Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF’s Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.May 22, 2012
The Central Scenario and Risks
1. Current policies are aimed at assisting economic rebalancing and financial sector stability. Strong fiscal consolidation is underway and reducing the high structural deficit over the medium term remains essential. The UK has made substantial progress toward achieving a more sustainable budgetary position and reducing fiscal risks. Bold monetary stimulus has helped support the economy, as has the free operation of automatic fiscal stabilizers. This macroeconomic policy mix assists in rebalancing the economy toward investment and external demand. Further, financial sector stability in the UK is of global importance as highlighted in spillover analysis. In this context, policies have encouraged the buildup of capital and liquidity buffers, the domestic oversight framework is being strengthened, and work is underway to enhance the capacity to deal with systemically important financial institutions.
2. But the economy has been flat. The hand-off from public to private demand-led growth has not fully materialized. Much of this underperformance relative to earlier expectations is due to transitory commodity price shocks and heightened uncertainty following the intensification of stress in the euro area. However, the weak recovery also indicates that the process of unwinding pre-crisis imbalances is likely to be more protracted than previously anticipated, in part due to persistent tight credit conditions. Reflecting these forces, output remains more than 4 percent below its pre-crisis peak. Encouragingly, labor market performance has been better, with falling unemployment in recent months and fewer employment losses than in the aftermath of previous major UK recessions. This disparity between output and labor market indicators complicates the assessment of the current state of the economy. But unemployment at 8.2 percent, with a large number of youth without a job, is still much too high.
3. The recovery is expected to gain pace, but much productive capacity could remain idle for an extended period. The projected modest pick up in growth in the second half of 2012 is premised on less drag from budget consolidation this fiscal year, the dissipation of last year’s commodity price shocks, and an assumed easing of strains in the euro area. Over the medium term, economic activity is expected to gain additional momentum, but the continued headwinds from private-sector deleveraging and the need to reduce the structural fiscal deficit will constrain the pace. The output gap is projected to remain sizeable for an extended period, raising the risk of hysteresis as sustained cyclical weakness reduces the economy’s productive capacity.
4. Inflation is falling. Inflation has been on a downward trend since peaking in September 2011, as the impact of indirect tax hikes and commodity price shocks have begun to dissipate. This trend will continue as the large output gap exerts disinflationary pressure. Thus inflation is expected to decline below the 2 percent target over the next 18-24 months with an unchanged macroeconomic stance and barring any sustained increase in commodity prices.
5. Risks are large and tilted clearly to the downside. Setbacks in the euro area are the key risk to economic prospects and financial stability in the UK as trade and financial links are substantial. An escalation of stress in the euro area could set off an adverse and self-reinforcing cycle of lower confidence and exports, higher bank funding costs, tighter credit, and falling asset values, resulting in a substantial contractionary shock. By contrast, a decisive and durable resolution to stress in the euro area would aid the UK’s recovery and remove this downside risk. Another risk is that the adverse impact of public and private deleveraging may be even larger than expected and the anticipated rebalancing of demand is even slower to materialize. Commodity price volatility also remains a risk for both inflation and growth.
Policy Support to Secure Sustainable Recovery
6. Policies to bolster demand should help close the output gap faster. It needs to be recognized that policy options in this regard come with risks, including uncertainty about their effectiveness. However, these risks need to be weighed against the risk of weak demand that leads to persistently slow growth and high unemployment that become entrenched in decisions made by consumers and investors.
7. Further monetary easing is required. Anemic nominal wage growth and broadly stable inflation expectations suggest underlying inflationary pressure is weak, providing space for greater monetary easing. That said, uncertainty about inflation dynamics and the strength of disinflationary pressure coming from the output gap imply risks that inflation could take longer-than-expected to return to target, with convergence being further delayed by additional monetary easing. Nonetheless, the cost of such a delay is likely to be low relative to the benefits of a more rapid closing of the output gap.
8. Monetary stimulus can be provided via further quantitative easing (QE) and possibly cutting the policy rate. Evidence suggests that QE can continue to support demand by lowering long-term interest rates and improving banks’ liquidity. The Monetary Policy Committee should also reassess the efficacy of cutting the policy rate below its current level of 0.5 percent. With the yield curve now essentially flat at the policy rate out to 3-year maturities, a rate cut is likely to reduce yields nearly one-for-one well out into the curve, increasing its stimulative impact. Effects on yields of 5 years or below are important, as most lending to the private sector is linked to this range. However, the possible effect of a cut in the policy rate on net interest margins and thus financial stability needs to be assessed before taking such a step to provide monetary stimulus.
