Mission Concluding Statement 

United Kingdom: Staff Concluding Statement of the 2024 Article IV Mission

May 21, 2024

Washington, DC: With growth recovering faster than expected, the UK economy is approaching a soft landing, following a mild technical recession in 2023. CPI inflation has fallen faster than was envisaged last year and is projected to return durably to target in early 2025. As monetary policy reaches an inflection point, the timing and pace of rate cuts must carefully balance the risks of premature and delayed easing. Fiscal policy has been appropriately tight, but difficult choices will need to be made over the medium term to stabilize public debt, given significant pressures on public services and critical investment needs. The banking system remains healthy, but continued vigilance of all banks is warranted. Maintaining progress on initiatives to better assess and mitigate risks stemming from non-bank financial institutions (NBFIs) is important. Further, ambitious, structural reforms to boost economic potential and living standards are urgently needed, with a focus on easing planning restrictions, addressing skills shortages and improving health outcomes. The UK should also stay the course on climate policies to realize the UK’s ambitious emission reduction targets.

Recent economic developments and outlook

1. The UK economy is approaching a soft landing, with a recovery in growth expected in 2024, strengthening in 2025. Growth was 0.6 percent q/q in 2024Q1, marking a stronger-than-expected exit from the technical recession in the second half of 2023, which left full-year growth at 0.1 percent. Real GDP growth is now forecast at 0.7 percent in 2024 (a slight upgrade from the 0.5 percent in the April WEO), before rising to 1.5 percent in 2025 as disinflation buoys real incomes and financial conditions ease. Longer-term growth prospects – unchanged from the April WEO – remain subdued due to weak labor productivity and somewhat higher than expected inactivity levels due to long term illness, only partly offset by higher migration numbers. Reliable data on inactivity and unemployment are a pre-requisite for economic analysis and policymaking, underscoring the importance of ongoing efforts by the Office of National Statistics to improve the quality of its Labour Force Survey.

2. Disinflation has advanced faster than expected, though services inflation and wage pressures remain elevated. Headline and core CPI inflation stood at 3.2 percent and 4.2 percent y/y, respectively, in March, having declined rapidly due to stronger energy and imported goods price deflation, and the impact of restrictive monetary policy. Although services inflation (6 percent y/y in March) and private sector regular pay growth (5.9 percent y/y in March) remain high, wage growth momentum (3m/3m) is now 5 percent (March) and the labor market is gradually cooling. Wage and price-setting expectations for the next 12 months have also eased notably. Some upward pressure on inflation is expected in the second half of the year as base effects from lower energy prices wane, but a durable return to the Bank of England’s (BoE’s) 2 percent target is forecast by early 2025.

3. Risks to growth and inflation are balanced. Inflation could be lower (and growth higher) if favorable second-round effects from falling energy prices are stronger and permit earlier and larger rate cuts. Inflation and growth could both be lower if domestic demand does not pick up as expected and the savings rate remains elevated. Wage pressures could be stronger, which would cause services inflation to stay elevated for longer. Inflation could be higher (and growth lower) if deepening geo-economic fragmentation and/or intensification of regional conflicts, like in the Middle East, materialize. A shock to UK sovereign risk premia can also not be ruled out in the event of systemic financial instability at the global level. The key downside risk to growth over the longer term is that investment and labor productivity do not pick up as forecast, and labor supply disappoints due to higher inactivity, lower immigration, and/or stronger aging effects. Bold implementation of ambitious growth enhancing reforms and AI adoption present upside risks.

Monetary policy

4. Monetary policy has reached an inflection point and the Monetary Policy Committee (MPC) has appropriately shifted to neutral forward guidance since February. With Bank Rate more than 2 ppts. higher than staff’s estimate of the neutral rate, the next phase of monetary policy is to ease, and the question is when and how fast to cut rates. In this context, 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. 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’s recommendation of about 50-75 bps cuts in 2024 is aimed at balancing these risks. Monetary policy should, of course, continue to closely monitor and be informed by incoming data, especially on inflation and the labor market in the next few weeks, as well as the outlook on risks, and adjust as needed. In this context, the MPC’s current “meeting-by-meeting” approach, including to evaluate the accumulation of evidence on persistent inflationary pressure, is appropriate. Moreover, possible divergence from the US Fed’s rate path will place a premium on effective MPC communication with markets. Staff sees merit in a press conference after each MPC decision, akin to the approach taken by other major central banks.

5. The MPC’s Quantitative Tightening (QT) strategy has been implemented well thus far but may need recalibration going forward. The reduction in the Asset Purchase Facility’s (APF’s) gilt holdings, among other factors, means that 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. Therefore, articulating a clear rationale for future QT plans will be important. 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. In this context, the BoE should continue to monitor signs of any undue pressure on short-term money market rates and gilt yields and adjust QT implementation as needed. Moreover, decisions on the steady-state composition of the BoE’s balance sheet should carefully consider various aspects of demand for reserves, including banks' needs for high-quality liquid assets.

