Chief Economist’s Weekly Brief – Breaking (almost) all the rules

bw2_1121-copyLower growth forecasts meant the Chancellor had some tough choices to make in last week’s Budget. By pressing ahead with business and personal tax cuts now he chose to postpone a big chunk of austerity until the final year of this parliament. Austerity will have to be extended unless productivity and wages stage a dramatic recovery.

Sofa not so good. Some £27bn was found down a back of a sofa in November. However, forecasting changes can go down as well as up. As a result, the OBR lost £56bn down the same couch. Alongside an array of tax and spending adjustments, this necessitates an additional £36bn of government borrowing over the next three years. This is due to an economic outlook that is “materially weaker” relative to the Autumn Statement. The downgrades in economic growth are significant and stem from poor productivity performance. In turn, this results in lower revenues, wages and living standards. But a more marked slowdown will complicate the fiscal arithmetic further.

Osborne rules not ok. The Chancellor’s fiscal charter for budget responsibility has three rules. First, a welfare cap; second, a supplementary debt target with debt as a proportion of national income (GDP) falling every year; and third, achieve a budget surplus by 2020 and every year thereafter (the so called fiscal mandate). Rules are made to be broken. The first was broken in November and Budget 2016 noted it will be breached in each of the next 5 years. Debt as a % of GDP will rise, not fall, this year. Two out of three ain’t good! It could get even worse. The third fiscal rule, a surplus, will only be met by shuffling the timing of revenue / spending decisions and an additional £3.5bn of unspecified spending cuts. A potential triple whammy of fiscal failure remains on the cards.

Sugar coating austerity. In April 2009, the fiscal gurus at the IFS warned of “two parliaments of pain”. Few listened. Last week they once again poured cold water over the Chancellor’s latest fiscal projections. Austerity will extend into a third parliament. Avoidance lay at the heart of Budget 2016. Not just the £12bn of revenue hoped for (fingers crossed) from tax avoidance measures, but avoiding tougher decisions. The Budget delivered £8bn of tax cuts which are permanent giveaways. Meanwhile, of the £5bn of tax rises, some £2bn is linked to uncertain avoidance measures. Furthermore, much of the planned revenue increases are temporary. Permanent tax rises are required. The Chancellor may have unleashed a cocktail of measures, a staggering 77 policy changes in all, with the new sugar levy grabbing the headlines. However, a spoonful of sugar tax will not help austerity go down.

Tale of two recoveries. NI’s incoming output and employment statistics point to continued recovery in the final quarter of 2015. However, the labour market recovery looks the more impressive. Some 95% of the jobs lost during the downturn have been recovered, with some sectors – notably services – faring better than others – particular construction. Services, the largest sector in NI’s economy, now has 3% more jobs than it had at its pre-recession peak (Q2 2008). The same sector’s output recovery has been much less impressive, with less than 40% of the output lost during the recession having been recovered so far. More jobs and less output means lower productivity. The latter, as highlighted in last week’s Budget, is a growing policy concern at a UK level. And NI’s productive gap with the UK already appears to have been widening at significant rate.

Weaker today, weaker tomorrow. The Office for Budget Responsibility substantially reduced its forecasts for UK growth this year and for each of the next four years. 2% GDP growth is now expected in 2016, down from 2.4% in the last set of assumptions back in November. But this isn’t a temporary knock. The OBR has become significantly more pessimistic about the UK’s ability to grow, as shown by its lower expectations for productivity growth. It expects the economy to be 1.3% smaller in 2020 than it previously thought, which means lower wages and lower tax revenues.

Debt rule delay. A smaller economy means that debt as a proportion of GDP won’t have fallen in the 2015/16 fiscal year, as was targeted by the Chancellor in one of his three fiscal rules. Instead, this year is now forecast to be the high point with a net debt number 83.7% of GDP, a shade under £1.6 trillion. That debt burden puts us neck and neck with the US but fractionally below the average amongst Euro area countries. France, Spain and Italy are more indebted, Germany less so.

Headline tax rates down but offset by detailed changes. The big measures announced were planned reductions to corporation tax (down to 17% by 2020) and rises in the income tax threshold (up to £11,500 in April 2017). ISAs got a boost, raising the allowance to £20,000 a year from April 2017 when savers under 40 will also benefit from a new “Lifetime ISA” that awards a 25% bonus on up to £4,000 of annual contributions. Smaller businesses outside Scotland will also pay less Business Rates, but the restriction on tax relief of interest payments is expected to recoup £1bn a year.

The unstoppable force. The UK labour market clearly isn’t drinking any of the Chancellor’s “dangerous cocktail of risks”. The employment rate stayed at a record high of 74.1% in the three months to January. There were 28,000 fewer people unemployed and average earnings growth crept up a little, with pay excluding bonuses up 2.2%y/y. All very good at face value, but average earnings adjusted for inflation are still 7.3% below where they peaked in 2008. That lack of productivity is hurting households just as much as the public finances.

Canary in the coalmine? US retail sales grew by a healthy 3.1%y/y in February. But they were down m/m, as they had been in January. While it’s never wise to lose sleep over a couple of months’ data weakening sales are worth watching. US growth has been disappointing in the last year, yet without consumers’ spending it would have been slower still. Employment is rising briskly and wages are growing, too, so these might prove to be temporary reverses. We hope. 

Underlying progress. Headline inflation in the US remained muted in February at 1.0%y/y, down from 1.4% in January. That’s well adrift of where the Fed would like it to be. More encouragingly, core inflation, which excludes volatile items like energy and food, accelerated to 2.3%, the highest level since January 2012. That will encourage the Fed in its view that inflation is moving towards more normal levels, albeit slowly. 

Low for longer. The Fed held its main interest rate in the 0.25-0.5% range last week. While the US is generating plenty of new jobs output growth is hardly running at breakneck speed and clouds from weakening economies overseas are gathering on the horizon. Reflecting this, Fed members nudged down their forecasts of growth in 2016 and of inflation this year and next and are now signalling two rate rises this year, not the four they advertised in December. 

Outsized. China’s January credit tsunami receded in February. After a £372bn binge in new financing in January (mainly bank loans but also corporate bonds) February’s was a more modest £85bn. Still, if China’s new financing so far this year was an economy on its own it would be the world’s 20th largest, nestled in between Saudi Arabia and Switzerland. To say this level of credit growth is “unhealthy in the long-run” would be a significant understatement.

Reckoning. China’s fiscal stimulus and credit binge has yet to arrest the decline in growth. Industrial production slowed to 5.4%y/y in the first two months of the year, continuing the decline that began over two years ago. The Chinese authorities will be hoping the recent stimulus will be enough to change economy’s fortunes in the coming months.


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