9. Options to further boost demand through credit easing measures that utilize the government’s balance sheet should be explored. Elevated funding costs have limited the quantity and tenor of bank lending to the private sector, while government borrowing costs have fallen to record lows. In this context, the government has recently adopted measures to ease credit constraints for both SMEs and households. The government has announced that it intends to go further to boost credit for business, housing, and infrastructure, which is welcome because some diversification of policies aimed at lowering private-sector borrowing costs would be valuable. Options to consider should include:
Purchasing private-sector bonds, as undertaken by several major central banks, to support mortgage lending and financing for business. In the UK’s case, the Bank of England could act as the government’s agent for such purchases. The allocation of purchases within a class should be guided by nondiscretionary rules, such as allocation according to market share.
Providing longer-term bank funding facilities against a broad range of collateral (with haircuts) to reduce funding costs and boost demand for assets eligible as collateral. Such actions would need to be complemented by regulatory policies to ensure that banks do not become dependent on such facilities.
10. To support recovery, financial sector policies should focus on strengthening bank balance sheets by building capital rather than reducing assets. The rebuilding of banks’ capital and liquidity buffers over the last few years has been valuable in the face of recent market distress and heightened spillover risks from the euro area. In a context of tight credit conditions and a need to support growth, the interim Financial Policy Committee (FPC) has appropriately provided guidance that, going forward, banks should focus on improving capital buffers by raising external capital as early as feasible and by limiting the payout of bonuses and dividends, rather than hindering credit supply through asset-shedding. In this connection the interim FPC should clarify its expectations about the transition path to Basel III capital ratios, as an accelerated pace has adverse cyclical implications. And in evaluating liquidity requirements, the interim FPC should take into account such cyclical considerations and the availability of liquidity insurance from the Bank of England.
11. The slower pace of structural fiscal consolidation in FY12/13 is appropriate in view of the outlook. In November 2011, the authorities decided not to undertake additional discretionary tightening over the next 3 years in response to upward revisions to the structural deficit by the independent Office for Budget Responsibility. Instead, consistent with the flexibility in the fiscal framework, the government allowed automatic stabilizers to operate freely and budgeted additional structural adjustment only in the outer years (2015–17). This response was right given the weak outlook and did not elicit an adverse market reaction, demonstrating the credibility of fiscal policy and institutions in the UK. The cyclically-adjusted primary balance as a share of potential GDP is expected to narrow by about a ½ percentage point in FY12/13. Reflecting the OBR revision to trend output, this pace of consolidation is below the original projection for this fiscal year in the June 2010 budget. It is also well below the average annual 2 percentage point pace in the two previous fiscal years.
12. There is scope within the current overall fiscal stance to improve the quality of fiscal adjustment to support growth. The government has taken steps over the past year to make consolidation more “growth friendly” through cuts in spending on items with low multipliers (such as public employee wages) to fund higher spending on items with high multipliers (such as infrastructure). However, the scale of these adjustments has been modest and further budget-neutral reallocations should be sought, recognizing inevitable implementation lags and challenges. Fiscal space for further growth-enhancing measures could be generated by property tax reform, restraint of public employee compensation growth, and better targeting of transfers to those in need. This fiscal space could be used to fund higher infrastructure spending, which has a high multiplier and raises potential output. It will also be important to shield the poorest from the impact of consolidation.
13. Fiscal easing and further use of the government’s balance sheet should be considered if downside risks materialize and the recovery fails to take off. In particular, if growth does not build momentum and is significantly below forecasts even after substantial additional monetary stimulus and further credit easing measures, planned fiscal adjustment would need to be reconsidered. Under these circumstances, gains from delaying fiscal consolidation could be larger as multipliers are estimated to move inversely with growth and the effectiveness of monetary policy. To preserve credibility, reconsidering the path of consolidation should be in the context of a multi-year plan focused on further reducing the UK’s large structural fiscal deficit when the economy is stronger and taking into account risks to sovereign borrowing costs. Fiscal easing measures in such a scenario should focus on temporary tax cuts and greater infrastructure spending, as these may be more credibly temporary than increases in current spending.