6. The Bernanke review provides a timely opportunity to strengthen the BoE’s data and forecasting infrastructures, and communications. The review found shortcomings in the BoE's data platforms and central forecasting model (COMPASS); as well as in the ability of the central forecast to communicate the full richness of MPC views. Staff welcomes the BoE's commitment to act on the recommendations. Staff advises that the design of the proposed “alternative scenarios” include 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.

7. 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. However, 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. 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.

Fiscal policy

8. The fiscal consolidation strategy pursued since November 2022 has delivered an appropriately restrictive fiscal stance, although there has been some loosening of late. The consolidation, which has 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), was the net result of a number of measures. The increase in the corporation tax rate, freezing of personal income tax thresholds and tight limits on spending, were deficit-reducing. At the same time, the government included tax cuts in the last two budgets, notably, making capital investment allowances permanent (in line with the 2023 Article IV recommendation) and the lowering of the main National Insurance Contributions (NIC) rate. In light of the medium-term fiscal challenge noted below, staff would have recommended against the NIC rate cuts, given their significant cost (½ percent of GDP per year). 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) that will partially offset their fiscal cost over the medium-term.

9. Looking ahead, however, the government faces pressing service delivery and investment needs which, in staff’s view, will be difficult to accommodate within the official medium-term spending plans. These plans, which assume recurrent departmental spending growing at 1 percent in real terms, and capital spending flat in nominal terms (after FY2024/25), do not appear to sufficiently account for known pressures in public services (especially health and social care), and critical growth-enhancing investment needs (including for the green transition). Staff’s baseline projection assumes additional spending relative to the government’s plans to address these needs, resulting in a higher (2 percent) real growth rate for departmental spending. Under this baseline, total non-interest spending still declines as a share of GDP over the medium term, but this is not sufficient to stabilize public sector net debt (excluding BoE) over the medium term as a share of GDP (which reaches an elevated level of around 97 percent in FY2028/29). Pressures extending beyond the 5-year projection horizon (e.g., ageing-related spending and higher public investment needs) will add further to this debt burden.

10. Absent a major boost to potential growth, assuredly stabilizing debt in the medium-term will likely involve some tough choices. Staff’s analysis shows that to stabilize debt in FY2029/30, the primary balance will need to be, on average, around 1 ppt. GDP higher compared to staff’s baseline starting FY2025/26. This could be achieved, for example, by raising additional revenue from higher carbon and road-usage taxation, broadening the VAT and inheritance tax bases, and reforming capital gains and property taxation (which could also allow a reduction in stamp duty), broadly echoing the 2023 Article IV recommendations. On the spending side, staff continues to recommend indexing the state pension (only) to cost of living increases, recognizing the authorities’ efforts to contain the non-pension welfare bill by incentivizing work. Other options could include expanded use of charges for public services, 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. Against the backdrop of these challenges, as a general principle, staff would advise against additional tax cuts, unless they are credibly growth-enhancing and appropriately offset by high-quality deficit-reducing measures.

11. There is scope to further improve the UK’s sophisticated fiscal framework. First, staff recommends strengthening the debt rule with the requirement that debt be falling by the fifth year with a high probability (e.g., 75 percent), to increase fiscal buffers against adverse shocks. Second, the credibility of fiscal plans should be enhanced by producing 4-5 year expenditure frameworks every two years, replacing the non-rolling 3-year spending reviews; requiring that an OBR forecast accompany each fiscal event; and extending the OBR’s forecast horizon for its Economic and Fiscal Outlooks to ten years to better capture longer-term spending pressures, as well as dividends from growth-enhancing measures (especially public investments and the impact of private investment incentivized by the recently-implemented capital allowances), which will help provide a more complete picture of the sustainability of public finances. Finally, staff recommends moving to one fiscal event per year, to reduce political pressure points for fiscal loosening.

Structural and climate policies

12. Like other European peers, the UK has faced a major trend growth 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. 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. Moreover, the impact of relatively low rates of 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.

13. 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 delivered several helpful measures over the last three budgets, e.g., investment tax reliefs for businesses to boost investment, an expansion of childcare, and active labor market policies. While supporting the medium-term outlook, these measures are unlikely to sufficiently lift the UK’s long-term potential growth (which staff estimates at around 1.3 percent) towards pre-GFC levels. Additional ambitious reforms in at least three areas, including building on past efforts, are needed to address key impediments to growth and help reduce the growth shortfall.

(i) Easing planning restrictions. The current localized and discretionary system of decision-making is overly stringent and unpredictable. It hinders new construction (both residential and commercial) and infrastructure projects, restricting labor mobility (as workers stay trapped in suboptimal jobs due to unaffordable housing in areas with better prospects). It also raises investment costs for businesses, who often endure long and uncertain wait times or are forced to relocate to suboptimal locations. Accordingly, staff supports: (i) broader geographic and rules-based decision-making for business and large residential developments to reduce uncertainty for investors; (ii) digitalized and standardized plans at the local level which are, additionally, binding for designated growth areas; (iii) targeted incentives (to overcome new builds resistance) and resources to local authorities (including skilled staff to facilitate compliance with new environmental requirements); (iv) careful review of scope to release Green Belt land of little environmental or amenity value near stations with easy access to major cities.

