(Updates with Treasury comment in seventh paragraph.)
Aug. 1 (Bloomberg) -- The U.K. government and Bank of England may need to increase stimulus through tax cuts or bond purchases if weak economic growth and high unemployment persist, the International Monetary Fund said.
“If the economy appears likely to experience a prolonged period of weak growth and high unemployment -- and if inflationary pressures consequently ease -- it will be important to ensure that the slowdown does not become entrenched,” the Washington-based fund said in a report today. Still, any temporary fiscal measures should be accompanied by additional steps to “safeguard fiscal sustainability and market confidence,” it said.
U.K. manufacturing unexpectedly shrank in July, adding to evidence of a weakening recovery after data last week showed the economy barely grew in the second quarter. Prime Minister David Cameron has vowed to stick to his budget cuts to reduce the deficit, adding to pressure on an economy where consumer incomes are being squeezed by inflation that is more than twice the central bank’s 2 percent target.
The IMF maintained its forecast for U.K. economic growth of 1.5 percent this year and 2.3 percent in 2012. It said that for now both the government and the central bank should stick to their current policy plans as the weakness in economic growth and high inflation rate will likely prove temporary.
The Bank of England will leave its benchmark interest rate at a record low of 0.5 percent and keep its emergency bond- purchase plan at 200 billion pounds ($329 billion) this week, according to economists in two Bloomberg News surveys.
“Strong fiscal consolidation is under way and remains essential to achieve a more sustainable budgetary position, thus reducing fiscal risks,” the IMF said. “The inflation overshoot is driven largely by transitory factors, and hence maintaining the current scale of monetary stimulus is appropriate.”
The Treasury in London said in an e-mailed statement that it welcomed “the strong support the IMF has again given for Britain’s strategy for reducing our deficit and dealing with our debt.”
The fund said that if growth resumes as expected in coming quarters, “the case for beginning to withdraw some monetary stimulus will slowly increase.” Two of the Bank of England’s nine policy makers voted to increase the key rate last month.
Still, the IMF said there were “significant risks” to inflation, growth and unemployment due to the crisis in the euro area, the impact of the fiscal squeeze, volatility in commodity prices and the housing market.
The report also said that while lack of supply will help support property values, “some softness” in house prices “seems likely going forward.” IMF staff “central scenario assumes a reduction in the house price-to-income ratio of 12 percent over the medium term,” it said.
In a section on financial stability, the IMF said that while Britain’s banks are “ahead of schedule” in raising capital required by Basel III and deposits have been increasing faster than loans, lenders should continue to build up capital to reduce risks they pose to the financial system. Balance sheets are still “sizeable,” at about five times gross domestic product, and banks remain vulnerable to any disruption in wholesale funding markets, the report said.
Exposures to European countries struggling to manage their debt “seem manageable,” though “potential major spillovers to the private sector in those countries and to core European banks could lead to solvency concerns.”
“Policy flexibility will be essential to respond to shocks, with the appropriate response depending on the nature of the shock,” the report said. “For example, if there is mounting evidence that weak demand is likely to cause the economy to stall and enter a period of prolonged low growth and subdued inflation, a significant loosening of macroeconomic policies will be required.”
--With assistance from Gonzalo Vina in London. Editors: Fergal O’Brien, Craig Stirling
To contact the reporters on this story: Svenja O’Donnell in London at email@example.com; Jennifer Ryan in London at firstname.lastname@example.org
To contact the editor responsible for this story: Craig Stirling at email@example.com