2 The Medium-Term Financial Strategy

2.01 The objective of the Government's economic policy is to promote sustained economic growth and rising prosperity. This requires structural policies to improve the long-term performance of the economy and a stable macro-economic environment. This chapter describes the role of macro-economic policy in achieving permanently low inflation and sound public finances.

Inflation

2.02 Economies function most efficiently in conditions of low and stable inflation. Since October 1992, the Government has had an explicit inflation objective. The aim is to keep underlying inflation (as measured by the RPI excluding mortgage interest payments) in the range 1 - 4 per cent and to bring it down into the lower half of this range by the end of the present Parliament. This aim is being achieved; underlying inflation is already in the lower half of the range and at its lowest levels for nearly 30 years.

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Monetary policy

2.03 It is the role of monetary policy to deliver low inflation. Since monetary policy influences inflation with a lag, interest rate decisions are based on an assessment of the prospects for underlying inflation in one to two years' time. This assessment is based on a wide range of information, including:
  • monetary and other financial indicators that could provide advance warning of changes in inflation pressures. They include the growth in the narrow and broad monetary aggregates, movements in the exchange rate and asset prices, and expectations about future inflation;
  • indicators of activity that could affect wage- and price-setting by firms and employees. If overall demand runs ahead of the economy's capacity to supply goods and services (as indicated for example by reductions in spare capacity, strong retail sales growth and labour shortages), inflation pressures may increase. The overall stance of fiscal policy is also taken into account;
  • indicators of costs which may affect final prices directly; in particular, rises in wage costs and material input prices (including commodity prices).
2.04 Since the start of the year, the minutes of the monthly monetary meetings between the Chancellor and the Governor of the Bank of England have been published. The Chancellor's and Governor's assessments of inflation pressures and the overall conduct of monetary policy are thus much more open to scrutiny. As a result the monetary framework is now one of the most open in the world.

2.05 M0 growth has been above the top of its 0 to 4 per cent range since early 1993. This is something the Government has taken seriously. It has been a signal of faster than expected growth in overall activity. But in part it probably has also reflected the temporary effects of adjustment to lower interest rate levels.

2.06 It is also becoming evident that the recent rapid growth in M0 may reflect a potentially lasting change in its medium-term trend relative to GDP. It is likely that, in an environment of sustained low inflation and lower nominal interest rates, there is less incentive to economise on cash holdings and velocity will grow more slowly. This may imply that over the medium term M0 can grow faster than previously thought without putting the Government's inflation objective at risk. This change in trend would be consistent with experience in the 1950s and 1960s. However, it is too soon to be certain that there has been a permanent shift in trend. For much of the next year annual M0 growth is expected to remain above the top of its 0 to 4 per cent range. But growth could fall back during the year as the effects of interest rate cuts weaken, and as growth in activity moderates.

2.07 Over the last year M4 has remained in the lower half of its 3 to 9 per cent range. Growth in lending has also been very weak, as industrial and commercial companies in total have continued to repay bank borrowing. There is uncertainty about trend growth in M4 also, which can be affected substantially by changes in financial innovation (as has happened in the US recently).

2.08 Given these uncertainties, the Government will retain for the time being the existing medium-term monitoring ranges for M0 and M4. It will continue to assess the growth of narrow and broad money alongside the evidence of all the other indicators. The monitoring ranges will however be reviewed carefully in the light of continued experience.

Fiscal policy

2.09 The role of fiscal policy is to ensure sound public finances. The Government's fiscal objective is to bring the PSBR back to balance over the medium term, and the November 1993 Budget set the public finances on a path to achieve this.

2.10 Aiming for budget balance is a prudent objective given the considerable uncertainties about medium-term prospects. It allows some safety margin against unfavourable developments and ensures that the ratio of public sector debt to GDP, and hence the burden of debt service, will fall over time.

2.11 As the PSBR returns toward zero, the general government financial deficit will fall below the reference value of 3 per cent of GDP set out in the European Union's excessive deficits procedure and the public sector's balance on current account will move into surplus. On the main projection set out in Chapter 4 below, these "milestones" will be passed in 1996-97 and 1997-98 respectively.

2.12 The Government is committed to reducing public expenditure as a proportion of national income. It does not have a target for capital spending, which is now more clearly distinguished in the public sector accounts. However, the Government intends that a steadily rising proportion of capital investment in the public services should be financed by private capital, based on a proper transfer or sharing of risk. 

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Reviewed 1 October 1996