(ii) Addressing skills gaps. There is an urgent need to upskill the UK workforce, given larger observed skill 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, teaching, and construction. Staff supports: (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.

(iii) Improving health outcomes. The size and productivity of UK labor supply could be at risk from weak health outcomes in the context of elevated service delivery pressures, as well as from rising inactivity linked to long-term illness. Staff supports: (i) implementing the NHS Long Term Workforce Plan, together with adequate capital investment, to create a better resourced and more productive health service; (ii) pursuing a forward-looking and integrated approach to NHS resource allocation and strategic decision-making that is focused on maximizing system-wide performance; (iii) increasing social care funding commensurate with demand over the medium-term; and (iv) improving 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.

14. The above reforms should ideally be nested within a stable, long-term growth strategy, backed by an independent growth commission. While progress on post-Brexit arrangements has reduced uncertainty, recurrent and piecemeal policy changes have arguably made it harder for businesses and workers to plan. In this context, consideration could be given to establishing an independent growth commission (similar, for example, to the productivity commission in Australia). 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).

15. The UK should continue its cautious approach to industrial policy, while maintaining its open trade orientation. The UK government has thus far avoided the potential distortions and fiscal costs associated with large-scale industrial subsidies, instead implementing broad-based tax incentives, e.g., capital allowances for business investment and R&D tax credits to promote innovation. These policies have been accompanied by 0.25 percent of GDP in fiscal support to the UK’s Advanced Manufacturing Plan, Green Industries Growth Accelerator, and creative industries, and by the announcement of 13 investment zones and 12 free ports. Any such policies should be narrowly targeted and focus on removing obstacles to investment and improving the business environment, where externalities or market failures prevent effective market solutions, while minimizing trade and investment distortions. The UK’s active participation in the WTO is welcome, as is the recently concluded Berne Financial Services Agreement with Switzerland.

16. Reforms to unlock pension savings for higher-return investments should not undermine financial stability or pensioner outcomes. There is a clear economic rationale for consolidating small pension funds, and potential benefits from encouraging the sector to invest more in higher-growth assets. However, realizing these outcomes will take time and persistent efforts. For instance, appropriate investment vehicles will need to be set up to facilitate the scaling up of such investments. These vehicles will need to be robustly designed, managed, and supervised. Caution is warranted around possible financial stability implications of the reforms, particularly given the context of ongoing defined benefit (DB) pension fund buy-outs and potential concentration risk created in the insurance industry from these concurrent changes. It will also be important to monitor the longer-term structural impact of these developments on gilt demand. 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.

17. The UK authorities should stay the course on climate policy. The UK has halved emissions relative to 1990 levels, but current policies and spending allocations are insufficient to meet the 2030 target. First, whole-of-economy green investment of around £50 billion per year by 2030 is needed, with an approximately 2:1 private-public split (in line with Climate Change Committee estimates). Private investment should be incentivized by full implementation of the 2023 Green Finance Strategy and by clarifying the pipeline of green projects requiring private participation. The required public investment should be protected, including to incentivize heat pump adoption and low-carbon power investment. Second, building on the welcome increase in the Boiler Upgrade Grant, stronger feebates could strengthen household incentives to convert to heat pumps. Feebates could also hasten the uptake of Electrical Vehicles (EV), as the EV mandate increases supply. Third, building on the net-zero consistent cap on Emission Trading Scheme allowances, a regulatory carbon price floor that rises over time should be added to eliminate the UK’s carbon price gap with the EU, which potentially exposes some UK exports to charges under the EU Carbon Border Adjustment Mechanism (CBAM) from 2026. The announcement of a UK CBAM is welcome, and staff encourage its implementation consistent with WTO rules.

Financial sector policies

18. Macroprudential policy remains appropriate and should continue to be calibrated as credit conditions and financial stability risks evolve. Households and corporates have thus far been resilient, supported by strong wage growth and enhanced regulatory measures. While default rates are likely to increase further as tight monetary policy continues to transmit through the economy, they are expected to remain manageable. Tight credit conditions have broadly been in line with macroeconomic developments but have eased somewhat recently. Against this backdrop, staff supports the Financial Policy Committee’s (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.

19. 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, 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.

20. The UK is making progress on pioneering initiatives to better assess and mitigate risks stemming from non-bank financial institutions (NBFIs). 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. Staff also welcomes progress on the design of the NBFI lending tool (initially envisaged for pension funds, LDI funds, and insurance companies) 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. Moreover, the ongoing work on enhancing liquidity management of sterling money market funds (MMFs) is progressing, and work should continue internationally given the large number of non-UK domiciled sterling MMFs. 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.

21. Structural financial sector reforms should continue to progress cautiously. The Edinburgh reforms have, so far, proceeded carefully and have preserved the primacy of financial stability objectives. Moreover, 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 encourage prefunding the FSCS to an appropriate level to avoid moral hazard.