Each country is also to allow continuous monitoring of its government finances by the other EU countries. A government budget deficit is normally not to exceed 3 per cent of GDP, though there is room for certain exemptions. If a country in the euro area does have a budget deficit above 3 per cent and this cannot be explained by factors that are exceptional and temporary, sanctions are to be imposed. EU countries outside the euro area are not liable to sanctions, however; they are only included in the monitoring provisions of the Pact. The task of establishing price stability in the euro area will be facilitated if low inflation in the area is also promoted by fiscal policies. The importance of fiscal policy lies both in creating sustainable government finances, which contribute to the general credibility of economic policy, and in countering tendencies to excessive price pressure in the economy. In that the single monetary policy is to be constructed in relation to the overall situation in the euro area, more will be required of fiscal policy in the context of national stabilisation policy - fiscal instruments will still be available for stabilising national economic trends. But this in turn does presuppose that there is room for manoeuvre in the national budgets. Partly on this account, the Stability and Growth Pact’s medium-term objective of a government budget balance or surplus is reasonable and it is highly important that the countries meet this undertaking.
Or it could be that the spare capacity is exerting little downward pressure, because businesses with limited access to credit are unwilling to run the risk of reducing their cash flow by cutting prices in order to boost market share. Moreover, even though pay growth has been muted, unit wage costs have nevertheless risen quite sharply because businesses have held onto skilled labour through the recession, rather than lay it off. So the firmness in underlying prices may just be the flipside of the better-than-expected labour market outturns. Despite these uncertainties, it seems likely that the margin of spare capacity will be sufficient to pull inflation back towards the 2% target from its present elevated level, as the near-term effects of the restoration in VAT and sterling’s past depreciation work through. Our latest projections, contained in the February Inflation Report, are shown in Chart 9. The risks of inflation being above or below the target are roughly balanced by the end of the forecast horizon. It should, I hope, be clear from my remarks that, although a recovery of sorts may have commenced, there are still considerable doubts about its strength and durability and about the accompanying path of inflation. The road ahead is likely to be bumpy and there is still the risk of further adverse shocks.