14. Continued structural reforms would further support sustainable recovery. In this context, the government’s ongoing efforts to ease planning restrictions to help boost investment are welcome. The agenda for tax reforms in recent budgets could be expanded by revenue-neutral reform of the corporate income tax to introduce an allowance for new corporate equity aimed at reducing the tax code’s bias in favor of debt over equity finance.
Strengthening the Framework for Financial Sector Stability
15. Efforts to further bolster the stability of the financial system need to continue. Such stability is critical to anchor a strong and durable recovery in the UK and reduce the risk to taxpayers. Moreover, spillover analysis highlights the potential for large shocks to be transmitted through the UK financial system. In light of these large contagion effects, it is crucial that “too big to fail” issues are addressed. In this connection, the progress made in developing a more flexible resolution framework and resolution and recovery plans for major institutions is welcome. Draft legislation to implement the proposals of the Independent Commission on Banking should be completed as soon as feasible to provide clarity on what will be in the ringfence.
16. A broader macroprudential toolkit is desirable. The interim FPC has appropriately requested powers to adjust the countercyclical capital buffer, sectoral capital requirements, and the leverage ratio. Additional powers should include the ability to limit loan-to-value and loan-to-income ratios, as higher capital requirements alone may be insufficient to restrain property bubbles. This will be especially true if most banks are comfortably above minimum capital requirements during the boom, such that higher risk weights on property loans may have little effect on banks’ lending behavior.
17. Intensifying supervision and broadening its authority over financial holding companies is a priority. The transition to the new institutional structure for the conduct of supervision, together with the new supervisory model designed to intensify supervision, is a complex task that will require skillful management. As highlighted in the 2011 assessment of the UK financial sector under the IMF’s Financial Sector Assessment Program (FSAP), adequacy of high-quality supervisory resources will be a key to the success of this transition. In addition, as recommended in that assessment, greater authority over financial holding companies than currently envisaged in the draft Financial Services Bill will be essential for the future Prudential Regulation Authority to effectively supervise large financial groups. The emerging international crisis management framework provides an opportunity to revisit this issue. Progress has been made in implementing most other FSAP recommendations, although many initiatives are closely tied to the transition to the new structure and will need to be assessed in the future.
The Central Scenario and Risks
1. Current policies are aimed at assisting economic rebalancing and financial sector stability. Strong fiscal consolidation is underway and reducing the high structural deficit over the medium term remains essential. The UK has made substantial progress toward achieving a more sustainable budgetary position and reducing fiscal risks. Bold monetary stimulus has helped support the economy, as has the free operation of automatic fiscal stabilizers. This macroeconomic policy mix assists in rebalancing the economy toward investment and external demand. Further, financial sector stability in the UK is of global importance as highlighted in spillover analysis. In this context, policies have encouraged the buildup of capital and liquidity buffers, the domestic oversight framework is being strengthened, and work is underway to enhance the capacity to deal with systemically important financial institutions.
2. But the economy has been flat. The hand-off from public to private demand-led growth has not fully materialized. Much of this underperformance relative to earlier expectations is due to transitory commodity price shocks and heightened uncertainty following the intensification of stress in the euro area. However, the weak recovery also indicates that the process of unwinding pre-crisis imbalances is likely to be more protracted than previously anticipated, in part due to persistent tight credit conditions. Reflecting these forces, output remains more than 4 percent below its pre-crisis peak. Encouragingly, labor market performance has been better, with falling unemployment in recent months and fewer employment losses than in the aftermath of previous major UK recessions. This disparity between output and labor market indicators complicates the assessment of the current state of the economy. But unemployment at 8.2 percent, with a large number of youth without a job, is still much too high.
3. The recovery is expected to gain pace, but much productive capacity could remain idle for an extended period. The projected modest pick up in growth in the second half of 2012 is premised on less drag from budget consolidation this fiscal year, the dissipation of last year’s commodity price shocks, and an assumed easing of strains in the euro area. Over the medium term, economic activity is expected to gain additional momentum, but the continued headwinds from private-sector deleveraging and the need to reduce the structural fiscal deficit will constrain the pace. The output gap is projected to remain sizeable for an extended period, raising the risk of hysteresis as sustained cyclical weakness reduces the economy’s productive capacity.
