A. Monetary Policy

16. Monetary policy has reached an inflection point. While wage and services inflation remain high at around 6 percent and the upper tails of survey- and market-based inflation expectations still exceed historical averages, wage and price-setting expectations for the next 12 months have eased notably (to 4.1 and 3.8 percent, respectively, in May), and core inflation momentum (3m/3m) has moderated. In this context, staff’s baseline foresees headline inflation to already reach 2 percent this quarter; inflation will then rise to around 2½ percent in Q4. The current real shadow rate using staff’s 1-year ahead inflation projection (2 percent in 2025Q2) is 325 bps, which, given an estimated real neutral rate of around 100 bps, implies a significantly restrictive monetary stance.¹⁰ Therefore, the next phase of monetary policy is to ease.

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Monetary Stance

(Percent)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Notes: Monetary stance is calculated as the difference between the real interest rate (the Bank Rate plus QT impact and minus different reference rates on inflation) and the real natural rate ar1 percent. The iorecastof the Bank Rate is based on the team's baseline conditioning assumption.Sources: Haver analytics and IMF staff calculations.

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United Kingdom: Inflation Expectations and Monetary Stance

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

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17. In deciding when and how fast to cut rates, the MPC will need to balance the risks of premature vs. delayed easing. The MPC has highlighted the need to see-through regulated energy price base effects and wait for clearer signs of receding inflation persistence to guard against the risk of premature easing.¹¹ At the same time, there is a risk of delayed easing. Keeping Bank Rate constant as inflation and inflation expectations fall would raise ex-post real rates, which could stall or even reverse the recovery, and lead to an extended undershooting of the inflation target. Staff sees that 50–75 bps rate cuts in 2024 would appropriately balance these risks.

18. Still, a “meeting by meeting approach” is warranted given significant uncertainties. Since the start of the year the market has lowered its expectations of rate cuts in 2024 (to about 40 bps since late May), in light of the higher-than-expected inflation data both in the US and in the UK. Should inflation deviate notably from the baseline path on the upside or downside, monetary policy will need to be adjusted accordingly. Moreover, model-based policy rate paths (see SIP on monetary policy issues) show, intuitively, that concerns about below-potential growth could justify earlier cuts than the path staff recommended, while concerns about a prolonged period of above target inflation leading to de-anchoring of inflation expectations could call for a more cautious approach.

19. The possible divergence from the US Fed’s rate path will place a premium on effective MPC communication with markets. Our empirical work shows that Fed announcements were largely supportive of UK monetary policy transmission during the pre-COVID period, given that market reactions were largely reinforcing (see SIP on monetary policy issues). However, staff also finds that, in the current tightening cycle, market reactions to Fed and MPC decisions sometimes went in opposite directions (as in December 2023). Looking ahead to a period where the BoE could diverge from the Fed (including by cutting rates earlier), there is a risk of spillovers from Fed announcements working against MPC objectives. In this context, staff proposes that the BoE enhance the frequency of its monetary policy communications with markets, including by holding a press conference after each MPC decision, akin to the approach taken by other major central banks.¹² This will enable the BoE to elaborate or caveat MPC views when the market’s reaction to Fed decisions is inconsistent with the direction the MPC’s policy decision would lead the market toward.

20. The MPC’s QT strategy has been implemented well thus far but may need recalibration going forward. According to the current pace of QT (£100 billion gilt reduction per 12 months) and the expected maturities of the Term Funding Scheme with additional incentives for SMEs (TFSME), the level of reserves may approach the estimated range for the BoE’s steady-state balance sheet size as soon as the second half of 2025.¹³ Therefore, a clear rationale for future QT plans, including how it will help the BoE converge to a steady-state balance sheet, will be critical. The QT strategy should continue to be guided by the MPC’s key principles, which include leaving Bank Rate as the active monetary policy instrument and not disrupting smooth market functioning. At the same time, the BoE should continue to monitor undue pressure on short-term money market rates and gilt markets and adjust QT implementation as needed. In this context, staff supports the BoE’s adjustment on QT auction sizes to smooth gilt supply across maturities. Moreover, staff stresses that the steady-state composition of the BoE’s balance sheet (gilts vs. short-term repos) should ensure that money market rates remain aligned with the policy rate (i.e., minimizing wedges),¹⁴ while taking into consideration various aspects of demand for reserves, including banks’ needs for high-quality liquid assets.

21. For future cycles of Quantitative Easing (QE)/QT, consideration could be given to adjusting the treatment of QE/QT profits and losses. QE programs have been employed to underpin the economy at times of financial crisis and to avoid sustained periods of below target inflation. Staff’s analysis indicates that QE/QT could be neutral or even beneficial to the fiscal position over the cycle, with direct profit transfers and indirect fiscal benefits via higher tax revenue and lower interest payments during the QE phase outweighing the losses arising during the QT phase (Annex VII). Moreover, the full ex-ante backstop guarantee from the Treasury was intended to protect central bank independence. That said, the fiscal implications of large APF losses during the current tightening cycle have led some stakeholders to suggest that QE/QT decisions pass a narrow value-for-money test, which could potentially affect the BoE’s ability to independently carry out its mandate.¹⁵ While this is still an evolving issue for many central banks implementing QT, staff suggests some high-level principles for capital policies governing future QE/QT rounds: (i) the treatment of profits/losses should be fully transparent, ex-ante, and symmetric (as is currently the case); (ii) the size and frequency of transfers between the Treasury and the BoE arising as a result of QE/QT profits/losses should be reduced, to insulate the BoE from any political pressure associated with the fiscal implications of the transfers; and (iii) the profits/losses should be included in the debt definition used for the fiscal rule, as is currently the case, but there would be a case to exclude the profits/losses from any annually-applying deficit rule.

