IMF Executive Board Concludes 2014 Article IV Consultation with the United Kingdom

KEY ISSUESThe economy has rebounded strongly and prospects are promising. Headwinds thatpreviously held back the economy—relating notably to credit conditions andconfidence—have eased. Nonetheless, sustaining strong growth will depend on arecovery in productivity growth and further demand rebalancing. The housing marketbrings risks of financial vulnerabilities. Sterling is moderately overvalued.The overall policy mix is appropriate, but policy settings might need to be adjustedquickly. Effective monetary conditions are very supportive, compensating for ongoingfiscal consolidation:? Accommodative monetary policy is appropriate for now, given weak inflationpressures, but policy might need to be adjusted quickly if inflation takes off. Interestrate increases may also need to be considered if macroprudential tools areinsufficient to deal with financial stability risks from the housing market.? The authorities have recently implemented macroprudential measures, includinglimiting the share of high loan-to-income mortgages lenders can issue, establishingthem as the primary defense against housing-related risks. They should stand readyto tighten these limits should current settings prove ineffective in reining in thoserisks.? A lasting solution to house price pressures requires measures to address insufficientsupply. Significant planning reforms have been undertaken, but political consensus isneeded to make further progress in this area.? High deficits and rising debt mean that fiscal consolidation needs to continue. Thepace and composition of deficit reduction over the near term is appropriate. Furtherreducing the deficit over the medium term will be challenging; both revenue andexpenditure measures should be considered, keeping in mind both equity andefficiency.? The financial sector is more robust, the new financial architecture is settling in, andsignificant changes have been made to banks’ liquidity backstops to adapt tochanging needs. Implementing macroprudential policy will be a test of the newarchitecture. Some problems—such as Too Important To Fail and bank misconduct—persist, and new challenges, such as from shadow banking, are emerging.

Abstract

KEY ISSUESThe economy has rebounded strongly and prospects are promising. Headwinds thatpreviously held back the economy—relating notably to credit conditions andconfidence—have eased. Nonetheless, sustaining strong growth will depend on arecovery in productivity growth and further demand rebalancing. The housing marketbrings risks of financial vulnerabilities. Sterling is moderately overvalued.The overall policy mix is appropriate, but policy settings might need to be adjustedquickly. Effective monetary conditions are very supportive, compensating for ongoingfiscal consolidation:? Accommodative monetary policy is appropriate for now, given weak inflationpressures, but policy might need to be adjusted quickly if inflation takes off. Interestrate increases may also need to be considered if macroprudential tools areinsufficient to deal with financial stability risks from the housing market.? The authorities have recently implemented macroprudential measures, includinglimiting the share of high loan-to-income mortgages lenders can issue, establishingthem as the primary defense against housing-related risks. They should stand readyto tighten these limits should current settings prove ineffective in reining in thoserisks.? A lasting solution to house price pressures requires measures to address insufficientsupply. Significant planning reforms have been undertaken, but political consensus isneeded to make further progress in this area.? High deficits and rising debt mean that fiscal consolidation needs to continue. Thepace and composition of deficit reduction over the near term is appropriate. Furtherreducing the deficit over the medium term will be challenging; both revenue andexpenditure measures should be considered, keeping in mind both equity andefficiency.? The financial sector is more robust, the new financial architecture is settling in, andsignificant changes have been made to banks’ liquidity backstops to adapt tochanging needs. Implementing macroprudential policy will be a test of the newarchitecture. Some problems—such as Too Important To Fail and bank misconduct—persist, and new challenges, such as from shadow banking, are emerging.

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 Board Assessment2

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.

United Kingdom: Selected Economic Indicators, 2012–15

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Sources: Bank of England; IMF’s International Finance Statistics; IMF’s Information Notic System; HM Treasury; Office for National Statistics; and IMF staff estimates.

ILO unemployment; based on Labor Force Survey data.

The fiscal year begins in April. Data exclude the temporary effects of financial sector interventions. Debt stock data refers to the end of the fiscal year using centered-GDP as a denominator.

In percent of potential output.

Average. An increase denotes an appreciation.

Based on relative consumer prices.

1

Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

2

At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in summings up can be found here:http://www.imf.org/external/np/sec/misc/qualifiers.htm.