Mr George reports on the overall economic situation in the United Kingdom  (Central Bank Articles and Speeches, 12 Jan 99)
Central bank: boe | Type: speech | Date: 1999-01-12

## Mr George reports on the overall economic situation in the United KingdomSpeech given by the Governor of the Bank of England, Mr E.A.J.

George, at the Instit Manufacturing in London on 12/1/99.I am only too well aware of the pressure currently facing large parts of the manufactu of the economy and I welcome this opportunity to explain the macro-economic context an something about the prospect.Let me begin with the overall economic situation.Since the trough of the last recession in 1992 - that's 26 quarters up to the third q year - total economic output in this country has grown at an average annual rate of ar That is well above any plausible estimate of the underlying rate of growth of capac economy as a whole - which is typically estimated at some 2-2½% - so that what we were doing over this period was steadily reabsorbing the economic slack created by the recession.

In the labour market, this was reflected in a rise in employment of some 1 all-time high of 26.5m, on the latest LFS figures.

It was reflected, too, in a fall unemployment, from a peak of 10.6%, again on LFS figures, to the current level of 6.2% is the lowest rate for about 20 years.

These developments in the labour market produce gradual pick-up in pay settlements compared with past periods of labour market tighten underlying retail price inflation - measured by the Government's target inflation RPIX - has averaged 2¾% a year through the expansion, and is currently precisely on t 2½%.By around the beginning of 1997, it was becoming clear that overall output growth ne moderate if we were not to run up against overall capacity constraints.

In fact, out actually picked up during the course of 1997, from a rate of close to 3% to around 4 under the impact of the windfall effect of building society demutualisation on c spending.

Aggregate demand growth, in other words, needed to slow if we were to overheating.That essentially was the background to the tightening of monetary policy during 1997.But there was, of course, a major complication.

In the autumn of 1996 sterling's exch against the core European currencies started to strengthen, and by early 1997 it ha appreciated by some 17% against the deutschmark.

Although sterling appreciated rathe against the dollar - which also strengthened against the core European currencies period, sterling's effective exchange rate index (ERI) still rose by some 13.5%.

Sterli further against the deutschmark right up until the spring of last year.It was never entirely clear just why sterling - and the dollar - strengthened in this w appropriately why the core European currencies weakened - when they did.It appeared to have little to do with relative monetary conditions between the Ang countries and the Continent.

It may have had more to do with market perceptions - or misperceptions - about the future prospects for the euro.

Financial markets appeared at to take the view that European Monetary Union was being driven increasingly by pol determination - even if that meant softening the interpretation of the economic con criteria; that this implied a broad rather than a narrow initial euro membership; and turn, implied a weak rather than a strong euro.But whatever the reason - and whether it was valid or not - the effect of sterling's a was to introduce a pronounced imbalance into the UK economy.

It dampened net exte demand, and had a restraining exchange rate influence on cost and price inflation, at a domestic demand growth remained unsustainably strong, and when we were approaching f capacity.On the one hand, we understood very well that, after a relatively favourable excha environment following our exit from the ERM, the abrupt appreciation meant that internationally exposed sectors of the economy, including large parts of manufacturing were now suddenly confronted with much harsher trading conditions.

That, as I say, dampening effect on the UK economy.

But we couldn't just rely on that to cool the econo us.

Clearly at some point the exchange rate would stop appreciating, and this external effect would have worked its way through.

In the meantime, we needed to slow the r growth of domestic demand sufficiently to avoid overheating in the economy as a whole strong exchange rate gave us somewhat more time than otherwise to bring about the do slowdown - it meant that monetary policy did not need to be tightened as much as woul been necessary otherwise.

But we could not avoid tightening policy altogether - even th realised that this would be likely to increase the pressures on the internationally exp because in anything other than the short term that would have put the whole economy - in the internationally exposed sectors we were trying to shelter - at risk of accelerati And I would remind you that right up until the spring of last year we were seeing increasing pressures in the labour market, even in the manufacturing sector - ref increasing skills shortages and recruitment difficulties as well as pay press uncomfortable reality, as I've said very often before, is that monetary policy can onl economy as a whole - it can't seek to protect individual firms or sectors, or region much we might wish it otherwise.

That - as I've discovered - is not exactly a popular there's no question that it is the reality of it.Over the past year the world - and I mean the world - has changed very substantially.In point of fact, the strong exchange rate against continental Europe - whatever effec margins and profitability, and I don't underestimate that - had puzzingly little effect with the rest of the EU.

And goods trade volumes - both exports and imports - to the r EU have in fact continued to grow fairly steadily over the past two years.But, of course, over the past year or so the internationally exposed sectors of the ec been dealt the further massive blow of global economic slowdown.

This started with fi turmoil in Asia in the latter half of 1997, but even as late as last summer it was pos that it would have limited impact on the overall world economy.

In May, for example, was still looking for world economic output growth of over 3% in 1998 and over 3¾% in That certainly was a slowdown compared with average expected growth of around 4¼% only months earlier - but it was not catastrophic.Through last summer though, it became increasingly clear that things would be much wors that.

The financial collapse in Russia, deepening recession in Japan and increasing ne about the situation in Brazil, coupled with fears of the possible knock-on effects industrial countries' financial markets and hence on their economies, all created a sen by around the time of the IMF Annual Meeting such as I've rarely experienced - and don' wish to experience again!The mood has improved since that low point.

