The U.K. government should be nimble in its policy response if it looks as though the economy is headed for a prolonged period of weak growth, high unemployment, and subdued inflation. Currently, we don’t expect this scenario to happen. But if such a scenario appears to be in prospect, we recommend responding quickly with some combination of further quantitative easing by the Bank of England and temporary tax cuts.

The most likely scenario for the U.K. economy is that it will gradually recover, although it will face continued headwinds from a soft housing market, household and financial sector deleveraging, and ongoing consolidation of the budget. Against this, the economy should get a push from private investment and an increase in exports driven by the global recovery. Labor productivity may also rebound and improve competitiveness.

Led by these forces, the IMF is expecting a bumpy and uneven recovery in the U.K. and our updated growth forecast for the near term, taking into account the recent GDP release for the second quarter, will be published with the September World Economic Outlook. Over the medium term, we expect growth to accelerate gradually to about 2½ percent.

But volatile commodity prices, the uncertain magnitude of fiscal headwinds, and problems in the eurozone have added a lot of uncertainty to this outlook. It’s not easy to steer a clear course in such circumstances.

Three scenarios
In our recent discussions with policymakers, we outlined different scenarios for the U.K. economy. The precise nature of the policy response will, of course, depend on which way the wind blows.

• Stronger growth and higher inflation. If growth and inflationary pressures are stronger than expected, monetary tightening will need to accelerate, and all fiscal windfalls should be saved.
• Prolonged slump and subdued inflation. If there are signs the economy is entering a prolonged period of weak growth, high unemployment, and subdued inflation, rapid action may be needed to kick-start growth to avoid the slump becoming entrenched. If this happens, the risk is that productive capacity could be permanently lost, as temporary job losses morph into long-term unemployment due to job-seekers losing skills and dropping out of the labor market. Such measures to kick-start growth could include a combination of expanded asset purchases by the Bank of England and temporary tax cuts, combined with further reforms of pension and other entitlement programs to safeguard fiscal sustainability and market confidence.
• Weak growth and high inflation. If a slump weren’t bad enough, add to that high inflation. If that scenario unfolds, the appropriate response will depend on what is the root cause. If volatile commodity prices are the main driver of price increases, policies need not respond as long as there remains little evidence that commodity price spikes are producing more persistent price pressures. But if weak growth and high inflation are the result of labor and skills shortages, as evidenced by rapid wage growth, policymakers would have little choice but to tighten monetary policy. A narrower output gap would also imply a higher structural deficit and would therefore require more fiscal adjustment over the medium term.

The most important thing for the government is to stay nimble, and be ready to alter course, should any of these scenarios manifest themselves. For now, staying the course and implementing the wide-ranging policy program that was agreed last year seems the right thing to do.

This post originally appeared at iMFdirect and is reproduced here with permission.