Last year again proved a disappointing one for the UK economy with GDP declining by around 3/4 per cent, although activity does appear to have stabilised over the course of the year with some continuing weakness in domestic demand in the fourth quarter being offset by more favourable trading conditions in export markets. Since our last forecast in November little has happened to change our view as to how the economy will develop over the coming months. Domestic activity should be buttressed by the recent relaxation in monetary policy, allowing a moderate export-led recovery to get underway. However, conflicting signals as to the state of the economy may appear for some while since it is to be expected that the full impact of the recent reductions in interest rates will take some time to materialise.

Turbulence has continued in European foreign exchange markets over the last three months. The realignment of European exchange rates in September was not particularly conducive to promoting economic stability, and subsequent realignments have produced more strain. We had argued for some time before Black Wednesday that European exchange rates were not near their fundamentals. We have often said that such a realignment might be beneficial. Any realignment involves some loss of credibility, but the disorderly rout seen in September appears to have damaged the reputation of a number of governments outside the core ERM countries, and it has affected confidence badly. A realignment could have been an aid to a weak recovery. It appears that the effects of the realignment and decline in confidence in the abilities of the authorities have helped turn what might have been a concerted upturn in France, Italy and the UK into a period of, at best, stagnation.

Before 1914 long-term price stability was confidently expected in the UK. The typical yield then of 3 per cent per annum on long-term UK government bonds can be compared with the 4 per cent per annum on government index-linked bonds at end-1992. Inflation has made conventional long-term Government bonds riskier, and it is estimated that the real expected yield on these was about 5 per cent per annum at end-1992. Estimates are also provided for years in between, and for expected real returns on equities, and for the US, and these may surprise some. As estimated, expected real long-term UK government conventional bond yields were mostly at or above 4 per cent per annum. As bonds became relatively more risky, the risk premium on equities came down and is currently quite small, so that the cost of equity capital has not risen as has the cost of government conventional bond borrowing. In the absence o f a prolonged world depression, it seems likely that current expected real long-term interest rates will not fall, and could go higher.

This note examines the question of whether the responsibility for the operation of monetary policy in the UK should be ceded to an independent Bank of England. While sterling was committed to membership of the European Monetary System, this issue was pre-empted since monetary policy was effectively determined by the actions of the Bundesbank. Now, with the UK's withdrawal from the EMS and no immediate prospect of any return, the question has again returned to the policy agenda. In fact, the arguments used to justify such a delegation of responsibility are closely related to those originally associated with the decision to join the EMS itself; that monetary policy should be controlled by an authority with a strong aversion to inflation and a reputation for sticking to its announced policy. It has been argued that an independent Bank of England would offer precisely these advantages without compromising the domestic (ie UK) objectives which were overridden by the Bundesbank.

The whole of Europe has embarked on a major programme of economic change. The former CMEA countries are trying to move rapidly from state planning to market economies. In the west, not only is the European Community well down the road to removing a large number of non-tariff barriers between the member states through the Single Market programme—extended to EFTA through the European Economic Area agreement but it has also agreed, through the Maastricht Treaty, to try to converge to an economic and monetary union with low inflation, low public sector deficits and controlled public debt, before the end of the century. Negotiations are beginning over extending this, through full membership of the Community, to Austria, Finland, Norway and Sweden.