IMF Concludes 2021 Article IV Consultation with United Kingdom

Washington, DC : The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation[1]with the United Kingdom. This also included a discussion of the findings of the Financial Sector Assessment Program (FSAP) exercise for the United Kingdom.[2]The publication of the Staff Report and Financial System Stability Assessment (FSSA) bundle will be followed in early March by publication of the FSAP Technical Notes underpinning the FSSA.

The UK entered 2021 with significant challenges but also with some positive developments. Covid cases were spiking again, prolonging health and economic impacts. Elements of the post-Brexit framework were left unsettled, policy frameworks were under review, and post-pandemic growth strategy and climate policies had not been spelled out. At the same time, the EU-UK Trade and Cooperation Agreement was concluded. An ambitious vaccination campaign was just launched, and further policy support was deployed to contain the pandemic impact.

The recovery in 2021 has proceeded faster than expected, but rising price pressures have emerged. Growth is estimated to have reached 7.2 percent in 2021 on the back of continued policy support and rapid vaccination. However, inflation rose to 5.4 percent at end-2021 due to strained global supply chains, rising traded goods and energy prices, and tightened labor markets. Fiscal policy has been able to rotate towards more targeted support, with a back-loaded medium-term consolidation plan. With continued above-target inflation readings, the BoE made a first move to raise the policy rate in December, and followed this with another rise in February. Financial stability has been maintained, and macroprudential policies are returning to more standard risk settings.

The near-term growth outlook remains strong, but so too are price pressures. Despite an expected mild slowdown in Q1 due to Omicron and associated restrictions, strong private demand should support continued growth in 2022, projected at about 4.7 percent. Inflation is expected to peak at about 7 percent in the Spring of 2022 before gradually returning to target by 2024Q2 (helped by declining global energy prices, more robust supply chains, and tighter demand management policies). In the medium-term, growth is projected to 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. There is a risk of higher inflation in the near term, but 2–3 years out, the risk shifts to lower growth (as policy interventions pull inflation back). However, the major risk stems from new Covid-19 waves and spillovers from tensions in Eastern Europe.

The United Kingdom operates a well-functioning financial stability framework with resilient banks and insurers. This framework—well-aligned with global standards—has helped support the safety and soundness of the core part of the UK financial system through the strains of Brexit and the COVID-19 shock. As outlined in the FSSA, practical use is being made of macroprudential policies. However, data and information gaps exist concerning non-bank financial institutions (NBFI) and their cross-border operations. Debtors, creditors, and market intermediaries face interlinked risks ranging from adverse macrofinancial effects of a prolonged pandemic, lingering post-Brexit uncertainties on financial services, and rapidly shifting financial conditions. Financial stability also remains highly sensitive to the interconnectedness of markets and cross-border risks. These, and issues relating to other ongoing financial sector transitions, are starting to pose a challenge for the financial stability authorities. Post-Brexit regulatory and related institutional reforms that are now being considered offer the opportunity to reaffirm the primacy of the authorities' objective of financial stability.

Executive Board Assessment[3]

Directors commended the authorities' strong policy measures and rapid vaccination campaign that helped contain the health, economic, and financial impact of the pandemic, which supported a faster than expected recovery. Directors noted that the near-term outlook remains strong but is subject to significant risks, including from emerging price pressures, medium-term scarring, and Covid-19 uncertainties.

Directors welcomed the Bank of England's recent policy rate increases as they saw the need to withdraw the exceptional monetary support provided during 2020–21 to counter growing inflation pressures. They supported moving the policy toward a more neutral setting while emphasizing that the pace of the policy withdrawal should weigh the risks to inflation and growth. In this regard, they emphasized that predictability and clear communications about forward guidance would improve policy effectiveness.

Directors emphasized that fiscal policy should retain an important role in responding to large macroeconomic shocks. They supported gradual fiscal tightening with well targeted support to protect households from the sharply rising cost of living. Given continued demand-supply imbalances, a few Directors saw scope for moving forward some fiscal consolidation while bolstering spending on Build Back Better priorities later, which would improve growth over the medium term. However, a few Directors questioned the political feasibility of this suggestion. Directors recommended further increasing fiscal automatic stabilizers by formalizing some well-targeted and effective pandemic programs to protect marginalized workers and small businesses. They welcomed the authorities' new fiscal rules and noted that a structured and timely commentary on alignment of proposed rules with overarching fiscal objectives would be helpful.

Directors welcomed the positive assessment of the effectiveness of the UK's financial stability framework reflected in the FSAP review and supported the report's recommendations. To manage potential systemic risk posed by complex cross-border financial firms, they emphasized the need to address data and information gaps, expand regulatory perimeters, and enhance international coordination, especially on non-bank financial institutions. Directors also called for continued vigilance on housing market risks and the use of macroprudential measures. They encouraged the continued proactive approaches on the future regulatory framework, LIBOR transition, green finance, and cyber threat related risks, and securing institutional safeguards for preserving financial stability and market integrity.

Directors commended the authorities' "Build Back Better: Our Plan for Growth" agenda to facilitate structural transformation for green, inclusive growth. They supported efforts to further scale up public investment and strengthen active labor market policies, building on experience gained. Directors welcomed the ambitious Net Zero Strategy and encouraged the authorities to hone it further as necessary to deliver their targets. On implementing the EU-UK trade agreement, Directors urged continued engagement of both parties to find mutually beneficial solutions.