22. The Bernanke review provides a timely opportunity to strengthen the BoE’s data and forecasting infrastructures, and communications. The Review found, inter alia, that (i) the BoE’s forecasting performance has worsened in recent years but is not worse than that of other central banks and other UK forecasters; (ii) there were significant shortcomings in the BoE’s central forecasting model (COMPASS) and data platforms; and (iii) the central forecast, used as a communication device, may not fully reflect MPC’s view of the economy as the central forecast is conditioned on a set of standard assumptions, which “may not always accurately represent the views of the MPC” (see Annex VIII). The Review made 12 recommendations on improving forecasting infrastructure, publishing alternative scenarios, and retiring the inflation fan chart, but stopped short of formally recommending that the MPC publish its own policy rate path(s); the Review left it as a possible solution to issue (iii) above for the BoE to consider later. Staff welcomes the BoE’s commitment to act on the recommendations. Staff advises that in designing the proposed “alternative scenarios”, consideration should be given to including scenario-specific monetary policy paths generated by BoE staff, to better support MPC decision-making and communications. Accordingly, allocating adequate resources to enhance and maintain the required modeling infrastructure is also critical.

23. Authorities’ Views. The MPC voted to maintain Bank Rate at 5.25 percent in May and stated that it would: “continue to monitor closely indications of persistent inflationary pressures and resilience in the economy as a whole”. There is still a range of views among MPC members on the role second-round effects are playing in the persistence of domestic inflationary pressures. While MPC members did not seem overly concerned about immediate spillovers from Fed decision announcements to UK markets (including in a context of divergence between BoE and Fed rate paths) and, therefore, did not see a case for major changes to the MPC’s communication plan, the BoE said they would consider staff’s suggestion for a press conference after every rate decision in the context of implementing recommendations from the Bernanke Review. On other recommendations of the Review, the BoE said they will consider the pros and cons of including more scenarios, and accompanying them, as staff suggests, by scenario-specific monetary policy paths generated by BoE staff. In particular, the BoE agrees on the importance of ensuring adequate resources to durably enhance the required data and modeling infrastructure, and work is already underway. The BoE noted that QT has been operating in the background as intended, leaving Bank Rate as the active policy tool. The BoE will conduct its annual QT review this summer, which will inform the MPC’s decision on the pace of QT for the next 12 months. At the same time, ongoing work at the Bank on the size and composition of the steady-state balance sheet (SSBS) is progressing. The availability of the Short-Term Repo (STR) facility (launched in 2022) means the MPC can continue to make independent decisions on the path of QT, even as the balance of the APF reduces reserve supply towards the estimated size of SSBS. The BoE views the current indemnification arrangement on the APF as clear and transparent but noted the Fund staff’s high-level principles on capital policies for future QE/QT rounds.

B. Fiscal Policy

24. The fiscal consolidation strategy pursued since November 2022 has delivered an appropriately restrictive near-term fiscal stance that should be maintained to rebuild fiscal buffers. The consolidation helped bring the primary deficit from 3.6 percent of GDP in FY2021/22 to 1.3 percent of GDP in FY2023/24 (broadly its pre-pandemic level), while stabilizing debt in year 5 in the OBR’s forecast (one of two fiscal rules introduced in the Autumn 2022 statement; the other being that the public sector borrowing requirement be below 3 percent of GDP in year 5). The consolidation was the net result of a number of measures. The 6 ppts. increase in the corporation tax rate, freezing of personal income tax thresholds, and tight limits on spending were deficit-reducing. At the same time, as noted earlier, the government included tax cuts in the last two budgets. Although the fiscal stance remains restrictive, staff would have recommended against the NIC rate cuts, given their significant cost (½ percent of GDP per year) in a context of significant medium-term spending pressures, described below. But staff does recognize the potential labor supply benefits of the NIC cuts and that they were accompanied by well-conceived measures (e.g., reform of the ‘non-dom’ regime, consistent with staff’s recommendations to close loopholes (see Annex IX)) that will partially offset their fiscal cost over the medium-term.

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Fiscal Impulse

(Percentage points of GDP; change in eye.-adj. pr. clef. adj. by 0.4 multiplier)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Source: IMF staff calculations.

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United Kingdom: Fiscal Projections

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

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25. The main fiscal challenge, also identified in the 2023 Article IV consultation, is the unrealistically-low medium-term spending path in official budget projections, given mounting spending pressures (See Selected Issues Paper on Spending Pressures). The current official plans assume limited growth of Departmental Expenditure Limits (DEL) (around two fifths of total public spending), with recurrent DEL spending rising by one percent per year in real terms from FY2025/26, with flat nominal capital spending. The OBR has assessed these plans as lacking detail, with similar sentiments echoed by both business groups and leading think tanks. The assumed pace of spending growth is likely inadequate to accommodate widely reported pressures on public services, particularly health, education, and social care, as well as critical growth-enhancing investments, including for the green transition. Some of the announced sectoral spending commitments, such as the NHS long-term workforce plan, the ‘triple lock’ policy (likely implying above-inflation pension increases), and the aspiration to increase defense spending to 2½ percent of GDP, would require significant real cuts (as yet unidentified) to other spending areas, to be consistent with the announced pace of aggregate spending growth.

