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United Kingdom staff concluding statement of the 2021 Article IV Mission

WASHINGTON, USA – Thanks to a rapid vaccination campaign the economy reopened during the summer of 2021. The recovery has been faster than expected amid strong continued policy support. However, capacity constraints and rising price pressures have emerged while new Covid-19 variants pose downside risks to the outlook. Continued rotation of policies is needed to support a strong non-inflationary recovery. Looking ahead policy adjustments can be made to manage macroeconomic volatility and protect financial stability, the UK’s strong policy frameworks can be refined to preserve policy space, and opportunities exist to further advance the UK’s Build Back Better objectives.

Developments and outlook

It has been a challenging year for the UK, but with strong policy support the economy proved to be resilient . Thanks to a rapid vaccination campaign the worst health impacts of the pandemic were broadly contained by summer and the government was able to reopen the economy. Output and employment have returned to close to pre-pandemic levels backed by strong policy support for jobs and firms. Financial stability has been maintained, and fiscal policy has been able to rotate towards end year to more targeted support, with public debt and deficits expected to stabilize. The UK’s strong policy frameworks have been critical in providing the space to facilitate the overall impressive, coordinated, and extended policy response.

At the same time, it has become clear that Covid-19 and the behavioral changes it has caused will not fade quickly . The pandemic has shifted global and UK demand from services to goods; made the nature of work more digital and social interaction more localized; and has restrained labor market participation. Together these changes have strained supply chains, contributed to rising traded goods and energy prices, and tightened labor markets, putting pressure on inflation. The global effects of Covid-19 are expected to start to wind down gradually during 2022. The UK has felt these global impacts, and amid signs of domestic capacity constraints and tight labor markets, inflation has broadened of late and inflation expectations have risen. More recently, a new variant of Covid-19 — Omicron — has led to the reintroduction of some activity restrictions and an accelerated vaccination booster effort.

The outlook suggests that growth will remain strong in the near term, but so too will price pressures. Our forecast sees elevated growth of about 6.8 percent in 2021 and
5 percent in 2022, with a mild slowdown in 2022Q1 due to newly introduced restrictions, and supply bottlenecks still prevalent during 2022H1. Inflation would peak at about 5½ percent in the spring of 2022, before gradually returning to target by early 2024 (helped by declining global energy prices, more robust supply chains, and tighter demand management policies). In the medium-term, growth would ease to about 1½ percent, with real GDP settling about 2–2½ percent below its pre-pandemic trend, held back by investment shortfalls in 2020–21 and a less-than-full recovery of labor force participation.

Risks are considerable in the period ahead. In the near term, there is a risk of higher inflation but 2–3 years out the risk shifts to lower growth (as policy interventions pull inflation back). External developments could impact this (such as a rapid tightening of global financial conditions and global slowdown, or continued frictions in the UK-EU relationship). However, the major risk is new Covid-19 waves and the uncertainty they bring. Omicron could extend global demand-supply imbalances and inflationary pressures beyond projections, but if it or a future outbreak is more virulent this could weigh on confidence and demand, with disinflationary impact.

Near-Term macroeconomic management priorities

Monetary policy needs to withdraw the exceptional support provided during 2020–21. Given the shadow of Covid-19/Omicron uncertainty, in choosing the pace policymakers will have to weigh risks. On the one hand early action could slow the recovery at a point when its sustainability is not assured; on the other hand, inaction could allow second-round effects of inflation to proliferate (which would raise the costs of returning it to target). In this context, it is important to bear in mind that initial steps would still leave policy accommodative, that changes in policy can provide important signals to dampen inflation expectations, and that policy is best focused on the period 12 to 24 months out, when it has its maximum impact (and this would be beyond near-term Covid-19 developments).

Fiscal policy should retain an important role in responding to large macroeconomic shocks. In the event the present outlook holds, fiscal policy can help address what has been sudden and sharp global shocks generating demand-supply imbalances. The authorities could bring forward some fiscal tightening from FY23–24 to FY22–23 to help contain demand in the short run with the benefit of also reducing the drag on growth in outer years. To avoid re-opening the Spending Review, the authorities could consider adjusting the profile of spending as opportunities present and/or broadening the tax base at the uppermost income quintile (to be later matched by more build back better spending—see below).

