LONDON The Bank of England won backing from the International Monetary Fund on Monday for keeping interest rates low, even as the IMF welcomed signs that Britain's surprisingly strong economic recovery is broadening.
In a report that will please finance minister George Osborne, who last year clashed with the Fund over his policies, the IMF said the government had struck the right approach to bringing down Britain's budget deficit, although it might have to consider raising more tax revenues in future.
In an update of its wide-ranging annual assessment of Britain's economy, the IMF welcomed recent measures to address the risk of a bubble in the housing market and said sterling was overvalued by 5-10 percent.
Last week, the IMF made Britain the clear leader, in terms of growth, among the world's big rich economies, forecasting gross domestic product would expand by 3.2 percent in 2014.
That is double the forecast it gave last year, when it called for more investment spending as a way to invigorate the then moribund economy.
"Overall, we are much more optimistic than we were a year ago both about short-term growth and about the prospects for growth to continue in the medium term," said Philip Gerson, deputy director of the IMF's Europe department, citing in particular a pickup in investment by companies.
The Fund said interest rates might need to go up quickly if inflation took off. But it said inflation pressure was weak for now.
"Wages are growing very slowly and, although output is beginning to pick up, the recovery is still at an early stage and there is still a lot of slack in the economy," Gerson said.
The Fund said Britain's output gap - or the difference between what the economy is currently producing and what it could do at maximum capacity - was equivalent to 1.3 percent of gross domestic product and would close gradually as unemployment fell to its natural rate of 5.5 percent only in 2019.
That suggested the Fund was close to the view of BoE policymakers who are less worried about the risk of a surge in inflation while wages are growing very slowly.
To date, all nine members of the Bank's Monetary Policy Committee have voted to keep interest rates at rock bottom to avoid the risk of derailing the economic recovery.
But economists expect a split to emerge soon, given the speed of job creation over the past year.
The IMF sounded relaxed about Britain's weak productivity growth, something that could cause inflation to pick up.
Gerson said the Fund believed the causes of the productivity puzzle were transitory and linked to a shift in activity between sectors in Britain's economy and to the continued reluctance of banks to lend as they recover from the financial crisis.
While the IMF did not expect an imminent rate hike by the BoE, it should start to explain how it will implement monetary policy once it begins tightening to avoid upsetting financial markets after more than five years of record-low rates, he said.
"With prospects of a rate rise strengthening, the Bank will need to announce soon what the new monetary control framework will be and how the transition to it will be managed," the report said.
On housing, the Fund sounded less worried about risks than in a version of its assessment of Britain's economy, published in early June, which was before the BoE introduced new controls on mortgage lending.
The IMF said on Monday it saw few signs of a bubble caused by over-lending, with credit growing only modestly. But a steady rise in high loan-to-income mortgages meant households could be more vulnerable to an interest rate shock.
Only if further controls on lending proved ineffective should the BoE consider raising interest rates to address risks from housing, the Fund said, echoing the BoE's position.
On Britain's commercial banks, more capital would probably be needed in the medium term - something several lenders also expect - while the big presence of HSBC and Standard Chartered in Asia represented a new risk if China's economy slows.
(Writing by William Schomberg; Editing by Hugh Lawson)