On July 23, 2014 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Kingdom.1
The economy has rebounded strongly and prospects are promising. Headwinds that previously held back the economy—including adverse credit conditions and diminished confidence—have eased. There are signs that demand is becoming more balanced, with growth in business investment now ahead of private consumption. Employment growth has remained strong. Despite this, inflation has been contained.
Nonetheless, sustaining strong growth will depend on a recovery in productivity growth and real wages. In addition, the housing market is becoming buoyant, potentially creating financial stability risks. Further demand rebalancing is needed: net trade has made only a modest contribution to the recovery, and the real exchange rate is moderately overvalued.
Policies have been directed toward supporting growth, while strengthening public finances through a mix of revenue and expenditure measures and ensuring financial stability. Monetary policy remains highly accommodative, and effective monetary conditions have eased compared with last year. A number of micro-prudential and credit policy measures have been introduced in an effort to take some of the steam out of the housing market, such as modification of the Funding for Lending Scheme and the introduction of tighter underwriting standards for owner-occupier mortgages. The Financial Policy Committee of the Bank of England has also recommended the implementation of macroprudential measures aimed at insuring against excessive household indebtedness. Meanwhile, the 2014 Budget implies a half-percentage point tightening in the cyclically-adjusted primary balance. Going forward, fiscal policy aims to eliminate the budget deficit by FY2018 and to put the debt ratio firmly on a downward path while preserving the delivery of quality public services and paying due attention to social equity.
After the overhaul of the UK’s financial regulatory architecture in 2013, which saw the establishment of the Prudential Regulation Authority, Financial Conduct Authority, and Financial Policy Committee, efforts to strengthen bank balance sheets and implement durable structural reforms to the financial sector have continued. These include higher bank capital and provisioning, a robust multi-pronged framework for assessing capital adequacy, and stress testing of major banks for large shocks. Liquidity backstops have been strengthened, which should help solvent UK banks ride out temporary funding stresses that could otherwise create domestic and outward credit spillovers. But easier access to liquidity requires commensurately strong supervision of banks and other financial intermediaries.
Executive Directors welcomed the rebound in output and employment in the UK economy amid improved credit conditions and confidence. They agreed that the overall policy mix is appropriate in view of remaining slack in the economy and a continued weak external environment, but encouraged the authorities to readily adjust the policy settings should inflation accelerate. Directors emphasized that sustaining strong growth and improving competitiveness will require a recovery in productivity growth and further demand rebalancing.
Directors supported the authorities’ near-term fiscal consolidation efforts, stressing the importance of strengthening public finances without undermining economic growth. They saw a need to continue these efforts in the medium term in order to put debt on a downward path. They encouraged the authorities to explore both revenue and expenditure measures, taking into account efficiency and equity considerations, while maintaining delivery of key public services. In this regard, Directors also welcomed the authorities’ efforts to analyze the distributional impact of fiscal consolidation.
Directors agreed that maintaining the accommodative monetary policy stance is appropriate in the immediate term. They noted the Bank of England’s strategy and intentions to raise the policy rate first when the time comes for normalizing monetary policy, and pointed out the need for flexibility in policy sequencing as developments warrant. In this context, Directors highlighted the particular importance of clear communications on the factors that would guide the decisions of the Monetary and Financial Policy Committees.
Directors agreed that macroprudential measures should be the first line of defense against financial stability risks arising from the housing market, and welcomed the micro- and macroprudential measures that have already been taken. They encouraged the authorities to stand ready to adjust the limits under the existing measures, modify the terms of the Help to Buy scheme, or undertake new steps, should financial vulnerabilities escalate. They noted that the Bank of England may need to consider raising interest rates in case macroprudential measures prove insufficient, but called for careful consideration of potential implications for growth and employment of such policy action. Directors agreed that strong house price growth in the U.K. may ultimately reflect inadequate supply and that further supply-side measures would be needed, including eliminating unnecessary restrictions on development and reforming property taxation.
Directors concurred with the importance of safeguarding the financial sector, and welcomed the measures to raise bank capital, strengthen the financial system’s resilience, and enhance prudential supervision. They noted that further efforts to bolster bank capital over the medium term are likely to be needed, and that ongoing efforts to address bank misconduct and the Too-Important-to-Fail problem remain essential. Directors encouraged the authorities to be alert to a build-up of risks in the shadow banking system, maintain strong coordination across regulatory bodies, and ensure international consistency of national reforms. They also underscored the importance of broadening the institutional perimeter of the stress tests and strengthening supervision beyond the major banks.
Over the medium term, Directors encouraged the authorities to undertake the necessary structural reforms to raise productivity, enhance competitiveness, and bolster the economy’s long-term growth potential. They agreed that priority areas could include infrastructure, especially transportation and energy, education and training, immigration, and financial intermediation.