Washington, DC – May 27, 2025:

Economic Outlook

After a slowdown in the second half of 2024, an economic recovery is underway and is expected to gain momentum. Economic activity decelerated during 2024 H2, partly reflecting weaker export performance in the challenging global environment. In recent months, high frequency indicators have shown signs of improvement. Growth is projected at 1.2 percent in 2025 and 1.4 percent in 2026, as monetary easing, positive wealth effects, and an uptick in confidence bolster private consumption, while the boost to public spending in the October budget will also help support growth. The forecast assumes that global trade tensions lower the level of UK GDP by 0.3 percent by 2026, due to persistent uncertainty, slower activity in UK trading partners, and the direct impact of remaining US tariffs on the UK. The authorities’ structural reforms, including to planning, and the increase in infrastructure investment could increase potential growth if properly implemented. However, medium-term growth is still forecast to remain subdued relative to the pre-GFC trend, at 1.4 percent, given weak productivity.

Risks to growth remain to the downside. Tighter-than-expected financial conditions, combined with rising precautionary saving by households, would hinder the rebound in private consumption and slow the recovery. Persistent global trade uncertainty could further weigh on UK growth, by weakening global economic activity, disrupting supply chains, and undermining private investment.

Fiscal Policy

The authorities’ fiscal strategy for the next five years appropriately supports growth while safeguarding fiscal sustainability. The new spending plans are credible and growth-friendly, taking account of pressures on public services and investment needs. They are expected to provide an economic boost over the medium term that outweighs the impact of higher taxation. As revenue is projected to increase, deficits are set to decline and stabilize net debt.

It will be important to stay the course and reduce fiscal deficits as planned over the medium term. There are significant risks to the successful implementation of the fiscal strategy, from the high level of global uncertainty, volatile financial market conditions, and the challenge of containing day-to-day spending. Materialization of these risks could result in market pressures, put debt on an upward path, and make it harder to meet the fiscal rules, given limited headroom. To this end, staff recommends adhering to the current plans, and implementing additional revenue or expenditure measures as needed if shocks arise, to maintain compliance with the rules.

In the longer term, difficult fiscal choices will likely be needed to address spending pressures and rebuild fiscal buffers. Under current policies, staff analysis suggests spending to be around 8 percent of GDP higher by 2050, mainly due to additional outlays on health and pensions from population ageing. There is limited space to finance this spending through extra borrowing, given high debt and elevated borrowing costs. Unless revenue is increased, for which there is scope, tough policy decisions on spending priorities and the role of the state in certain areas will be needed to better align the coverage of public services with available resources.

While recent reforms of the fiscal framework enhance its credibility and effectiveness, further refinements could improve predictability and reduce pressure for frequent fiscal policy changes. The new current balance rule helps preserve space for investment, while the debt rule safeguards fiscal sustainability. The transition to a three-year rule horizon, aligned with the spending reviews, is expected to make the rules more credible, while allowing time to adjust gradually to shocks. Staff welcomes the authorities’ commitment to hold a single annual fiscal event, but notes that there is still significant pressure for frequent fiscal policy changes, given that small revisions to the economic outlook can erode the headroom within the rules, which is the subject of intense market and media scrutiny. Refinements to the fiscal framework could promote further policy stability. Options include (1) de-emphasizing point estimates of headroom in OBR assessments of rule compliance; (2) establishing a formal process so that small rule breaches do not trigger corrective fiscal action outside of the single fiscal event; or (3) assessing rules only once per year at the time of the fiscal event.

Monetary Policy and Operations

A gradual and flexible approach to monetary easing continues to be appropriate to support the economy and protect against inflationary risks. The pickup in inflation that began in 2024 is expected to last through the second half of this year, with a return to target later in 2026 as underlying inflationary pressures continue to recede. Although monetary policy calibration has become more difficult due to still-weak growth, the temporary rise in inflation and high long-term interest rates, staff sees the BoE’s gradual pace of easing as appropriate. Given the elevated uncertainty, the MPC is encouraged to retain flexibility to adjust the monetary stance in either direction if needed.

The BoE should continue to strengthen its forecasting capacity and communications. Staff welcomes the implementation of the Bernanke Review and the use of scenarios and conditional guidance in the BoE’s communications. The BoE will benefit from continuing to invest in modeling capacity, data and personnel, to be able to tailor scenarios promptly as economic conditions change. In the scenarios, interest rates should be allowed to adjust to economic developments, so that the scenarios are more informative and consistent, rather than assume that interest rates follow current market expectations. Lastly, MPC members could make greater use of the information from the central forecast and the alternative scenarios to justify the MPC decision and explain their personal views.

The BoE’s transition to a repo-based framework will mitigate balance sheet risks. QT continues to be conducted in a gradual and predictable manner. As the balance sheet normalizes, transitioning to a demand-driven approach, with reserves provided to banks mainly through repo operations, will reduce the market footprint of the BoE and limit its exposure to interest and credit risks. This will also maintain monetary control and the flexibility for new QE in the future, while providing sufficient reserves for financial stability reasons. The transition is being accompanied by a timely review of BoE instruments to consider the relative role of repo operations and asset purchases, as well as the balance between short and long-term repos.

