George Osborne has been told by the International Monetary Fund to rethink the pace of his deficit reduction plan after the Washington based institution cut its forecast for UK growth in both 2013 and 2014.
The IMF's flagship publication – the half-yearly World Economic Outlook – provided fresh ammunition for the chancellor's Labour critics when it said the Treasury should contemplate being flexible about its austerity strategy.
In its latest forecasts, the Fund said gross domestic product in the UK would rise by 0.7% this year and by 1.5% in 2014 – in both cases a cut of 0.3 points from its last set of predictions in January.
Eagerly awaited growth figures for the UK are due out next week but regardless of whether they show Britain in an unprecedented triple-dip recession, the IMF said recovery was progressing slowly, held back by the weakness of trade and attempts to reduce the government's budget deficit.
"Domestic rebalancing from the public to the private sector is being held back by deleveraging, tight credit conditions and economic uncertainty, while declining productivity growth and high unit labour costs are holding back much needed external rebalancing," the WEO said.
It added: "In the UK, where recovery is weak owing to lacklustre demand, consideration should be given to greater near-term flexibility in the fiscal adjustment path."
Although not specifically referring to the UK, the Fund said that the effect of raising taxes and cutting spending might have been increased in an environment where monetary policy – cutting interest rates, lowering exchange rates and creating new electronic money – was proving less effective than usual.
"Even though monetary policy has been effective, policymakers have had to resort to unconventional measures," the IMF said, noting that the ultra-low level of interest rates and the deep-seated damage to financial systems had lowered the traction of monetary policy.
"This, together with the extent of the slack in these economies, may have amplified the impact of contractionary fiscal policies. Four years into a weak recovery, policy makers may therefore need to worry about the risk of over-burdening monetary policy because it is being relied on to deliver more than it traditionally has."
For the world economy as a whole, the Fund marginally cut its 2013 growth forecast by 0.2 percentage points to 3.3%, but said its prediction of an acceleration to 4% in 2014 remained unchanged.
It said growth continued to be powered by emerging markets, with the developed world continuing to struggle. Olivier Blanchard, the Fund's chief economist, said that within the developed world there was a contrast between the United States, expected to grow by 1.9% in 2013 and 3% in 2014, and the eurozone – which will contract this year and experience only 1.1% expansion in 2014.
"Recent good news about the United States has come with renewed worries about the euro area. Given the strong interconnections between countries, an uneven recovery is also a dangerous one," Blanchard said. He noted that some risks to the global economy, such as the UK falling off the fiscal cliff or a breakup of the euro, had diminished, but that it was "not time for policymakers to relax".
Blanchard told a press conference in Washington that the IMF would hold talks with the UK government in the coming months, to "see what can be done" about the pace of deficit reduction.
"In the face of very weak private demand it is time to consider adjustment to the original fiscal plan," Blanchard explained.
The Fund said that some central banks – including the Bank of England — would find it difficult to remove the huge stimulus provided over the past four years, warning that some could face "significant trade offs" between fighting inflation and preventing a tightening of policy leading to fresh outbreaks of financial instability.
"Such risks are particularly relevant for central banks that have been purchasing large amounts of debt securities with long maturities, such as the (US) Federal Reserve and the Bank of Japan, which recently adopted continued monthly asset purchases, or the Bank of England."
The Fund said it was difficult to make banks safer while at the same time encouraging them to lend more, unless governments were prepared to pump more money into weak but viable institutions or to subsidise lending.
"Examples of the latter are Japan's loan support programme and the UK's funding for lending scheme. Although it is still early days, so far the FLS's impact has been limited, encouraging mortgage lending more than lending to small and medium-size businesses."
HM Treasury spokesperson said: "Today's report from the IMF highlights the risks that continue to face economies around the world. Though the UK is forecast to have stronger growth than either France or Germany in 2013, difficulties in the euro area are still creating economic headwinds.
"However, as the chancellor said at the budget, we are slowly but surely fixing this country's economic problems. The deficit is down by a third, a million and a quarter new private sector jobs have been created and because of the credibility the government has earned, families and businesses are benefiting from near-record low interest rates."
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