26. Accounting for some of this spending pressure, debt continues to increase over the 5-year projection horizon under staff’s baseline. Staff’s projections assume real growth of DEL spending will be around two percent per year over the medium term, accommodating critical spending needs in public services (particularly the NHS Long-Term Workforce Plan, meeting demand for social care, pension spending under the ‘triple lock’ and higher defense spending), as well as real growth of public investment, which is presently very low, and spending for the green transition. Non-interest Annually Managed Expenditure (AME) (mostly non-discretionary, including welfare) is assumed to rise with inflation and the rate of population growth. On a net basis, staff’s projections imply that non-interest spending declines by only ¾ ppt. of GDP between FY2023/24 by FY2028/29, compared with a 1.7 ppts. decline in the OBR forecast, so that public sector net borrowing will be 1½ ppts. above the OBR forecast by FY2028/29. Under staff’s more realistic forecast, public sector net debt (excl. BoE) continues to rise over the medium-term to reach about 97½ percent of GDP by FY2028/29 (OBR projects about 93 percent of GDP), an 8 ppts. of GDP increase from end-FY2023/24 levels (see Figure 4). Although the risk of sovereign stress is still assessed as low (see Annex X) and the UK still retains some fiscal space, the non-stabilization of the debt/GDP ratio over five years is a deterioration from the last Article IV, where debt just stabilized in year 5; it is also consistent with the observed deterioration in the SRDSF’s medium-term mechanical risk signals.

27. Absent a major boost to potential growth, additional consolidation will be needed for debt to stabilize with high probability. The amount of fiscal effort required will depend on (i) the target probability by which debt must stabilize (higher probability will imply larger effort); (ii) the horizon over which debt is to be stabilized; and (iii) the extent to which spending pressures are accommodated. As shown in the table below, relative to staff’s baseline, the annual primary balance would need to be higher by 0.8 ppt. of GDP on average during FY2025/26–FY2029/30 to stabilize debt in year 5 (FY2029/30) with 50 percent probability. In order to reduce fiscal sustainability risks, staff recommends an adjustment path such that debt is projected to stabilize with a higher probability (e.g., 75 percent) over five years (using the SRDSF debt fanchart methodology), requiring keeping the annual primary balance on average at least 1.2 ppts. of GDP above staff’s current baseline.¹⁶

^{Text Table 2.}

United Kingdom: Fiscal Effort to achieve Debt Stabilization: Adjustment Scenarios (ppts. of GDP)

^{Text Table 2.}

United Kingdom: Fiscal Effort to achieve Debt Stabilization: Adjustment Scenarios (ppts. of GDP)

	Scen. 1 (50% prob. over 5-yr horizon)	Scen. 2 (75% prob. over 5-yr horizon)	Scen. 3 (75% prob. over 10-yr horizon)
Average annual excess public sector primary balance relative to staff’s baseline	0.8	1.2	1.4
Debt level at end of horizon relative to staff’s baseline	-3.9	-5.9	-11.1
For further details, see Selected Issues Paper on Spending Pressures.

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^{Text Table 2.}

United Kingdom: Fiscal Effort to achieve Debt Stabilization: Adjustment Scenarios (ppts. of GDP)

	Scen. 1 (50% prob. over 5-yr horizon)	Scen. 2 (75% prob. over 5-yr horizon)	Scen. 3 (75% prob. over 10-yr horizon)
Average annual excess public sector primary balance relative to staff’s baseline	0.8	1.2	1.4
Debt level at end of horizon relative to staff’s baseline	-3.9	-5.9	-11.1
For further details, see Selected Issues Paper on Spending Pressures.

28. High-quality consolidation measures will be required to realize the additional effort required.

• On the revenue side, there is considerable scope to raise revenues, including through (i) aligning the rates of capital gains tax with the equivalent rates of personal income tax (around ½ percent of GDP), to treat capital and labor income equally; (ii) removing unnecessary VAT exemptions (around ½ percent GDP), to broaden the consumption tax base; (iii) reforming property taxation (replacing Council Tax with a broad-based property tax) (around ¼ percent of GDP); and (iv) broad-based wealth taxation (around ½ percent of GDP), or reforms to inheritance taxation, by removing unnecessary reliefs. Stronger carbon taxation (use of feebates) could be a further source of revenue, while supporting the green transition.¹⁷ These measures should be implemented as part of a broader pro-growth structural reform agenda (see below) and will support the climate transition while making the tax system more efficient and fairer.¹⁸

• On the spending side, the overly-generous pensions ‘triple lock’, under which the state pension will likely grow above the rate of inflation, should be abolished, saving around 0.1 percent of GDP per year. Other options could include expanded or enhanced charging for public services, while taking care to protect the vulnerable, as well as pursuing productivity gains, such as from the government’s announced investment in digitalization and AI within the public sector (including the NHS), although the savings associated with these initiatives are difficult to quantify at this time.