In the event of a virulent Covid-19 wave requiring widespread mandated closures, the authorities should be ready to redeploy a subset of the most successful previous exceptional programs (such as a furlough scheme and targeted support to the most vulnerable households and small businesses), but with due attention to lessons learned about their design (including tapering and timely sunset).

The financial cycle appears to be slightly ahead of the economic one, calling for continuing assiduous macroprudential and supervisory vigilance. While the risk environment appears standard at present, financial stability risks may build up fast as investors search for yield in a low real rate environment and demand-supply dynamics impact the mortgage market and house prices. The latest Financial Policy Committee decision to proactively and gradually re-establish the countercyclical capital buffer is a welcome one and in line with the current and evolving risk environment.

Staff also notes the latest adjustments announced to the structural mortgage recommendations. While these have served the UK well the data support the need for some simplification. Still, vigilance about housing market developments and broader systemic risk developments remains in order. It will be necessary to continue to analyze the effectiveness of remaining measures and detect any leakages early, while the bank stress test design must continue to capture housing market correction risks and related systemic risk contagion channels.

Managing policies with higher macroeconomic and Macro financial volatility

Even setting aside present uncertainties, the macroeconomic landscape is likely to be more volatile going forward. Sectoral shifts, as the economy adjusts to new post-pandemic and post-Brexit norms and undergoes an energy transition, may not be smooth; and some endogenous stabilizing mechanisms for the UK (net immigration and imports) may be less potent. Shorter economic cycles with greater impact from supply-side disturbances may manifest. Financial market measures of expected inflation indeed appear to be pricing some combination of higher inflation and risk due to volatility.

Fiscal policy has a key role to play in addressing volatility through automatic stabilizers. The changes enacted through the Spending Review will have a side benefit of increasing automatic stabilizers. Still, there are opportunities to go further, by building on certain pandemic programs that were aimed at protecting marginalized labor market participants and also small businesses. Staff would in particular point to the benefit from more automatic funding of active labor market policies for youth (e.g., Kickstart-like), while preserving some discretion to adapt their design. However, staff would note that a program like the Coronavirus Job Retention Scheme (CJRS) should not be part of the regular toolkit in the UK (given existing private-sector labor contracting approaches) and is best considered for responding to very large, temporary, and non-structural shocks.

Monetary policy also has a key role to play in managing volatility but could face difficult trade-offs. The bank of England’s Monetary Policy Committee has the tools to address volatility including discretion to manage the path of inflation back to its targeted level. However, it would not be a simple matter to see through extended shifts in relative wages and prices while keeping expectations anchored. It would be important to avoid inaction bias, in view of costs associated with containing second-round impacts. Careful communication would be needed to lay the groundwork with markets for potentially more frequent policy moves.

There appears to be a need for new approaches to strengthen the resilience of non-bank finance and core financial markets against disruption. The IMF’s Financial Sector Assessment Program (FSAP), conducted during 2021, notes that the authorities should be commended for their swift policy actions at the pandemic outset to restore market liquidity and maintain financial stability. However, the experience also revealed the need to improve the liquidity risk resilience of the broader non-bank financial sector to avoid disruptions to core markets.

This is a major cross-border challenge, and it will be important for the UK, along with relevant foreign authorities, international standard-setting bodies and the FSB to speedily augment the data collection, monitoring, and self-insurance in non-bank financial institutions (NBFIs). Meanwhile, the authorities should strengthen backstops to the functioning of core markets in times of stress by considering allowing appropriately regulated, large, interconnected NBFIs access to repo and/or Gilt purchase operations.

Anchoring policies and preserving space through strong frameworks

The authorities’ new fiscal rules have anchored fiscal policy well, but in the medium-term, the framework would benefit from a supporting change. Debt and current deficit targets have been successfully deployed in the past in the UK, and the addition of debt affordability and balance sheet considerations are important innovations.

