 1%), but measured on the European Consumer Prices Index (CPI).

Differences between RPIX and CPI

• The main differences between the two measures are in the statistical techniques used to calculate the indices and in the coverage of goods and services.
• The CPI, for example, excludes housing depreciation and council tax. Given the importance of housing expenditure to the typical UK household, and what has been happening to house prices and council taxes, it is no surprise that throughout the period since 1997, the annual rate of CPI inflation has been lower than the RPIX, by around 0.5 percentage points.
• In many ways, it looks a softer target, which could have the effect of keeping base rates lower. Between May 1997 and May 2005, CPI inflation in the UK never topped 2% and, for much of the time was below 1.5%. Low inflation in the UK, however, is not solely attributable to this government’s policies.

Low inflation not solely attributable to this government's policies

• The seeds were sown before New Labour came to office in 1997, going back to the UK’s exit from the ERM in 1992. Using the CPI or measure, inflation had been 3% pa or less in each of the 15 calendar years between 1993 and 2007.
• This is unprecedented since 1945 and indicates that the UK is now a fully paid up member of the low inflation club. (See 6 The Effects of Stability and Low Inflation and 8 Inflation .)

Inflation has not gone away

• Yet it would be wrong to think that inflation has gone away. In 2008, consumer price inflation moved up, rising at an annual rate of 3.6% on the CPI and by 4.3% measured by the RPIX.
• Oil and other energy prices initially fuelled the rise and then non-seasonal foods added to the upward pressure on the price level.
• This was not a uniquely British experience but it led to higher UK interest rates which in turn ended the housing market boom and put pressure on the heavily indebted consumer sector.

Ending of the ‘nice’ decade

• The Governor of the Bank of England has referred to the ending of the ‘nice’ decade, ten years of non inflationary, consistently expansionary growth.
• Inflation in the UK has benefited from the imports of manufactures from China of goods that were once made here but are now produced more cheaply in Asia.
• Domestically-generated inflation (primarily in service activities) has been running well above the target rate of 2% for a number of years, but it has been more than offset by imports from China, the prices of which have been rising more slowly (and in some cases even falling year-on-year).
• If, amongst other things, imports of manufactures start to get more expensive and the ‘China Effect’ wears off, the UK will find it harder to hit its inflation target without higher interest rates (with slower growth an obvious consequence).
• The fact that only eight times between 1946 and the setting up of the MPC in 1997 (three of which were in the post-ERM period before New Labour took office) would the inflation target have been met shows how big has been the change in the inflationary climate since 1992.
• Achieving the target so consistently since 1997 suggests that the authorities have been either very smart or very lucky. If their luck is starting to change, they will have to be even smarter and interest rates over the next five years will on average have to be higher than the in last five to meet the inflation target.

Sustained output growth in the UK, based on the expansion in services (initially private sector but more recently public sector) and construction, have stimulated a steady rise in employment.

Every year between 1993 and 2008, total employment in the UK has increased, despite the sharp fall in manufacturing jobs, and in 2006 it passed 29 million for the first time ever (climbing eventually to 31.7 million). This is 3.0 million higher than when New Labour won office in 1997.

At the same time, unemployment fell. Measured in terms of the number of people claiming benefit (the claimant count), the total dropped from the last peak of 2.9 million in 1993 to under 800,000 in 2008 for the first time since 1975.

It has since risen back to over 1.5 million as activity slowed sharply. As a share of the labour force (and using Labour Force Survey data), the UK's unemployment rate dropped below 5%, much lower than in the major economies of Europe. In Q1 2009, the rate was back over 7%, and rising. (See The Labour Market 11.3 Recent Trends in Unemployment.)

From a net borrowing requirement of £51 billion in 1993-94 (7.7% of GDP), government finances were transformed in the late 1990s and a surplus of £18 billion was recorded by 2000-01 (1.9% of GDP).

This turnaround, which started under Mr Clarke, continued for a while under Mr Brown, but has now turned again, with a vengeance. Since announcing increases in spending on public sector services in 2002, the Chancellor has seen his borrowing requirement rise, and much faster than he had expected. For the fiscal year (2005-06), for example, his initial forecast of borrowing was £17 billion but the out-turn was more than twice as much, at £37.4 billion.

The recession has played havoc with public sector finances, wrecking both sides of the Chancellor’s accounts. In his 2009 Budget, Mr Darling forecast net borrowing of £175 billion for the 2009/10 financial year, equivalent to 12.4% of GDP. This is the first time the fiscal deficit has exceeded £100 billion in a single year and is the result of both falling tax revenues and higher spending.

When he went to the Treasury, Mr Brown was determined not to be a reckless ‘tax and spend’ Labour Chancellor and to demonstrate his ‘prudence’, he established two fiscal rules.

The Golden Rule

The first, that the government only borrowed to invest, in other words that over the life of the cycle, the current budget was in surplus. Only by a series of technical redefinitions could Mr Brown claim this rule had not been breached but Mr Darling cannot even fall back on this device. The Golden Rule has been consigned to the history books.