29. Against the backdrop of these challenges, as a general principle, staff advises against additional tax cuts. The UK’s revenue/GDP ratio is well below the level in G7 European peers but its welfare state is, in some ways (e.g., healthcare), similarly expansive as in those peers. In this context, the bar for further tax cuts needs to be set very high: specifically, staff advises that tax cuts be eschewed unless they are credibly growth-enhancing and appropriately offset by high-quality deficit-reducing measures. Of course, in the event that growth disappoints, automatic stabilizers should be allowed to operate, but, again, considering the fiscal challenge at hand, any discretionary stimulus should be well targeted, including, to protect the vulnerable, and with strong regard to debt sustainability risks.

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Revenue

(Percent of GDP, general government)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Source: October 2023 World Economic Outlook.

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Primary Expenditure

(Percent of GDP, general government)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Source: October 2023 World Economic Outlook.

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30. There is also a need for broader reforms to fiscal institutions and processes.

• Fiscal Rules. The current rules under which PSND (excl. BoE) must fall by the fifth year and PSNB must fall below three percent of GDP are insufficiently constraining in the near-term and encourage unrealistic assumptions further out. Staff proposes a probabilistic approach (which takes better account of uncertainty) for the debt rule under which debt must decline in the fifth year with a high probability (the “additional effort” table above shows results with 75 percent); this will increase the likelihood that debt does eventually decline.¹⁹ This approach could be nested within a higher-level fiscal standard that sets a bar for “responsible” fiscal policy (see Annex VI, 2023 Article IV Consultation Staff Report). Separately, as noted in the monetary policy section, staff does not support the exclusion of QE/QT profits/losses from the fiscal aggregates used to assess compliance with the debt rule, since net losses of QE/QT are liabilities of the public sector. However, staff could support exclusion from flow aggregates in a future fiscal rule, such as an annually-applying deficit rule, subject to the principles discussed in the monetary policy section.

• Enhanced OBR Role. The OBR, while empowered to produce the economic and fiscal forecasts underlying the two fiscal events a year, should be required to provide an updated forecast whenever there is a major fiscal policy change (such as that surrounding the ‘mini-budget’). Extending the OBR’s forecast horizon in the Economic and Fiscal Outlooks to ten years is also recommended to better-capture longer-term spending pressures, as well as dividends from growth-enhancing investments, which will help provide a more complete picture of the sustainability of public finances. Furthermore, the OBR’s public views should be sought on any changes to fiscal rules at the time of their consideration, while the recommended addition of escape clauses to the fiscal rules should be accompanied by a role for the OBR to determine when they are triggered.

• Budget Process. Transitioning from semi-annual to annual budgets is also recommended to streamline the budget process and reduce political pressure for fiscal loosening, which seems to manifest itself in revenue windfalls being mostly spent, but adverse revenue shocks being fully accommodated. There is also scope to improve the credibility of the medium-term fiscal framework, by providing visibility on spending plans for at least three years ahead. This can be done by producing medium-term (four or five-year) spending ceilings, updated every 2 years based on detailed assumptions and policies. This new framework would replace the current system of periodic spending reviews, which fix limits on DEL (i.e., excluding pensions, welfare and interest payments) for three-years, providing progressively less guidance about the medium term as the end of the three-year period is approached, as is the case presently. The medium-term framework would also provide greater certainty for capital spending projects, as found by the 2022 PIMA.

31. Authorities’ Views. While acknowledging the uncertainty over expenditure allocations pending the next spending review, the authorities noted that the fiscal rules were being met under the OBR’s independent forecast. They also explained that the NIC rate cuts and disability benefit reforms were designed to incentivize work in the context of a notable rise in inactivity and a high share of people with disabilities. The authorities acknowledged pressures on public services but felt recent funding increases for the NHS, social care and schools should help address immediate challenges, while longer term needs are being addressed via implementation of the NHS Long-Term Workforce Plan and other strategies. In terms of public investment, the authorities expect to set future plans at the time of the next spending review, to be held after the upcoming general election. Regarding the fiscal framework, the authorities noted its strength and underscored the important role of the OBR. The authorities saw some merit in exploring the role that the probability of debt stabilization could play in any future review of fiscal rules. Staff’s recommendations to have a single fiscal event each year and replace spending reviews with rolling four or five-year spending frameworks updated twice a year were noted. The authorities concurred with staff’s assessment of sovereign risks and underlying assumptions, as well as the extent of fiscal space.

C. Reforms to Boost Growth

32. Like other European peers, the UK has faced a major trend growth and productivity slowdown since the GFC. This, combined with a series of subsequent adverse shocks (Brexit, COVID, energy price surge), and longer-term trends (such as aging), has left the level of UK GDP at around a quarter below the level implied by the trend in the decades before the GFC, accompanied by worsening income, inter-generational,²⁰ and spatial equality.²¹ Although the UK has done better than peers in terms of total hours worked, the drop in labor productivity growth, the key driver of living standards – from around 2 percent pre-GFC to around ½ percent thereafter—has been noticeably bigger than in other advanced economies. Most of this drop was due to the loss of pre-GFC growth engines such as North Sea Oil and a leverage-driven boom in the financial sector, which was then exacerbated by reduced firm dynamism post-GFC and the recent shocks mentioned above (see Annex IV). Moreover, the impact of a prolonged period of relatively low rates of TFP-supporting investment and high service delivery pressures, notably in health, on economic potential, is beginning to show (e.g., via an uptick in long-term illness-induced inactivity). Finally, aging and policies to rein in immigration will constrain total hours worked going forward, creating additional headwinds to growth.

