United Kingdom: Staff Concluding Statement of the 2023 Article IV Mission
IMF News, May 23, 2023
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- Published: May 23, 2023
Mission Concluding Statement — key messages
- Buoyed by resilient demand in the context of declining energy prices, the UK economy is expected to avoid a recession and maintain positive growth in 2023.
- Economic activity has slowed significantly from last year and inflation remains stubbornly high following the severe terms-of-trade shock due to Russia’s war in Ukraine and, to some extent, labor supply scarring from the pandemic.
- Monetary policy will need to remain tight to keep inflation expectations well-anchored and bring inflation to target.
- Fiscal policy should continue to be aligned with monetary policy in the fight against inflation, while protecting key public services and the vulnerable.
- The UK financial system has weathered the recent global banking stress well; continued strong oversight, including of smaller banks and the diverse non-bank financial sector, will be critical to preserve UK financial stability.
- Realizing the UK’s full growth potential will require wide-ranging, further evidence-based reforms, including addressing the post-pandemic rise in labor inactivity (mainly due to long-term illness); removing impediments to business investment (especially policy and regulatory uncertainty); and enhancing public investment and transformational spending to boost productivity and accelerate the green transition.
Economic outlook and risks
- Staff forecasts growth to slow to 0.4 percent in 2023, held back by tighter monetary and fiscal policies needed to curb inflation, and lingering impacts of the terms-of-trade shock.
- This forecast represents a 0.7 percentage point upgrade to the IMF’s April World Economic Outlook forecast of -0.3 percent and reflects higher-than-expected resilience in both demand and supply.
- Growth projections:
- 1 percent in 2024.
- Average around 2 percent in 2025 and 2026.
- Settle at 1½ percent thereafter (staff’s estimate of trend growth).
- Inflation trajectory:
- Declining energy prices and widening economic slack are expected to substantially reduce inflation to around 5 percent y/y by end-2023.
- Below the 2 percent target by mid-2025.
- Major risks:
- Upside: greater-than-anticipated persistence in price- and wage-setting leading to higher inflation for longer, intensifying the need for tighter demand-management policies and/or a drift-up in inflation expectations with potential re-pricing of long-term financial assets and macro-financial spillovers.
- Downside: further tightening in global financial conditions that restrains credit and trading partner demand, amplified if contagion to the UK financial sector occurs and/or adverse macro-financial feedback loops (such as a housing market correction) are triggered.
Macroeconomic management priorities — monetary and fiscal policy
- Monetary policy actions and assessment:
- The Bank of England (BoE) was the first major central bank to lift its policy rate (in December 2021) and has since hiked Bank Rate by 440 basis points.
- The BoE commenced quantitative tightening (QT) in March last year with passive run-off and accelerated in November with active gilt sales.
- Given transmission lags, sizable rate hikes implemented since August are expected to have their peak impact from the second half of 2023.
- Inflation momentum, measured with annualized 3-month core inflation rates, remains strong, at about 5 percent in March.
- Inflation is projected to return to the 2 percent target only by mid-2025, 6-months later than in staff’s April forecast, with risks tilted to the upside.
- Policy recommendation: some further monetary tightening will likely be needed, and rates may have to remain high for longer; continuous review of pace and magnitude is warranted. The BoE should focus on underlying measures of inflation—such as wage growth and services inflation—and see-through base effects in energy prices.
- QT strategy recommendation: continue as envisaged to reduce BoE’s footprint in markets and establish headroom for future asset purchases; incremental approach while relying on Bank Rate as the key instrument is advantageous.
- Fiscal policy actions and assessment:
- The last two budgets have aligned fiscal policy with monetary policy and should stabilize debt.
- Staff’s forecast implies a 3 percent of GDP headline deficit reduction between FY2022/23 and FY2027/28, with public sector net debt (excluding the BoE) stabilizing at 97 percent of GDP at the end of the forecast period.
- With a close-to-neutral fiscal stance in 2023 and contraction thereafter, fiscal policy is supporting disinflation.
- Near-term recommendation: save any revenue overperformance to avoid complicating monetary policy and rebuild fiscal buffers; ensure the Energy Price Guarantee scheme expires as planned and target any future support; invest in data and IT systems to reach vulnerable households outside the welfare system.
- Medium-term recommendation: the fiscal strategy should account better for spending pressures to preserve service delivery and investment needs. The Spring Budget’s assumed expenditure envelopes after FY2024/25 could imply large reductions for some departmental budgets under realistic allocations.
- Policy options to achieve consolidation while protecting services and growth-enhancing investment:
- Replace the triple lock on pensions with the best practice of inflation-indexation.
- Strengthen carbon taxation to deliver Net Zero targets.
- Reform property taxes, including updating real estate valuations and rebalancing away from transaction taxes.
- Improve efficiency and fairness by eliminating loopholes in wealth and income taxation, and national insurance contributions.
Financial sector stability and macroprudential framework
- Credit and balance sheet conditions:
- The current credit downturn is showing signs of bottoming out.
- Household and corporate balance sheets have thus far shown resilience, but corporate insolvencies have risen and pressures have intensified in the mortgage and commercial real estate markets.
