Although the latter has also been affected by the non-indexing of allowances, this means the levels at which people are dragged into higher tax brackets on their income has not been increased in line with inflation for some time. It has highlighted the high tax take in the UK and the importance of indexation in the tax system.
Nonetheless, it was the right approach for fiscal policy to provide a boost to the economy in the Statement, with the aim of supporting demand, as well as outlining a host of supply-side factors. Yet, the UK’s longer-term fiscal outlook, like that of five other members of the G7 countries (not Germany) remains poor.
On the fiscal front, a government’s options are to grow the economy, borrow, control spending, have the right level of tax, or reform. Plus, some might say, inflate the debt away, but I don’t agree that this is an option, but more a consequence of economic outcomes and monetary policy.
It is, though, important to look at fiscal policy when one considers monetary policy. That is because in a well-run economy, there should be consistency between monetary and fiscal policy. This used to be an important hallmark of thinking here in the UK, but increasingly it is less mentioned. It was important in the wake of the global financial crisis, for instance, when both monetary and fiscal policy provided a stimulus, with rates being cut and there was a widespread, coordinated fiscal response at the London Summit.
However, since then, there has been an ongoing problem. Consistency has been replaced. From a monetary policy perspective, fiscal policy is taken as a given. That is, fiscal plans are then factored into economic forecasts, which in turn influence decisions now about future inflation and thus about current policy.
Therefore, the small but significant fiscal stimulus provided in the Statement was seen as – if anything – supporting the idea of interest rates staying higher for longer. But that direct impact on interest rates from last week’s fiscal change is likely to be minimal.
The markets hold policy makers to account – and when it comes to fiscal policy in an inflationary environment, any stimulus needs to be seen as necessary, affordable, non-inflationary and targeted. Too often, unfortunately, comments are made suggesting any fiscal boost, or even increased borrowing, is by its very nature inflationary. It is not, and it depends upon the economic environment and the actions that are taken. Last week’s boost, for instance, is not inflationary. I suspect the likely fiscal boost in the March Budget, too, will not be inflationary – as by then the economy will be stagnating.
The economy will likely need both a fiscal and monetary boost as we move through 2024. The trouble is that the room for manoeuvre on fiscal policy is limited, and for monetary policy much depends on what is happening to core or underlying inflation. It should be decelerating, but when we have seen shifts in the inflation environment before, such as in the 1970s or in the early 1990s, policy makers and markets can be caught out by underlying changes, expecting inflation to return to where it was before.
In the current context, the expectation is that inflation trends to 2%. While I think inflation could undershoot its target on an annual basis next year, our expectation is that inflation subsequently settles at a higher rate in 2025 than pre-pandemic. For example, 3% as opposed to 2%.
The key driver for global financial markets in recent years has been the end of cheap money. Now that is changing. Many economies – often referred to as emerging economies – are easing interest rates and this is likely to continue. Next year, western economies will ease, too, including the UK, US and euro area.
Already this has driven global equity markets higher over the last month. Inflationary pressures have peaked. Global growth prospects are not good and debt levels globally are high.
Meanwhile, the UK is faced with three recessionary indicators: weak signals, like the purchasing managers’ indices; monetary growth and the growth of bank lending in negative territory; and the full impact of monetary policy tightening yet to feed through. Against this is that the economy has proved resilient; firms are holding onto staff, recognising it is hard to recruit skilled labour; inflation is decelerating, so real incomes will grow; and there is room for policy stimulus.
The lagged impact of monetary policy is hard to gauge but it can take 12 months or longer for tightening to feed through. In October, the Bank of England noted that interest rates on new mortgages and refinancings averaged at 5.01%. While this was lower than the 5.2% of the previous month, it compares with those who are refinancing from potential rates of around 2%. So those refinancing face a big increase in borrowing costs, and while this relates to mortgages, the reality is that financial conditions have tightened across the economy and that is captured in the weak monetary and lending data.
Although the economic outlook is poor, the Bank’s recent messaging has been relatively cautious. While headline inflation has decelerated, core inflation is stubborn. But the two factors that led to higher inflation in this cycle have been reversed. In the UK this inflation shock was triggered by supply-side factors and lax monetary policy.
Now the supply-shocks have been reversed, and monetary policy has been tightened significantly. Instead, attention is focused on second-round inflation effects, and while one can understand the Bank’s focus, these fears must be kept in context and not overstated. Wage growth is now exceeding inflation, but it is playing catch-up. Compared with January 2020, for instance, prices are 22% higher. So even if inflation is now decelerating there has been a large cost of living impact, reflected in the higher level of prices, which could have been significantly mitigated if monetary policy had been better managed.
Having kept rates too low for too long, the Bank is likely to err on the side of caution. I already think rates have risen too far. The messaging suggests that rates will not be cut anytime soon. Indeed, this week the OECD in its half-yearly assessment mentioned that UK rates could be unchanged through 2024. By the summer, inflation may be back at target, and by then the economy could be in recession, or growing at a very modest pace. The OBR, with its forecast of 0.7% growth next year, is in the latter category.
The market is factoring in one interest rate cut by summer, to 5%, and another by year-end to 4.75%. It hasn’t ruled out the possibility of 4.5%. The latter is partially factored in. Such thinking makes sense. It is in line with what we have said here in recent weeks. I think rates will be at 5% by mid-year and 4.5% by year-end, and if rates are not at these levels, I think they are more likely to be lower, not higher.
Please note, the value of your investments can go down as well as up.