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Productivity: GDP Per Hour Worked

(Ratio of GDP per hour worked compared to the US, current PPP)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Sources: OECD.

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Drivers of Labor Productivity Growth

(Market sector, contribution to GVA per hour growth, 5-year rolling average, percent)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Source: ONS.

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33. The authorities have responded to this slowdown via a series of initiatives, but further ambitious reforms are needed to boost potential growth. The authorities adopted the “levelling up agenda” in 2022; the “4Es’ strategy” (“enterprise, education, employment, everywhere”) in January 2023; and “110 reforms to boost growth” in Autumn 2023. They have also delivered, since Autumn 2022, a number of helpful measures, most notably, permanent investment tax reliefs for businesses, and strengthened the incentives and capacity to work (in the form of tax cuts, changes in working age benefits, and expansion of childcare support).²² They have also initiated reforms to unlock pension savings for higher-return investments. While supporting the medium-term outlook, these measures are unlikely to sufficiently lift the UK’s long-term potential growth to the 2 percent level seen in the UK in the decades before the GFC, or in US at present. Leveraging the wide body of work by UK academics and thinktanks on impediments to growth, staff has identified three key areas that need the most urgent attention, including by building on past efforts. These key reforms also have the benefit of being relatively less costly in fiscal terms. If implemented, these reforms will also improve competitiveness and the UK’s external position.

• Easing planning restrictions. The current regime for planning is excessively stringent and has severely inhibited the construction of new housing and infrastructure projects, thus constraining labor mobility (workers are forced into sub-optimal jobs as they are unable to move to more expensive areas with better jobs due to unaffordable housing).²³ Cheshire (2015) estimates the attendant TFP effect at a massive 32 percent for some businesses. This has resulted in high and increasing prices overall, and widening disparities between high and low growth regions, given inelastic housing supply. Key reforms: (i) establish up-to-date, binding plans at the local level to streamline the decision-making and avoid the “not in my backyard” problem in designated growth areas, with incentives and additional resources to local authorities to overcome opposition and increase efficiency; (ii) digitalize and standardize planning process to help reduce delays and increase transparency; (iii) institute broader geographic and rules based decision-making for business developments to decrease uncertainty and provide more clarity and predictability to investors; (iv) introduce targeted incentives (to overcome new builds resistance) and resources for local authorities (including skilled staff to facilitate compliance with new environmental requirements); (v) carefully review the scope to release Green Belt land of little environmental or amenity value near stations with easy access to major cities; (vi) ensure better housing standards and higher-quality housing across all income groups, particularly in the private rented sector, alongside flexible land use policies to adapt to changing economic needs and environmental considerations; and (vii) lower stamp duty for both residential and non-residential properties (alongside a reform of the council tax to ensure net revenue gain) to stimulate high-growth firm activity and facilitate workforce mobility (see Planning SIP).

• Upskilling the workforce. There is an urgent need to upgrade the skills of UK workers, given larger observed skills gaps than in peer countries, and surveys reporting widespread recruitment difficulties that are limiting output, particularly in high skill sectors like digital and software, manufacturing, medicine and life sciences, teaching, and construction. Despite an increase in public funding for primary and post-secondary education since 2019 (reversing earlier cuts), outcomes, particularly science scores, have declined over the past two decades, accompanied by a decline in workplace training and apprenticeship. Since Brexit, there has been an increase in non-EU migrants, but they have not directly offset the loss of EU-workers given different skillsets and hurdles (especially for small firms, in sponsoring skilled worker visas). Key reform: (i) more and better-quality training and apprenticeships to develop skills in high-demand, including via higher government support; (ii) ambitious targets consistent with a reversal of the recent decline in STEM outcomes; (iii) schemes to further encourage younger workers to enter future growth sectors and improve retention; and (iv) a simplified worker visa regime to facilitate smaller employers (who were large employers of skilled EU-labor pre-Brexit) hire non-EU workers (see Skills SIP).

• Improving health outcomes. The UK has done well to boost labor supply in the past (including through immigration), but this could be at risk going forward from rising inactivity (in the context of weak health outcomes) and an aging population. The post-pandemic decline in UK labor force participation is largely attributable to elevated rates of long-term sickness and disability, with more than 20 percent of the population recorded as having disabilities (above G7 peers). Moreover, illness is a major drag, not just on labor supply but also on labor productivity—for the segment of the population who remain in the workforce but are not healthy. Given that the number of hospital beds, doctors, and nurses per capita are lower than the OECD average, the authorities have responded by committing additional resources to the health system, including through the NHS Long-Term Workforce Plan, which aims to increase NHS staff numbers by around 800,000 over the next ten years, while also announcing £3.4 billion (0.1 percent of GDP) in the Spring Budget to support efficiency improvements using digitalization and AI. The authorities have also announced reforms to the benefit system to incentivize work, including by increasing the stringency of the Work Capability Assessment (WCA), which determines access to incapacity benefits.²⁴ Key reforms: (i) full implementation of the NHS Long-Term Workforce Plan, accompanied by real increases in capital spending, to create a better-resourced and more productive health service;²⁵ (ii) pursue a forward-looking and integrated approach to NHS resource allocation and strategic decision making that is focused on system-wide performance (e.g., integrated and digitalized patient records); (iii) increased funding for social care commensurate with demand over the medium-term; and (iv) improved health services for those with disabilities (including mental health), while ensuring that those capable of work are incentivized to do so and are adequately assisted through training, coaching, and integrated health support, building on recent reforms.