Financial markets have recovered much of nerve - helped by monetary policy easing in the US and Europe; the Yen has appreciated,some of the pressures on the rest of the Asian region; the IMF has organised support and seen its resources substantially replenished.

Even so, the forecasts of world activity continue to be revised downwards, so that the IMF's latest (December) forecast growth in 1998 and 1999 has been cut to under 2¼% - barely half the trend rate.

And t probably remain on the downside.We are still not talking, in these forecasts, about global downturn or recession - th exactly what we are seeing in a large part of the world economy.

The expectation is th and Europe will sustain domestic demand to accommodate the flood of goods imports from rest of the world which is necessary if the suffering economies, now facing substantial capital inflows, are to see any kind of recovery.

That means a prospective imbalance domestic and external demand in the industrial world as a whole, which is somewhat sim that which we were already seeing in this country - but on a mega scale.

In the UK t been a sharp deterioration in the overall balance of trade in goods, to a deficit of £ past four quarters - about a 50% increase on what went before.

This deterioration wa entirely with countries other than the EU and North America.

This picture has been mir the US, where the deficit on trade in goods has risen to around $65bn (3% of GDP).

A picture of a weakening trade balance in goods is reflected in falling manufacturing em in both the UK and US.In continental Europe the trade picture looks rather better at first sight, but that re fact that these economies are at a different point in the cycle.

But, here too, the particularly promising; in Germany, for instance, downward revisions to growth forecas reflected a sharp fall in the forward-looking survey measures of export expectatio manufacturing sector.So the pressures on manufacturing are not confined to this country - cold comfort tho may be.This global economic slowdown represents, as I say, a further blow to the interna exposed sectors of the UK economy, particularly the commodity and goods-producing sec Even though the strength of sterling has tended to ease since last spring as the eur reality, what this means for us is that external demand will be even weaker - and rema for longer - than we'd previously expected, and that there will be a further dampening inflation from weak world prices.

So we have even more time than before to bring ab domestic slowdown - in fact we could afford for the time being to act to sustain demand.

So the worsening global economic situation, and the related further weakn external demand that became apparent through last summer, pointed to an easing o monetary policy stance.But it was not the only factor.

Domestic demand, too, particularly consumer goods spend weakened more sharply in the latter part of last year than we expected, for reasons tha fully understand.

Continuing growth of employment, and higher pay settlements than la suggested that labour income was also continuing to increase - and after a wobble in th financial asset prices remained buoyant.

At the same time consumer borrowing and the gr households' money holdings remained fairly robust.

So it's not easy to explain the sud in consumer confidence reflected in retail spending - and not easy to predict how long fact last.

In any event, given the further weakening of external demand we surely di such a sharp, simultaneous, slowdown in domestic demand, so the evident weakness of con spending, too, pointed to an easing of policy.The arguments were not in fact entirely one way - they rarely are.

The imbalance in the remained a major complication, with the much larger services sector holding up much bet manufacturing, and this dichotomy was neatly reflected in the fact that while overal was on track - at 2½% - this outcome included 3½% inflation of services prices and on over 1% inflation of goods prices.

There has been a similar divergence between servi goods price inflation for some time now in all the major economies.

Moreover, the UK market remained tight, although there have recently been some tentative - but not conc signs that it may now be beginning to ease.

We have, of course, been unsighted for some as to what this has meant for average earnings in the economy.But taken altogether the evidence was becoming pretty clear through the summer that w seeing the slowdown in the economy as a whole that we needed to see to keep inflation with the target.

And as we moved through the autumn the downside shocks to the w economy - and to consumer spending in this country - meant that we were at ris undershooting the inflation target.

And that explains why we have moved quite aggress reduce interest rates over the past few months.So that's where we are.

What you'd like to know is where we go from here.There is no doubt that we are currently seeing a slowdown in the overall economy - as necessary slowdown.

The effective choice was always between an earlier - and hopefully moderate - deceleration or a later, but almost certainly sharper, decline.The issue is about the extent - and the duration - of the slowdown, which is much more to assess.

In fact, given the uncertainties about the global economic situation, an extent of the imbalance between the different sectors of the domestic economy, that as is about as difficult as at any time that I can remember.

Of course there are plenty of claim to know with great confidence - and who put their money, or their mouth, on extreme possible outcomes.

And it's true that outside bets do sometimes win.Our own approach is to attach varying degrees of probability to alternative possible which we reflect in our quarterly Inflation Report.

I can't predict what our next Inflat which we publish next month - will in fact show, but frankly I'd be surprised if o projection were to suggest that the economy as a whole was falling into steep or p recession.

But I can repeat to you the assurance that I have given elsewhere - which will respond symmetrically to the prospect as we see it.

If, on the balance of risk probability that inflation will undershoot the Government's target, we will not hesit policy further, just as we moved to tighten policy when the risks to inflation were i direction.That is in fact what we have been doing, and it should provide some reassurance to there is not a lot more that we can do directly - through monetary policy - to affect global economic weakness which is adversely affecting the prospect for manufacturing this country and more generally in the industrial world.

It remains the case that, tempted to go further in easing monetary policy and take significant risks with infla upside, we would be likely simply to make matters worse for you in anything but the shorI hope that I have provoked you to a lively discussion!