The labour market rebounded quickly and job vacancies have reached record highs. Unemployment has fallen below pre-pandemic levels to 3.7%. Labour force participation has declined since the onset of the pandemic, mainly due to long-term sickness and early retirement by those aged above 55 years.

Trade in goods and services was negatively affected by Brexit and the pandemic. Non-tariff trade barriers with the EU have increased administrative costs. Trade with the EU has recovered somewhat after a sharp drop at the end of the transition period in January 2021, but imports from the EU remain suppressed.

Monetary policy has been normalising on the back of rising inflation pressures (Figure 2). In response to rapidly rising inflation and a tightening labour market, the central bank has gradually increased the policy rate since December 2021 from 0.1% to 1.25% in June, ended asset purchases, stopped reinvesting maturing gilts, and announced the gradual selling of its stock of corporate bonds. A winding down plan for the stock of government bonds will be discussed in August 2022.

Fiscal policy has to balance fiscal tightening with supporting growth and investment needs. The government has committed to a gradual medium-term fiscal consolidation plan, with planned increases in tax revenues and increased investment. As cost of living has risen sharply, the government introduced temporary and targeted support measures to aid vulnerable households. The government is on track to reach its new fiscal target, which will put net debt on a declining trajectory. In the longer run, the United Kingdom faces significant fiscal pressures mostly driven by ageing related expenditure and transitioning to net zero greenhouse gas emissions.

The financial sector weathered the pandemic well, and banks hold substantial provisions against future credit losses. Risks from the mortgage market remain contained but rapid house price growth warrants continuous vigilance. Well-developed capital markets and a sound banking system are expected to facilitate the required reallocation of capital as a consequence of Brexit, the pandemic and net zero transition but the long-term impact on the UK financial sector remains unclear.

Output growth is projected to weaken in 2022 and 2023 (Table 1), as rising living costs weigh on consumption. Business investment will be dampened by rising interest rates and lingering uncertainties. A deterioration in the public health situation and spill-overs from economic sanctions following Russia’s invasion of Ukraine are significant downside risks to the outlook.

Productivity growth has stalled since the Global Financial Crisis on the back of skill mismatches, low innovation and knowledge diffusion, as well as low investment. Productivity gaps are wide across regions.

Regional disparities weigh on aggregate productivity growth. “Levelling up the UK“ in terms of productivity and living standards is a key policy priority of the government, but the additional funding announced so far has been limited. Local authorities face a fragmented and complex funding landscape, challenging to navigate for local authorities, risking that capacity constrained local areas miss out on needed funding.

Better infrastructure is key to stronger productivity growth. Public investment has increased in recent years and will remain close to a significant 2.5% of GDP over the coming years under the government’s Plan for Growth. However, large investments will be needed to compensate for years of underinvestment and to address long-term challenges such as the net zero transition.

Higher private investment is needed to support productivity growth. Business investment in physical capital, innovation or new processes that would make labour more productive has been subdued due to uncertainties following Brexit and the pandemic.

Skill shortages weigh on productivity. Increasing digitalisation and transitioning to net zero will require intensifying adoption of new technologies. This implies an ever-growing need for workers to update their skills, but participation in continuing education and training is low.

More fully utilising women skills in the labour market would support productivity and growth. A third of women work part-time, roughly three times more than men. Mothers are likely to reduce working hours following childbirth. Parental leave for fathers is short and combined with low female pay replacement rates and a relatively high out-of-pocket price for childcare contributes to gender gaps in labour participation and earnings.

The United Kingdom has successfully reduced greenhouse gas emissions in the past, and a broad political consensus supports the target to reduce net emissions to zero by 2050. The UK’s strong institutional framework is an inspiration to countries around the world, and the country is pioneering work to embed climate considerations in the financial sector.

Achieving carbon neutrality will require policy to match ambition. Emission reductions so far were largely driven by electricity generation, a sector targeted by the emission trading scheme (ETS), a carbon price floor and a cost efficient renewables auction-design subsidy scheme. A landfill tax and the ETS also drove down emissions in other sectors (Figure 3). Expanding pricing instruments across the economy is an essential building block to reach targets, but well-designed sectoral regulation and subsidies are also needed to boost innovation and overcome a number of hurdles. A clearer transition policy path would allow the financial sector to better support the green transition.

Britons are conscious about the need to act, but do not necessarily support efficient policies like carbon pricing. This reflects that efficient climate policies will reduce incomes more among less affluent people and those living in sparsely populated areas (Figure 4), unless they are compensated or supported to reduce fossil fuel dependence. Climate change reducing measures will be more acceptable when implemented once energy prices have started to normalise following the current historical high.

Recycling revenue to support clean technologies and infrastructure increases popular support for direct pricing instruments. Transfers and programmes to support energy efficiency, notably for low-income households, can minimise unwanted distributional effects and strengthen energy security.