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Variation in Median House Price Across Regions

(Select regions, GBP)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Source: Office of National Statistics

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Qualification Mismatch

(Percentage)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Note: Qualification mismatch is defined by the discrepancy between the highest qualification held by a worker and the qualification required by their job. Over [under) qualification that is above [below] their job’s requirements.Sources: OECD Skills for Jobs Database

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Disability Prevalence

(People with disability as a share of the population aged 15–69, average over 2016–2019)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Sources: OECD calculations based on European Union Statistics on Income and Living Conditions [EU-SILC] for European countries

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34. In this context, staff proposes that the authorities adopt a clear and stable long-term growth strategy, potentially anchored in the advice of an independent growth commission. While progress on post-Brexit arrangements has reduced uncertainty, recurrent and piecemeal policy changes, including at semi-annual fiscal events, have arguably made it harder for businesses and workers to plan. With only one fiscal event a year and a longer horizon for official projections, the government might be better incentivized to articulate and follow through on a stable growth agenda which includes reforms with payoffs going well beyond the electoral cycle. In this context, consideration could be given to establishing an independent growth commission, similar, for example, to the productivity commission in Australia (see Growth Commission Annex XI). Such a body can take a longer-term view of reform priorities (making policy more strategic and focused); better coordinate across different levels of government; and track and report on implementation, serving as a disciplining and communication device (akin to the Climate Change Committee).

35. The authorities should continue their cautious approach to industrial policy. Relative to some G7 peers, the UK has been cautious in deploying vertical industrial policies, instead favoring broad-based tax incentives for business investment and R&D. Direct support to industry has been limited, with the UK government announcing an Advanced Manufacturing Plan in November 2023, together with a Battery Strategy. Under the plan, £4.5 billion (0.2 percent of GDP) will be invested strategically in high technology sectors, including the aerospace, automotive and life sciences, mainly in the form of grant funding for R&D and investment. Around £1 billion each (0.1 percent of GDP) has also been committed to a Green Industries Growth Accelerator, and for creative industries, while 13 investment zones and 12 free ports have been announced, which will offer tax concessions and other targeted support. Staff encourages the authorities to keep these plans and future policies narrowly targeted toward removing obstacles to investment and improving the business environment, focusing on industries and firms where externalities or market failures prevent effective market solutions, while minimizing trade and investment distortions, as well as adverse international spillover effects. Meanwhile, the UK’s active and constructive participation in the WTO is welcome.

36. Authorities’ Views. The authorities’ acknowledged the importance of further ambitious, evidence-based structural reforms to boost investment, productivity and labor supply and noted that this was their preferred means of building fiscal buffers while addressing spending needs. They agreed with staff on key reform priorities and noted recently implemented reforms in these areas. In particular, they highlighted planning reforms and full expensing (for qualifying plant and machinery business investments), and the cuts in the NIC rate, which should support labor supply. While agreeing that rising inactivity due to long term sickness was a challenge, they highlighted reforms to working age benefits, with the view of ensuring that people who are capable of work are incentivized to do so but agreed with the importance of adequately supporting such people through training and coaching; and to ensure that those who need healthcare receive it. The authorities opined that the main issue in healthcare was efficiency but acknowledged the need for capital investment, including in digital infrastructure, which was announced during the Spring Budget. The authorities also noted that addressing skills gaps was a priority with an emphasis on future growth areas such as digital and AI, STEM, life sciences and the creative arts, particularly for the young, but also for older workers through lifelong learning. The authorities explained that they have put in place measures to improve the quality of apprenticeship programs, and this in part explains the decline in total numbers. Recent efforts have also been made to grow apprenticeship numbers in key sectors and incentivise SMEs to create opportunities for young people. They were receptive in principle to the idea of a growth commission.

D. Financial Sector Policies

37. The overall level of systemic risk is assessed as broadly similar to that in the previous Article IV consultation, with the focus shifting somewhat from households to corporations. Household debt vulnerabilities have reduced somewhat, supported by strong wage growth and a lower expected policy rate path, while corporate vulnerabilities have edged up, mainly for firms exposed to some segments of market finance (see below). The banking sector is healthy, while vulnerabilities in the more complex NBFI sector, including high leverage and liquidity mismatch, and lack of data for a comprehensive assessment remain a source of concern (see Annex XII on FSAP recommendations). Moreover, in line with staff’s assessments the recent Financial Policy Committee (FPC) meeting summary highlighted that risk premia have decreased further below historical averages across several asset classes and a sharp correction in a broad range of asset prices could crystalize long-standing vulnerabilities in market-based finance. Moreover, global risks remain elevated, including from heightened geopolitical tensions, corrections in CRE markets globally, as well as the property market in China, which could spill over to the UK financial system.