4. Inflation is falling. Inflation has been on a downward trend since peaking in September 2011, as the impact of indirect tax hikes and commodity price shocks have begun to dissipate. This trend will continue as the large output gap exerts disinflationary pressure. Thus inflation is expected to decline below the 2 percent target over the next 18-24 months with an unchanged macroeconomic stance and barring any sustained increase in commodity prices.
5. Risks are large and tilted clearly to the downside. Setbacks in the euro area are the key risk to economic prospects and financial stability in the UK as trade and financial links are substantial. An escalation of stress in the euro area could set off an adverse and self-reinforcing cycle of lower confidence and exports, higher bank funding costs, tighter credit, and falling asset values, resulting in a substantial contractionary shock. By contrast, a decisive and durable resolution to stress in the euro area would aid the UK’s recovery and remove this downside risk. Another risk is that the adverse impact of public and private deleveraging may be even larger than expected and the anticipated rebalancing of demand is even slower to materialize. Commodity price volatility also remains a risk for both inflation and growth.
Policy Support to Secure Sustainable Recovery
6. Policies to bolster demand should help close the output gap faster. It needs to be recognized that policy options in this regard come with risks, including uncertainty about their effectiveness. However, these risks need to be weighed against the risk of weak demand that leads to persistently slow growth and high unemployment that become entrenched in decisions made by consumers and investors.
7. Further monetary easing is required. Anemic nominal wage growth and broadly stable inflation expectations suggest underlying inflationary pressure is weak, providing space for greater monetary easing. That said, uncertainty about inflation dynamics and the strength of disinflationary pressure coming from the output gap imply risks that inflation could take longer-than-expected to return to target, with convergence being further delayed by additional monetary easing. Nonetheless, the cost of such a delay is likely to be low relative to the benefits of a more rapid closing of the output gap.
8. Monetary stimulus can be provided via further quantitative easing (QE) and possibly cutting the policy rate. Evidence suggests that QE can continue to support demand by lowering long-term interest rates and improving banks’ liquidity. The Monetary Policy Committee should also reassess the efficacy of cutting the policy rate below its current level of 0.5 percent. With the yield curve now essentially flat at the policy rate out to 3-year maturities, a rate cut is likely to reduce yields nearly one-for-one well out into the curve, increasing its stimulative impact. Effects on yields of 5 years or below are important, as most lending to the private sector is linked to this range. However, the possible effect of a cut in the policy rate on net interest margins and thus financial stability needs to be assessed before taking such a step to provide monetary stimulus.
9. Options to further boost demand through credit easing measures that utilize the government’s balance sheet should be explored. Elevated funding costs have limited the quantity and tenor of bank lending to the private sector, while government borrowing costs have fallen to record lows. In this context, the government has recently adopted measures to ease credit constraints for both SMEs and households. The government has announced that it intends to go further to boost credit for business, housing, and infrastructure, which is welcome because some diversification of policies aimed at lowering private-sector borrowing costs would be valuable. Options to consider should include:
Purchasing private-sector bonds, as undertaken by several major central banks, to support mortgage lending and financing for business. In the UK’s case, the Bank of England could act as the government’s agent for such purchases. The allocation of purchases within a class should be guided by nondiscretionary rules, such as allocation according to market share.
Providing longer-term bank funding facilities against a broad range of collateral (with haircuts) to reduce funding costs and boost demand for assets eligible as collateral. Such actions would need to be complemented by regulatory policies to ensure that banks do not become dependent on such facilities.
10. To support recovery, financial sector policies should focus on strengthening bank balance sheets by building capital rather than reducing assets. The rebuilding of banks’ capital and liquidity buffers over the last few years has been valuable in the face of recent market distress and heightened spillover risks from the euro area. In a context of tight credit conditions and a need to support growth, the interim Financial Policy Committee (FPC) has appropriately provided guidance that, going forward, banks should focus on improving capital buffers by raising external capital as early as feasible and by limiting the payout of bonuses and dividends, rather than hindering credit supply through asset-shedding. In this connection the interim FPC should clarify its expectations about the transition path to Basel III capital ratios, as an accelerated pace has adverse cyclical implications. And in evaluating liquidity requirements, the interim FPC should take into account such cyclical considerations and the availability of liquidity insurance from the Bank of England.
