Shopper on Oxford Street in central London. Strength of U.K. recovery is driven in part by consumer spending (Photo: Justin Tallas/AFP/Getty Images/Newscom)
ECONOMIC HEALTH CHECK
Speaking to IMF Survey at the launch of the IMF’s regular health check of the U.K. economy, Philip Gerson, European Department Deputy Director and head of the IMF’s UK team, said consumption and investment are the primary drivers of fast growth in 2014.
IMF Survey: The UK economy has grown quickly. What are the factors explaining the rebound?
Gerson: The UK’s recent economic performance has been surprisingly strong. A year ago we—and most other forecasters—were expecting that growth this year would be about 1½ percent, but growth now looks to be about double that. Growth also seems to be increasingly broad based. At the start of the recovery, growth was very dependent on consumer spending. The rebound in spending seems to have been associated with an increase in consumer confidence and easier credit conditions. But more recently business investment has also picked up strongly, as firms too have grown more confident about the state of the economy.
So we are much more optimistic now than we were a year ago about both the current pace of the recovery and about prospects for future growth, although of course there are always risks on the horizon.
IMF Survey: Can you explain these risks on the horizon?
Although the overall outlook is positive, some key domestic and external risks remain. Domestic risks include uncertainty about future productivity growth and the potential for financial risks stemming from the housing market. External risks include the unwinding of unconventional monetary policies in the U.S., weaker-than-anticipated growth in emerging and advanced economies, and increased geopolitical tensions.
IMF Survey: How serious are housing market risks for the UK economy?
Gerson: Housing prices have been growing very rapidly in London, and recently in the rest of UK as well (by about 20 and 10 percent, respectively). We’ve seen before in the UK and in other advanced economies how rapid house price inflation can contribute to financial risks, with serious implications for the rest of the economy. Rising house prices can lead some borrowers to take out mortgages that are very large relative to their incomes, leaving them vulnerable to shocks to interest rates or to their incomes.
The authorities have taken a number of steps to try to contain financial risks associated with rapid house price growth. For example, they are introducing limits on the share of new mortgages banks can grant that feature very high ratios of loan amounts to borrower incomes. Banks are also being required to run more strenuous tests of loan affordability. We agree that these types of “macroprudential measures” to address systemic financial risks are the appropriate first line of defense, and that early action like this is warranted, especially as it may take time for these measures to have an impact. The effects of these measures will need to be monitored carefully, and settings may need to be modified over time to maximize their benefits.
At the same time, the fundamental factor driving housing price growth is inadequate supply of housing, and political consensus to fix this is essential. Recent reforms to the planning system are helping, but more needs to be done to lift unnecessary constraints on development, to ensure that the tax system encourages the most efficient use of land, and to further develop markets for rental housing.
IMF Survey: Should UK monetary policy continue to remain accommodative, or should we expect some tightening? And how about the pace of fiscal consolidation?
Gerson: Monetary policy should stay accommodative for now. Inflation is low and stable, wage growth has been slow, and although output growth has picked up, the recovery remains at an early stage and there is still slack in the economy. Until we see signs that inflation is rising, or that costs are running ahead of productivity growth, monetary policy should continue to support the recovery.
An accommodative monetary policy can also help offset some of the impact from further fiscal consolidation. The UK authorities have undertaken substantial deficit reduction in recent years, but the deficit this year is still likely to be very high, at close to 5 percent of GDP. The planned pace of deficit reduction this year looks appropriate. Over the medium term, fiscal policy should continue to aim to put debt on a firmly declining path while supporting long-term growth through adequate public investment and safeguarding social needs by protecting social expenditure. Given the scale of the effort that will be required, the authorities should look to measures on both the revenue and expenditure sides.
So overall the policy mix being followed by the authorities looks appropriate, with an accommodative monetary policy that is providing support to the recovery and fiscal consolidation that aims to bring down deficits and put the debt ratio on a downward path.