38. Macroprudential settings are appropriate but continued close monitoring of credit conditions and financial stability risks is merited in future calibrations. Reflective of the macroeconomic development, credit conditions remain muted, particularly for smaller businesses and certain sectors, Moreover, the latest results from the IMF global stress testing showed that in an adverse scenario, UK banks remain resilient, echoing the BoE’s 2022/23 stress testing results. Against this backdrop, staff supports the FPC’s decision to maintain the countercyclical capital buffer (CCyB) at its two percent neutral level. Should tighter financial conditions weigh on corporate and household debt vulnerabilities and increase credit losses materially, the authorities should consider easing prudential policy (for example, releasing the CCyB) to avoid exacerbating the credit downturn. In light of potential valuation risks in several asset markets, continued monitoring and appropriately stringent stress tests would be important.

39. While major UK banks remain healthy, continued strong supervision of all UK banks is warranted. The capital and liquidity positions of major UK banks remain robust (with CET1 ratio at 14.7 percent and LCR at 147 percent in 2023Q4), but the diverse business models of smaller banks merit continued close monitoring as stress in this segment has been idiosyncratic. Staff supports the BoE’s decision to conduct desk-based top-down stress testing this year, which would provide more flexibility to test multiple stress scenarios, and views this as a helpful complement to the bottom-up approach. Staff also encourages further utilization of stress testing tools to identify potential risks in smaller banks. Separately, the Prudential Regulation Authority (PRA) has made careful progress on a new Strong and Simple Framework to simplify the prudential framework for non-systemic domestic banks and building societies, while maintaining their resilience.

40. Ongoing initiatives to enhance risk monitoring and crisis response readiness with regard to NBFIs have gained momentum but challenges remain.

• Staff welcomes the progress thus far on the System-Wide Exploratory Scenario (SWES) and looks forward to important insights generated on the level of resilience of participants, their reaction functions to stressed financial market conditions, and potential propagation channels. Moreover, staff encourages considering making some data collection permanent for continued risk monitoring to build an ongoing capacity for system-wide stress testing.

• Staff also welcomes progress on the design of the NBFI lending tool, which, in line with FSAP recommendations, aims to act as a backstop to core markets in the event of systemic stress by providing liquidity to appropriately regulated and systemically interconnected NBFIs, while avoiding moral hazard. The first step is to have the facility accessible for pension funds, insurance companies, and LDI funds.²⁶ Staff urges that the design of the tool ensure an appropriate balance between signaling BoE readiness to provide sufficient support during stress episodes, and preserving incentives for NBFIs to enhance their resilience in normal times and encourages continued regulatory coordination to ensure the resilience of non-UK domiciled funds.

• Staff supports continued work to enhance the resilience of different segments of the NBFI sector, such as money market funds (MMFs) and pension funds. Staff welcomes the regulatory changes proposed by the Financial Conduct Authority (FCA) for MMFs and stresses that work should continue internationally given the large number of non-UK domiciled sterling MMFs.²⁷

• Reforms to unlock pension savings for higher-return investments, which could provide better outcomes for savers, are welcome, but should not undermine financial stability (see Pensions Annex XII). While investment reallocation could potentially improve returns, the asset allocation of pension funds should not be mandated, and any reforms should not hinder the ability of pension funds to fulfill fiduciary responsibilities effectively and achieve the best possible outcomes for their beneficiaries. Given the ongoing defined benefit (DB) pension fund buy-outs and potential concentration risk created in the insurance industry from these concurrent changes, monitoring possible financial stability implications, including the longer-term structural impact of these developments on gilt demand, will be important. In this context, staff continues recommending that The Pensions Regulator (TPR) be given an explicit financial stability remit, accompanied by a reinforcement of its staffing to achieve this mandate. Finally, staff encourages continued work to ensure adequate pensions for UK employees, including the consideration of expanding auto-enrollment efforts and raising the minimum pension contribution in the medium term.

• Progress on closing data gaps has been slower than expected, such as data on all Sterling asset holdings and data needed to improve the management of liquidity demands by fund managers and flow-of-funds data, including all cross-border NBFI exposures (see Data Issues Annex XIV). Therefore, it is important to maintain both domestic and international momentum to close NBFI data gaps and to better understand and take action to address the financial stability implications of NBFI leverage. In this context, staff welcomes the FPC’s continued evaluation of risks from private equity and interconnected markets and looks forward to the assessment to be published in the June 2024 FSR.²⁸

41. Structural financial sector reforms are progressing cautiously. The Edinburgh Reforms package (see Annex XV) in December 2022 and the Chancellor’s Mansion House speech on pension reforms in July 2023 have listed some government priorities on regulatory changes in the financial service sector. The government has taken steps on the 31 initiatives in the Edinburgh Reforms and has preserved the primacy of financial stability objectives. Moreover, the authorities are working on enhancements to the special resolution regime, including a proposal to allow the Financial Services Compensation Scheme (FSCS) to provide funds to the BoE to recapitalize and secure operational continuity of a failing small bank through resolution, and then recoup costs through industry levies. While this would help minimize disruptions from small bank failures, staff encourages prefunding the FSCS to an appropriate level to avoid moral hazard.

42. The authorities continue to strengthen the effectiveness of AML/CFT risk-based supervision, considering the UK’s high exposure to the laundering of proceeds of foreign crimes. To mitigate misuse of the financial and professional services sectors and UK-registered corporate structures, the authorities should continue to implement measures under Economic Crime Plan 2023–26 to improve the effectiveness and coordination of the AML/CFT supervisory regime. These include HMT’s consultations on potential changes to the Money Laundering Regulations and the implementation of a data framework to measure the effectiveness of supervisors. The FCA continues implementing a proactive, data-driven supervisory strategy to cover systemically important entities more frequently. To prevent the criminal use of virtual assets, the FCA pursues a stringent risk-based approach to the registration and supervision of virtual asset service providers. Additionally, the Economic Crime and Corporate Transparency Act passed in October 2023 provides broadened powers for law enforcement for quicker seizure and recovery of virtual assets which are the proceeds of crime.