11. The slower pace of structural fiscal consolidation in FY12/13 is appropriate in view of the outlook. In November 2011, the authorities decided not to undertake additional discretionary tightening over the next 3 years in response to upward revisions to the structural deficit by the independent Office for Budget Responsibility. Instead, consistent with the flexibility in the fiscal framework, the government allowed automatic stabilizers to operate freely and budgeted additional structural adjustment only in the outer years (2015–17). This response was right given the weak outlook and did not elicit an adverse market reaction, demonstrating the credibility of fiscal policy and institutions in the UK. The cyclically-adjusted primary balance as a share of potential GDP is expected to narrow by about a ½ percentage point in FY12/13. Reflecting the OBR revision to trend output, this pace of consolidation is below the original projection for this fiscal year in the June 2010 budget. It is also well below the average annual 2 percentage point pace in the two previous fiscal years.
12. There is scope within the current overall fiscal stance to improve the quality of fiscal adjustment to support growth. The government has taken steps over the past year to make consolidation more “growth friendly” through cuts in spending on items with low multipliers (such as public employee wages) to fund higher spending on items with high multipliers (such as infrastructure). However, the scale of these adjustments has been modest and further budget-neutral reallocations should be sought, recognizing inevitable implementation lags and challenges. Fiscal space for further growth-enhancing measures could be generated by property tax reform, restraint of public employee compensation growth, and better targeting of transfers to those in need. This fiscal space could be used to fund higher infrastructure spending, which has a high multiplier and raises potential output. It will also be important to shield the poorest from the impact of consolidation.
13. Fiscal easing and further use of the government’s balance sheet should be considered if downside risks materialize and the recovery fails to take off. In particular, if growth does not build momentum and is significantly below forecasts even after substantial additional monetary stimulus and further credit easing measures, planned fiscal adjustment would need to be reconsidered. Under these circumstances, gains from delaying fiscal consolidation could be larger as multipliers are estimated to move inversely with growth and the effectiveness of monetary policy. To preserve credibility, reconsidering the path of consolidation should be in the context of a multi-year plan focused on further reducing the UK’s large structural fiscal deficit when the economy is stronger and taking into account risks to sovereign borrowing costs. Fiscal easing measures in such a scenario should focus on temporary tax cuts and greater infrastructure spending, as these may be more credibly temporary than increases in current spending.
14. Continued structural reforms would further support sustainable recovery. In this context, the government’s ongoing efforts to ease planning restrictions to help boost investment are welcome. The agenda for tax reforms in recent budgets could be expanded by revenue-neutral reform of the corporate income tax to introduce an allowance for new corporate equity aimed at reducing the tax code’s bias in favor of debt over equity finance.
Strengthening the Framework for Financial Sector Stability
15. Efforts to further bolster the stability of the financial system need to continue. Such stability is critical to anchor a strong and durable recovery in the UK and reduce the risk to taxpayers. Moreover, spillover analysis highlights the potential for large shocks to be transmitted through the UK financial system. In light of these large contagion effects, it is crucial that “too big to fail” issues are addressed. In this connection, the progress made in developing a more flexible resolution framework and resolution and recovery plans for major institutions is welcome. Draft legislation to implement the proposals of the Independent Commission on Banking should be completed as soon as feasible to provide clarity on what will be in the ringfence.
16. A broader macroprudential toolkit is desirable. The interim FPC has appropriately requested powers to adjust the countercyclical capital buffer, sectoral capital requirements, and the leverage ratio. Additional powers should include the ability to limit loan-to-value and loan-to-income ratios, as higher capital requirements alone may be insufficient to restrain property bubbles. This will be especially true if most banks are comfortably above minimum capital requirements during the boom, such that higher risk weights on property loans may have little effect on banks’ lending behavior.
17. Intensifying supervision and broadening its authority over financial holding companies is a priority. The transition to the new institutional structure for the conduct of supervision, together with the new supervisory model designed to intensify supervision, is a complex task that will require skillful management. As highlighted in the 2011 assessment of the UK financial sector under the IMF’s Financial Sector Assessment Program (FSAP), adequacy of high-quality supervisory resources will be a key to the success of this transition. In addition, as recommended in that assessment, greater authority over financial holding companies than currently envisaged in the draft Financial Services Bill will be essential for the future Prudential Regulation Authority to effectively supervise large financial groups. The emerging international crisis management framework provides an opportunity to revisit this issue. Progress has been made in implementing most other FSAP recommendations, although many initiatives are closely tied to the transition to the new structure and will need to be assessed in the future.