The Sustainable Investment Rule

So too has the ‘Sustainable Investment Rule’ by which public sector net debt was to be kept at around 40% of GDP. From 42.5% when he took office, Mr Brown reduced the share to 29.7% by 2001-02, since when it has been rising steadily. Mr Darling’s latest estimate has a debt-GDP ratio of 76.2% by 2013-14.

Even though this is worse even than in the dark days of the 1970s, it is still broadly in line with most of the major eurozone countries (and lower than one or two).

It is nevertheless true that the huge escalation of the deficit cannot be blamed entirely on the recession, and that government finances will be the principal long-term casualty of the recession.(See Macroeconomic Policy 4.3 Fiscal Policy – Public spending framework.)

The much sought after economic stability appeared finally to have arrived.

Between 2000 and 2007, annual GDP growth was in the range 1.8% to 3.9%, the narrowest range for any seven-year period since 1960. Between leaving the ERM in 1992 and the start of the recession in 2008, the UK economy grew by around 58% in real terms, the longest period of sustained growth since records began in 1870. In every one of the calendar years between 1993 and 2007, moreover, GDP growth in the UK has been faster than the eurozone as a whole. In this period, the 12 countries recorded growth of just over 35%. (See The Effect of Stability and Low Inflation 6.1 The 90s & 00s vs the 70s & 80s.)

But the idea that somehow the policymakers had ended the boom and bust cycles proved to be an illusion in 2008. Despite the apparently ‘sound fundamentals’, activity went into reverse in mid-year, when the housing bubble burst, consumer confidence evaporated and business investment started to fall. All that was left to sustain output was the public sector and despite the huge boost to government spending, GDP growth slipped well into negative territory.

The crisis in the banking system, the ‘credit crunch’, was a simultaneous problem that did not cause the recession but it will have an impact on the pace and direction of recovery.

Although at an aggregate level, the UK appeared to be doing well, the economy had become unbalanced.

Activity has been too reliant on consumption, by households and the public sector, much of whose spending was dependent on borrowing. As interest rates rose in 2006-07, spending by the heavily indebted (£1.5 trillion of debt, equivalent to 160% of personal incomes) personal sector came under pressure. The public sector, the other key spending group, was also running up larger and larger deficits.

These imbalances are reflected in the profile of growth by industrial sector, since the service sectors (especially distribution, property and financial services) have generally been buoyant and contributed disproportionately (i.e. relative to their share of GDP) to growth, jobs and living standards. Manufacturing and agriculture, on the other hand, struggled and output growth was weak even before the recession. (See Growth 7.3 Output Trends.)

The industrial imbalance shows through in the UK’s trade performance. Manufacturing’s difficulties are apparent from a burgeoning deficit on trade in goods (excluding oil) which, in 2008, was almost £93 billion. Some of this is offset by the service sectors' international earnings (£54 billion) and the returns on the UK’s overseas investments (£28 billion). This meant that the current account balance of payments deficit was a slightly more manageable £25 billion, but still a record in absolute terms and equivalent to 1.7% of GDP.

Although the deficit has been a bigger share of GDP in the past, and big enough to put pressure on the currency and so lead to a change in policy, it is still a weakness for the UK. The component which has led to largest downward shift in the deficit is ‘Investment Income’ which, although a substantial sum, does not reflect the UK’s trade performance.

An indicator of the underlying problem the UK faces (particularly if it wants to rebalance the economy away from consumption) is the balance of trade in goods, which has been steadily deteriorating. In 1997, UK exports of goods accounted for 93% of the value of goods imports.

By 2000, this had fallen to 85% and in 2007 it was just 71%. This is a measure of the challenge for the UK if the post-recession agenda is to be more global. (See UK External Position 17.4 Trade in Services and 17.5 Trade in Goods.)

Since performance at regional level reflects the local industrial structure, the unbalanced economy has led to an unequal regional distribution of growth, employment and incomes.

Those areas with a disproportionately greater dependence on manufacturing and agriculture (and too great a reliance on public sector spending) have under-performed national trends.

This is most easily characterised by the ‘North-South’ divide. (See Regional Perspective 13.2 Regional Dimension.)

Output growth and employment growth seemed to go almost hand in hand between the last and the current recession.

As a result, the economy failed to generate productivity growth rates comparable with the UK’s major competitors, although there were signs that the investment in new technologies by the distribution and financial services sectors is starting to result in rapid productivity improvements.

Manufacturing’s improvement in output per worker reflects the fact that employment has been falling faster than output.

This government has claimed that raising productivity has always been a key priority to ensure that British businesses increase efficiency to maintain competitiveness and that the economy can improve its long-term growth rate. But the record up to 2007 was at best chequered and the recession is likely to put productivity considerations on hold. The expansion of the public sector will have a negative impact on productivity whatever other economic and social benefits it brings. (See 5.4 Microeconomic Policy since 1997.)