E. Climate Policies

45. The recent relaxation of climate policies and decline in the UK carbon price will put the UK’s ambitious climate targets further off track. The UK hosted COP26 in 2021 and adopted an Nationally Determined Contribution (NDC) to reduce emissions by 68 percent by 2030, having already reduced emissions by 50 percent below 1990 levels, mainly due to phasing out coal-fired power stations, so that the UK now accounts for around 1 percent of global emissions. In September 2023, the government softened climate policy by announcing an exemption for 20 percent of homes from the requirement to transition to electric heat pumps, while the transition deadline for homes off the gas grid was delayed from 2026 to 2035, despite a welcome increase of the boiler upgrade grant. In the transport sector, the requirement that 80 percent of new vehicles sold in the UK be ‘zero emission’ by 2030 (100 percent by 2035) has been enshrined in legislation, but the ban on purchasing internal combustion engine vehicles has been delayed from 2030 to 2035 (as in some EU countries). Despite announcing an emissions cap under the Emission Trading Scheme for 2035 that is consistent with the UK’s climate goals, the UK carbon price has declined to around 50 percent of its level in early 2023, to be well below the corresponding EU price, which, if it persists, will make some of the UK’s exports subject to the EU Carbon Border Adjustment Mechanism (CBAM) from 2026. The announcement of a UK CBAM, to be implemented from 2027, is welcome. Overall, however, the net impact of recent policy adjustments and announcements is that existing policies are only sufficient to achieve 57 percent of the UK’s NDC emissions reduction target by 2030 (see chart).

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Percent Reduction Below No-Climate Policy Counter-factual in 2030

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Source: IMF staff calculations.

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UK Greenhouse Gas Emissions

(Percent of Global Emissions)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Source: EU Emissions Database for Global Atmospheric Research.

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UK Greenhouse Gas Emissions by Sector

(Million Tonnes of CO₂ Equivalent)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Source: EU Emissions Database for Global Atmospheric Research.

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46. The UK should stay the course on climate policy, to maintain its status as a climate leader and to realize the benefits of the green transition. Whole-of-economy investment in the green transition should increase to £50 billion pounds per year by 2030 (from £20 billion in 2020), as the Climate Change Committee has recommended, with a public contribution of around one third. Public support to households for the transition from gas heating to electric heat pumps is a priority for the government’s contribution, given that the buildings sector is among the largest contributors to UK emissions, along with the transport and industrial sectors. The recently-announced exemption for certain homes from the requirement to transition to electric heat pumps should be narrowly defined, and the relaxation of energy efficiency requirements for rental properties should be reversed. Strengthening feebates on heating options for non-exempt homes in the near-term (with taxes on new fossil fuel heating funding subsidies for heat pumps) should be considered to accelerate the transition away from gas heating. Given the government’s decision to delay the ban on purchases of internal combustion engine vehicles to 2035, the government should instead consider stronger price-based incentives for zero-emission vehicles in the form of larger feebates, with higher taxes on internal combustion engine vehicles supporting non-discriminatory consumption subsidies for electric vehicles, consistent with WTO rules and without favoring local manufacturers. The CBAM can help to address carbon leakage concerns and encourage trading partners to make more ambitious mitigation efforts, but should be implemented in line with WTO rules including basing charges on actual carbon content in traded products, rather than benchmarks. In line with 2023 Article IV recommendations, consideration could be given to widening the coverage of the ETS to include road transport and buildings (or consider upstream carbon taxes in these sectors), supported by a fixed carbon price floor that rises over time, in order to achieve a more comprehensive, predictable, and uniform carbon price. The authorities should also pursue long overdue action on agricultural emissions, by implementing a self-reporting regime for farmers, with emissions subject to a fee.

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Carbon Prices

(12-month futures, euros)

Citation: IMF Staff Country Reports 2024, 203; 10.5089/9798400279379.002.A001

Source: Bloomberg Finance L.P.

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47. Authorities’ Views. The authorities explained the UK’s strong performance in reducing emissions, noting that emissions have been halved relative to 1990 levels and that the first three carbon budgets have been met, subject to the UK’s strong legal framework for climate policy. The authorities pointed out that recent changes to climate policy (e.g., delaying the ban on purchase of internal combustion engine vehicles) bring the UK more into line with peer countries. The authorities noted the legislative passage of the Electric Vehicles (EV) mandate, requiring 80 percent of new vehicles sold in the UK to be fully electric by 2030, and observed that the uptake of EVs is progressing well. The number of conversions to heat pumps for home heating has also accelerated, albeit from a low base, since the Boiler Upgrade Grant was increased. The authorities explained that a net-zero consistent cap on emission trading scheme allowances has been implemented and believe that this will be sufficient to support an appropriate carbon price in the UK. The authorities note the important role of public investment in the green transition, as well as public-private cooperation, particularly in the power sector. As with all areas, future public spending levels will be set at the next Spending Review.