- Macroprudential recommendations:
- Support for keeping the countercyclical capital buffer (CCyB) at 2 percent for now, with continued close monitoring to calibrate the buffer going forward.
- Strengthen the BoE’s top-down stress testing capacity, as recommended by the 2022 Financial Sector Assessment Program (FSAP).
- Bank resilience and supervisory recommendations:
- Major UK banks maintain capital and liquidity buffers well above prudential requirements.
- Prudential Regulation Authority’s (PRA) intensified liquidity monitoring is welcome; staff encourages expanded data collection and analysis on depositor behavior to inform policy deliberations on the liquidity coverage ratio (LCR) and domestic stress testing.
- PRA’s Strong and Simple Framework for non-systemic domestic banks and building societies should be carefully weighed before amending supervisory requirements for smaller banks.
- Lessons from the pension funds’ LDI crisis:
- The BoE’s intervention successfully restored market functioning via timely intelligence, coordination, reserve pricing for gilt purchases, and clear communication on temporary/targeted nature.
- Authorities’ actions to strengthen LDI resilience are welcomed; staff supports FPC recommendation that The Pension Regulator’s remit take into account financial stability considerations.
- Non-bank financial institutions (NBFI) vulnerabilities — recommended actions:
- Strengthen NBFI liquidity via enhanced liquidity management, operational readiness for margin calls, and more stringent liquidity regulation for NBFIs holding leveraged exposures in core markets.
- Improve understanding of NBFI risks through the authorities’ “system-wide exploratory scenario”.
- Close data gaps via enhanced cooperation among national regulators and coordination with the FSB and other jurisdictions.
- Consider allowing BoE liquidity backstops to systemically important and adequately supervised NBFIs.
Reforms to enhance policy frameworks and resolution regimes
- Fiscal framework reforms:
- All major discretionary fiscal policy changes should be accompanied with a full set of macroeconomic and fiscal forecasts by the Office for Budget Responsibility (OBR), unless the OBR assesses such a forecast is not necessary.
- Consider a mechanism for the OBR to provide parliament with an analysis of the impact of proposed changes in the fiscal rules before votes.
- Better defined escape clauses with clear conditions would help avoid loss of credibility associated with frequent rule changes.
- Consider a framework anchored in the probability of debt stabilization to provide greater flexibility while remaining stable.
- Resolution and depositor protection reforms:
- Recent bank resolutions show the BoE effectively used its 2009 Banking Act powers (example: sale of Silicon Valley Bank (SVB) UK to HSBC UK Bank plc fully protected all SVB UK depositors without cost to the taxpayer).
- Challenges identified: high speed of deposit withdrawals, risk of disruptions to businesses with uninsured deposits, and lack of loss-absorbing capacity held by smaller banks.
- Authorities are considering options to improve depositor payouts in bank failures; reforms should be supported by careful depositor data analysis and consideration of moral hazard.
- Recommendation from 2022 FSAP: Financial Services Compensation Scheme should build up a prefunded deposit insurance fund with an appropriate target level.
- Regulatory reform principles:
- Preserve the primacy of financial stability, safety and soundness, and market integrity objectives.
- Safeguard the FPC’s financial stability objective and strengthen its focus on global financial standards and cross-border surveillance.
- Allow adequate time for consultation on proposed reforms to balance stability and innovation; competition and innovation mandates should be subordinate to financial stability.
- Any adjustment to ring-fencing or the SMCR should be carefully weighed and maintain robustness.
Structural policies to uplift growth and accelerate the green transition
- Recent measures and context:
- The Spring Budget introduced supply-side measures, notably increased childcare support and a capital investment allowance.
- Decline in uncertainty due to the “Windsor Framework” agreement and a measured approach to retained EU laws should favorably impact business investment.
- Chancellor’s 4Es’ vision (enterprise, education, employment, everywhere) targets growth areas such as advanced manufacturing, life sciences, and clean energy.
- Recommended evidence-based reforms to add momentum:
- Further enhance policy certainty via wider permanent capital investment incentives and predictable tax and regulatory regimes.
- Boost small and medium-sized firms’ access to finance and R&D support (including, for example, via a return to Horizon Europe).
- Ease planning restrictions and accelerate catalytic public investments for the green transition and delivery of critical network and healthcare infrastructures.
- Raise labor force participation and productivity by strengthening skills and education outcomes, and improving healthcare services.
- Fine-tune the immigration system to alleviate sectoral and skilled labor shortages and enhance labor market flexibility.
- Accelerating the green transition:
- The UK has ambitious Net Zero targets underpinned by a strong legal framework but there is scope for additional quantifiable measures.
- Suggested actions:
- More rapidly extend the UK’s ETS and legally clarify the phase-in of carbon pricing regulations.
- Provide more incentives for the green transition (e.g., expanding the grant program for low-income households’ heat pump installations and home insulation).
- Remove bottlenecks by setting out longer-term plans to attract private investment.
- Benefits: lower energy input costs and increased energy security from transition to a greener energy mix.
Source: United Kingdom: Staff Concluding Statement of the 2023 Article IV Mission (May 23, 2023).