Financial Sector Policies

The banking sector remains broadly resilient and macroprudential settings are appropriate, despite global financial stability risks increasing over the past year. The banking system is adequately capitalized and liquid with healthy levels of profitability, and the 2024 desk-based stress test showed that it can support households and businesses during times of severe stress. Macroprudential settings remain appropriate, as indicators of financial vulnerabilities are close to their long-term average, although global risks have risen in the past year given more volatile asset prices and credit spreads.

Significant progress has been made assessing and reducing vulnerabilities in the non-bank sector and work should continue at the domestic and international levels. Managing risks in the sector is critical, as it accounts for over half of UK financial assets. The system-wide exploratory scenario (SWES) has improved understanding of linkages with the banking sector and contagion risks, while the BoE’s new repo facility for non-banks is in line with previous AIV recommendations. The BoE could, in the future, consider expanding access to this facility so as to include a broader range of non-banks with a large gilt market footprint, provided they are adequately supervised and regulated. Ongoing work, including with the FSB, is essential to better monitor and manage non-bank leverage, concentration, and liquidity risks. Work should also continue on closing data gaps to enhance financial system surveillance.

Recent episodes of global bond market turbulence underscore the importance of enhancing gilt market resilience. Gilt market functioning has remained orderly. Vulnerabilities have nonetheless risen, given increased supply and the reduction in demand by more patient investors, with hedge funds and non-residents playing a greater role, and the BoE reducing its holdings as part of QT. Staff recommends close monitoring as well as regular stress testing and engagement with market participants to detect and manage future risks. In this regard, the shift of issuance toward shorter-dated securities for FY2025/26 has been well received by the market. The authorities are considering policies to enhance structural resilience, such as central clearing for gilt repo transactions, which is welcome.

Reforms to the financial sector and its regulation should balance promoting growth with preserving continuity and financial stability. While staff supports the government’s aim of enhancing the role of financial services as a driver of growth, risks will need to be carefully managed. Regulatory reforms should balance simplification and modernization with mitigating vulnerabilities, while being well-communicated. Consolidating pension funds has the potential to reduce fees and expand access to diverse asset classes, but it will be important to guard against possible unintended side-effects, including from reduced competition. Staff supports the FPC’s recommendation that the Pensions Regulator has the remit to take financial stability considerations into account. This would strengthen its ability to oversee the evolving pensions landscape and help manage potential risks from consolidation of funds and changes in investment strategies.

Structural Policies

Persistently weak productivity remains the UK’s primary obstacle to lifting growth and living standards. The UK has faced a decline in trend productivity growth since the Global Financial Crisis (GFC), further widening the gap with the US. Along with adverse shocks, including Brexit, the pandemic and the energy price crisis, the slowdown has left the level of UK GDP around one quarter below what the pre-GFC trend would imply. This slowdown has multiple causes, including chronic under-investment, low private R&D, limited access to finance for businesses to scale up, skill gaps, and a deterioration in health outcomes.

While the authorities’ Growth Mission focuses on the right areas, careful prioritizing and sequencing of policies will be key to success. The agenda is ambitious and impacts many parts of the economy. Reforms are broadly aligned with past IMF recommendations, although many of them are still at the formulation and consultation stage. Delivering on the Growth Mission involves significant challenges given limited fiscal space, the breadth of the reforms, and the volatile external environment. In refining their strategy, the authorities will thus need to carefully sequence reforms, ensure internal coherence among them, and prioritize early wins to build momentum and garner support for more complex initiatives. Continued clear communication with the public and markets will also be essential.

Stability, capital, and skills are the most important aspects of the Growth Mission. Staff recommends prioritizing the following three most binding constraints to growth. First, policy stability is critical to support business confidence in an increasingly uncertainty global environment. In this context, recent efforts to strike trade agreements with key partners, including the EU, India, and the US, demonstrate the authorities’ commitment to finding common ground and establishing a more predictable environment for UK exporters. Second, the planning reform and complementary public infrastructure projects can lift the chronically-low private investment, which has weighed on productivity. Finally, boosting people’s skills, enhancing their health, and incentivizing work will address shortages in sectors like construction and healthcare, while providing the productive workforce needed by growth industries. Reforms in these three areas are likely to deliver the largest growth benefits, while laying a strong foundation for progress on other fronts.

Industrial policy can play a complementary role to support particular sectors, but economy-wide reforms should remain the main tool to boost competitiveness and growth. Structural reforms that apply horizontally across the whole economy, such as easing planning restrictions, are likely to have the greatest impact. These reforms are prerequisites to realize the full potential of vertical interventions at the sectoral level, such as investments by the National Wealth Fund and initiatives under the new industrial strategy. Sectoral interventions should be focused on addressing market failures, identified using an evidence-based approach, and supported by rigorous appraisal processes, while being subject to strict budgetary limits, prudent risk management, and comprehensive risk reporting.

The mission thanks the authorities and other counterparts for open discussions, productive collaboration, and constructive policy dialogue.