Stepping back, the UK has moved over time towards having rules reflect the choices of the elected government of the day. This correctly recognizes the shelf life of calibrated rules and is a plus for accountability but points potentially to more variation in the design of rules going forward. The question will naturally arise, if the design is altered, whether the new calibration is in line with higher-order fiscal objectives (sustainability, or any other objectives defined in law). Parliament would benefit from more structured commentary on this. The Office for Budget Responsibility already prolifically produces material that could illuminate how new rules meet defined objectives. Ensuring it would be available on a timely updated basis to Parliament as rules are considered would be important.

Recent work on the monetary policy toolkit is also important, but there is an area where more clarity would be helpful. The Bank of England has created additional policy space with its effort during 2021 to technically facilitate the implementation of a negative policy rate, if needed. Looking ahead there is an opportunity to further cement the bank rate as the key monetary policy instrument, and avoid markets second-guessing the Monetary Policy Committee’s intentions, by ensuring that the quantitative tightening (QT) strategy is as predictable as possible.

To this end, the Monetary Policy Committee could take the earliest opportunity to put the QT program onto a pre-programmed course and for the Bank to give guidance on the framework to be used to manage the process back towards the steady-state balance sheet (recognizing the need to assess market conditions, as the demand for reserves may change over time).

The FSAP found the UK’s financial stability framework to be in a resilient position but with opportunities for continued enhancements. The financial soundness of UK banks and insurers has increased since the global financial crisis and the system is well placed to face near-term macro-financial challenges. However, the UK financial system is also undergoing structural transitions, including a growing share of market-based finance, Libor cessation, making finance green, greater exposure to cyber risk, and rapid adoption of digital technologies. Many of these are cross-border in nature and it is early to form a firm view on how these will interact and influence financial stability conditions.

The FSAP has suggested specific approaches to help manage risks. First, continued enhancements to the perimeter of systemic risk monitoring and analysis. Second, accelerated efforts to address the data and information gaps (including at the international level) and to track exposures and risk management practices of complex cross-border financial firms. Third, pushing ahead with the existing pro-active approach to tackle climate-related and cyber threat related financial risks.

Building Back Better

The authorities have put forward and funded a comprehensive growth plan and should consider next steps. Staff welcomes the pillars (infrastructure, skills, and innovation) and strategies (Levelling Up, Net Zero, and Global Britain). The recent Spending Review also commits significant amounts of funding for these pillars and objectives until 2025. However, there are opportunities to further advance the effort, and these can be financed even within the proposed fiscal rules by further raising revenues. A good option would be to broaden the tax base for the upper end of the income distribution, since balance sheets have considerably strengthened for this cohort.

Infrastructure investment would be an area to further ramp up, but some challenges need to be overcome. The authorities have already substantially increased investment spending, and there are legitimate concerns about preserving value-for-money and deliverability of projects. The UK has one of the strongest public investment management frameworks worldwide, but there may be options to help address potential bottlenecks from this source. An ongoing dialogue between the UK and IMF is assessing this with a focus including coordination between levels of government and project appraisal methodologies among other things. A successful effort to improve investment management could motivate a less restrictive budgetary investment cap.

The effort to upgrade skills will need to be adjusted as experience is gained. Of the many new initiatives (e.g., the Lifetime Skills Guarantee, the Kickstarter and Restart programs, or the Skills bootcamps) some will prove more effective than others and should accordingly be prioritized. Stepping back, staff modeling suggests that a period of creative destruction lies ahead, and thus facilitating sectoral labor shifts will grow in importance. Higher funding for these skills-building policies should be a priority.

The Net Zero Strategy is a major achievement, but more steps lie ahead. The private sector will need to drive progress, which puts a premium on carbon pricing and regulation to secure the desired response. There are opportunities to be more ambitious, including more rapidly extending the UK’s ETS and legally clarifying the phase in of regulations. Greater ambition would need to be supported by more upfront compensation for vulnerable groups (including more grants for those living in homes that require significant retrofits) and tailoring some skills programs to retrain fossil-fuel industry workers.

The UK has made major strides in laying out its post-Brexit trade and financial sector frameworks. In the trade area (including financial services), there remain issues of contention between the UK and EU, and staff urges the two parties to find mutually beneficial outcomes. At the same time, as the UK concludes a review of its own post-Brexit financial regulatory framework, it will be important to preserve the primacy of financial stability objectives and safeguard the robust management of domestic and cross-border macroeconomic and financial sector systemic risks.



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