IMF yesterday gave broad support for the Chancellor's plans to reduce the government deficit by cutting public spending and insisted that there was no need to change course at the moment.
The global economic watchdog said the economy remained on track for a “moderate” recovery where interest rates remain low and inflation finally starts to ease next year.
But after its experts visited Britain for their annual survey, the IMF also warned of “significant” risks that growth will remain feeble and unemployment “unacceptably high”.
Some economists have said that, if the economy does stall, Mr Osborne should be prepared to relax his programme of cuts to borrow more and spend more.
By contrast, the IMF said that in such a scenario, the economy should be stimulated with a combination of more “quantitative easing” from the Bank of England and “temporary tax cuts” for businesses and low-income households.
Tax cuts would be “faster to implement and more credibly temporary” than any move to increase public spending, it said. Its economists even hinted that if the recovery did not materialise, larger cuts to welfare and other programmes might be needed to balance the budget and reassure financial markets.
The Chancellor has said that Britain’s structural deficit will be paid off by the end of 2014-15, cutting Whitehall departments’ budgets by almost £100 billion over four years.
That plan has come under pressure from gloomy economic indicators. Official figures show that economic growth was effectively zero in the six months to April.
The IMF said it was not time to adjust macroeconomic policies because the weak growth figures were largely temporary. That verdict was a political boost for Mr Osborne, but the fund also warned that his spending cuts will create “headwinds for short-term growth” that will have to be offset by the Bank of England keeping interest rates low.
Growth this year will be only 1.5 per cent, the IMF said, down from its last forecast of 1.7 per cent. Once the recovery is secured, growth will average 2.5 per cent. Before that, however, the UK still faces “large risks to growth and inflation” from the eurozone crisis, the housing market, the speed of the rebound from recession and high oil and food prices.
John Lipsky, the acting managing director of the IMF, proposed temporary tax cuts aimed at low-income households if weak economic growth and high unemployment persist. Lipsky said the post-crisis repair of the British economy was under way, though weak economic growth and the pick-up in inflation over the past few months had been "unexpected".
"This raises the question whether it is time to adjust macroeconomic policies. The answer is no, as the deviations are largely temporary," he said. But he added that there were significant risks to inflation, growth and unemployment. "If they materialise, the policy response will depend on the nature of the shock."
Osborne strongly defended his austerity measures, saying they would provide much-needed credibility and stability for the UK economy.
However, he appeared rattled by the protests from the more than 50 academics and economists who demanded in a letter to the Observer that the government pursue a "plan B" to boost jobs and growth.
Jonathan Portes, director of the National Institute of Economic and Social Research, who until February was chief economist at the Cabinet Office, and Vicky Pryce, who was head of the government's economic service until last year, joined the criticism. Osborne argued that there was room in his macroeconomic plan for spending to increase if unemployment rose. "There is flexibility built into the plan," he said.
Labour, which had promised to halve the cyclical deficit over four years, said the IMF's endorsement was expected given the politically explosive nature of a critical report at this point.
Ed Balls, the shadow chancellor, said: "The chancellor should not take too much comfort from the report he launched at a Treasury press conference.
"The IMF has warned that there are significant risks to inflation, growth and unemployment. And they have downgraded their forecast for economic growth this year to just 1.5%, compared with the 2.5% it was predicting before the new government came to power."
"In these circumstances the cautious approach for George Osborne to take, and for the IMF to recommend, would be the one advocated by the deputy secretary general of the OECD, who said only last month the pace of the cuts should be reconsidered if things turn out to be weaker than expected."
The IMF has repeatedly downgraded the UK growth forecast for this year and cut it again on Monday, to 1.5% – down from 2.5% forecast in April 2010. Inflation is likely to remain above 4% for most of this year, it said, before gradually returning to near the Bank of England's 2% target.
Balls added: "However much George Osborne and the IMF hope this is just a temporary blip, the cautious thing to do is not to wait and see and hope for the best, but get a plan B now. We need a balanced deficit plan that puts jobs and growth first, not a rash and extreme plan that increasingly looks like it isn't working."
Balls seemed to dismiss the idea that the government would be using automatic stabilisers to any great extent.
He said the British economy had gone from growth to flatlining in the past six months."We are getting into a vicious circle. If the economy is slower, if fewer people are working if fewer people are paying taxes, if more people are getting benefits, it is harder to get the deficit down."
He said the last two major politicians to claim there was no alternative in the economy were Margaret Thatcher in 1980 and Ramsay MacDonald in 1931 after the 1929 Wall Street crash.
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