Public Information Notice No. 08/99

Public Information Notice: IMF Executive Board Concludes 2008 Article IV Consultation with the United Kingdom

August 6, 2008

On July 30, 2008 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Kingdom.¹

Background

Economic growth was above trend in 2006 and 2007. In terms of expenditure, the expansion was largely driven by private consumption, on the heels of strong employment, steady real wage and living standards growth, and a surge in immigration. Compressed global credit market spreads, loosening credit conditions and a resulting expansion of household debt, alongside the decade-long housing boom provided additional fuel. Concurrently, investment was boosted by a low cost of capital and high corporate profitability. And notwithstanding favorable export market growth, the current account deficit reached 4¼ percent by 2007, a 3 percentage point worsening since 2003. The real effective exchange rate also appreciated by about 10 percent from 2006 through mid-2007.

With slack diminishing, inflation began to rise, prompting the initiation of a tightening cycle by the Bank of England. Still, rising commodity and services prices led CPI inflation to rise above 3 percent in March 2007, requiring the first explanatory open letter from the governor to the chancellor since the inauguration of the regime a decade earlier. During this period, the fiscal deficit remained high, with a structural tightening in 2005 reversed in 2006.

In the second half of 2007, the U.K. faced two new international shocks—the disruption to global financial markets and the sharp acceleration of the upward trend in world food and fuel prices. The combined effects of these shocks raised uncertainty, increased inflation risks on both sides, and compounded the ongoing correction in the domestic housing market. A run on Northern Rock, a medium-sized mortgage lender, raised the specter of financial stability weakness feeding through to the real sector.

Reflecting the disinflationary impact of expected output weakness, the monetary tightening cycle ended and the Bank of England lowered the bank rate by a cumulative 75 basis points (to 5 percent) in three steps from December 2007. The 2008 budget set a neutral fiscal stance, allowing full operation of automatic stabilizers. Since August 2007, the real effective exchange rate has depreciated by more than 10 percent, in line with monetary loosening, but also reflecting a reassessment of U.K. risk. And aided by lower outflows from foreign owned banks, the current account deficit fell toward the end of 2007.

So far in 2008, evidence points to a sharp slowing in activity alongside high inflation. Second quarter growth was weak, forward looking indicators are gloomy, sterling money market spreads remain elevated, unemployment has edged up, and house prices are falling rapidly. Accordingly, real GDP growth is projected to be 1.4 percent in 2008, falling to 1.1 percent in 2009. Inflation rose to 3.8 percent in June, on account of food and fuel price developments. And while there is scant evidence of second-round effects, as wages remain subdued, indicators of long-run inflation expectations have risen further.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They observed that, following a decade of sustained strong economic performance, including stable economic growth and low inflation, the UK economy is now facing several concomitant shocks. The strong policy frameworks and structural reforms that have underpinned this remarkable performance will be tested by lower growth, higher inflation from food and fuel price increases, ongoing strains in financial markets, rapid housing price reversals, and medium-term external imbalances. The financial sector strains have also triggered a broad-based effort to reform the financial stability framework.

In this difficult context, Directors noted that the authorities' inflation target of 2 percent will be exceeded for an extended period. In addition, the public net debt ceiling of 40 percent of GDP is likely to be breached. Rising long-term inflation expectations have added to the importance for fiscal and monetary policies to play their part in safeguarding the credibility of the nominal framework.

Directors welcomed the commitment made in the 2008 budget to tighten fiscal policy in the coming two years. Directors saw no room for slippages in the current fiscal year. A number of Directors recommended a stronger-than-planned fiscal stance for 2009 and beyond to support medium-term fiscal sustainability and help build headroom for full operation of automatic stabilizers. A stronger fiscal stance would also help address external imbalances. Some Directors favored a somewhat more gradual adjustment as planned given short-term output concerns.

Directors generally considered that any revision to the fiscal framework should enhance its credibility. They recommended that the net public debt ceiling of 40 percent of GDP be retained. Should it be breached, they called for concrete and frontloaded plans to bring debt back below the ceiling. Some Directors argued that the elevation of the status of nominal expenditure ceilings within the current fiscal framework would enhance its credibility. Some Directors suggested that any revision of the fiscal rules should strengthen consistency with the Stability and Growth Pact.

Directors agreed that monetary policy has been appropriately focused on stemming second-round effects from the food and fuel terms of trade shocks. Given the outlook for inflation and the stance of fiscal policy, Directors saw little scope for monetary easing at present. Directors considered that the current inflation-targeting framework contains sufficient flexibility in the target horizon and definition to accommodate the ongoing terms of trade shocks.

Directors noted that sterling has moved towards its equilibrium value, but remains on the strong side. This could adversely affect export growth, and underscores the case for improving the mix of policies to rebalance demand toward the external sector. Some Directors also stressed the need to enhance productivity.

Directors welcomed the ongoing efforts to stabilize financial markets, including the introduction of the Special Liquidity Scheme. They noted that further capital-raising and information disclosure initiatives by financial institutions would boost confidence in the financial system. With regard to the financial stability framework, Directors praised the thoroughness of efforts to diagnose and resolve the problems illuminated by recent market tension. They welcomed the close tripartite cooperation among the Bank of England, the Financial Services Authority, and the Treasury, and the openness of the consultation process. This process has correctly highlighted the need for a special bank resolution regime, a statutory role of the Bank of England in the financial stability framework, and strengthened operations of the Financial Services Authority. In addition, Directors agreed that success of the special resolution regime will require full clarity and accountability within the tripartite structure.

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. 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.