The onset of the credit crunch has affected most economies, and in different ways. In the UK, financial services matter for two major reasons.

UK occupies the global prime position in financial services

In the first place, it is one of the few industries in which the UK had a real international advantage and London was widely regarded as the financial services capital of the world. The sector made a disproportionately large contribution to output, to tax receipts and to the balance of payments.

If banking activity weakens globally, or if the UK loses its prime position because of the present uncertainty or ensuing regulation that is bound to come, it will be expensive for the UK.

UK businesses are heavily reliant on bank funding

Secondly, businesses in the UK are more reliant on bank funding than, say, those in the US. But in the current economic downturn, a major problem in the UK (and elsewhere) has been a lack of bank finance.

To stimulate economic activity, the authorities have pulled the traditional monetary and fiscal levers, but have also added a new one (quantitative easing), to try and improve the flow of finance. See Macroeconomic Policy 4.2 Monetary Policy - Quantitative easing - a return to direct controls.) Unless the banks are willing and able to provide the working capital companies need and the loans and mortgages households want, a real recovery could be some way away.

Uncertain banking conditions have a major impact

The present uncertain conditions in the banking sector, with two of the largest institutions effectively in public ownership, will also have an impact on government finances and pension funds.

If there is a speedy recovery domestically and globally, the UK government could make a reasonable return on its ‘investment’ in banking.

Alternatively, it could be a drain on public funds if the current malaise persists into the medium term.

Finally, companies like HBOS, Lloyds and RBS are so large that every pension fund had them as part of their share portfolio. The collapse of the share price, with little prospect of recovery, will put further pressure on already hard-pressed funds.

A decisive response

Much of the current recession is the result of developments in the UK economy rather than global events.

The response of the authorities has been very decisive. In 2008, the UK had its lowest Bank Rate (0.5%) since the Bank of England was formed in 1694, Mr Darling’s £175 billion deficit represents the largest ever fiscal loosening, sterling has weakened and, through quantitative easing, an additional £200 billion has been injected into the banking system.

If the banking system responds to the demands of industry and households the UK should be amongst the first countries to emerge from the recession.

The UK's advantages

Then the UK has to address the important question of the post-recession agenda. Going back to the way it was is a shortcut to another downturn. Sustainable growth means looking to trade and investment to make bigger contributions to activity than they have in the past. That won’t be easy but there is much the UK has to offer, particularly relative to the rest of Europe.

The English language is an immense asset in a global context. The UK can also boast a freer and more flexible labour market, with industrial relations problems a thing of the past in the private sector.

There is also a diverse industrial base with skills available in most activities and the business support infrastructure (banking, accountancy, law, etc.) is one of the most sophisticated in the world.

More needs to be done (such as on corporate taxation, training and R&D) to create an environment in which the UK is regarded as ‘the best place to be in business’ but this will almost certainly be on the post-election agenda of a new government. (See Macroeconomic Policy 4.2 Monetary Policy.)

Few major economies are as dependent on trade as the UK. Some 30% of GDP is exported and a similar proportion of annual consumption is imported.

The fiscal and current account deficits in the United States (reflected in the marked depreciation of the dollar), slow growth in Japan, fragility in the EU (which together account for two thirds of the UK's exports of goods) and the UK’s relatively poor performance in the faster growing markets of Asia has put the burden for growth on domestic demand.

Continuing the existing imbalances is a risk to the UK’s ability to generate growth at the old trend rate while increasing the contribution from the traded goods and services sectors is an enormous challenge. (See 19 The Global Economy.)

Movements of the pound on the foreign exchange have not eased exporters’ difficulties.

Although measured against a basket of currencies (the Sterling Effective Exchange Rate Index), the pound has been relatively stable, against specific currencies (the dollar in particular), the volatility has been very marked.

In the first quarter of 2002, for example, the exchange rate was £1= $1.42 but by the end of 2004 it had risen to £1=$1.87. In July 2007, sterling reached its highest level against the dollar since 1981 of over $2.00. This implies a severe loss of competitiveness for British companies exporting to the US, which is still the UK’s largest export market.

In 2008, sterling started slipping against both the dollar and euro. Because of the recession and the low interest rates, the pound fell to its lowest rate against the euro and a 24-low against the dollar. Although a potential boost for exporters, sharp movements in the exchange rate (in both directions) create uncertainty amongst exporters. (See UK External Position 17.8 International Trade & Exchange Rates.)

Uncertainty prevails about the UK's membership of the single currency.

The Chancellor, Gordon Brown, said in June 2003 that the conditions were not right in the short-term for the Britain to join the eurozone, and that decision has not been revisited since then.

The flexibility of policy the UK has had during the recession emphasised the advantages of being outside the eurozone. And it is clear that many of the eurozone economies (including Germany, the best economy) are having a much harder time than the UK. (See 16 Single Currency .)