The backdrop for Chancellor Hunt’s Autumn Statement tied his hands considerably. The combination of the pandemic and its legacy and the surge in energy prices due to the War in Ukraine have made the UK poorer. In addition, the Bank of England’s significant monetary policy failures have exacerbated the inflation outlook.
Since the GFC the UK has become addicted to cheap money, with low policy rates and excessive quantitative easing by the Bank of England (BoE) as it has bought government debt and now owns close to one-third of the national debt. Monetary policy should have been tightened last year, not eased. Furthermore, the Bank’s failure to get ahead of the curve, alongside its poor communication, contributed to the febrile state of the markets in recent months.
The Chancellor also felt the imperative to focus on ensuring that financial markets were in no doubt about his commitment to fiscal sustainability. The premium built into UK assets as a result of his predecessor’s mini-Budget had disappeared in the run-up to the Autumn Statement. The policy approach of the new administration (including measures already announced to reverse the tax cuts aimed to spark growth but would have exacerbated the inflation outlook) probably all contributed to this.
The early November 0.75% increase in UK policy interest rates also helped, too. Despite the disappearance of this risk premium, Jeremy Hunt felt the need to focus on stability as his main priority, to reassure financial markets about his fiscal stance.
Thus, in the run-up to the Statement, there was immense focus on the fiscal gap – referred to as the Black Hole in the public finances. Importantly, this is not a precise number, although it is often talked about as if it is. By the time of the Statement, it was seen as £55 billion, prompting tax hikes and a future squeeze on public spending.
UK government finances vulnerable
The UK ratio of debt to GDP is high, but manageable. It is, as the Government keeps reminding us, the second lowest in the G7 – another reminder of how high public debt is globally as we enter this worldwide downturn. Indeed, the Chancellor was right to highlight global conditions in his speech. In its recent forecasts not only did the International Monetary Fund (IMF) predict a significant global slowdown but pointed out that one-third of the world will be in recession. For the UK that recession has already begun.
A high ratio of debt to GDP leaves the UK government finances vulnerable to either a deterioration in the growth outlook or to expectations of higher interest rates. Since the Office for Budget Responsibility’s (OBR) last forecast in March, the growth outlook has deteriorated and higher inflation has pushed up expectations about interest rates and, with it, debt servicing costs.
After economic growth of 7.5% last year, the OBR now sees UK growth of 4.2% this year followed by a contraction of 1.4% in 2023 before growth rises 1.3% in 2024. Meanwhile, their inflation forecasts are 9.1% (2022), 7.4% (2023) and 0.6% (2024). This economic backdrop has profoundly changed the public sector borrowing outlook. Compared with March the OBR has now raised its forecast for public borrowing from £99.1 billion to £177 billion for 2022/23 and from £50.2 billion to £140 billion for 2023/24. This a huge deterioration.
Should the Chancellor have tightened policy?
Of course, such poor growth prospects raise the question as to whether the Chancellor should have tightened fiscal policy? After all, the UK is the only G7 country tightening fiscal policy going into a recession. Also, another factor arguing against fiscal tightening is that the margin of error on fiscal forecasts can sometimes be large. That is, these forecasts are not precise. For instance, the average two-year forecast error from the OBR’s previous forecasts is equivalent to £38.6 billion in today’s money.
The Chancellor updated his fiscal rules, so giving himself some more flexibility while retaining the message of fiscal prudence. The prudence was to show that in future the ratio of government debt to GDP would be on a clear downward path. The flexibility was to adjust his fiscal rules, so the ratio of debt would be falling “by the fifth year of the rolling forecast”.
In terms of GDP, the OBR reported that public sector net debt reached 97.4% in 2021/22 and is expected to peak at 106.7% in 2023/24 before decelerating to 99.3% in 2027/28. Excluding the Bank of England’s holding of government debt, net public debt was 84.3% in 2021/22 and is expected to peak at 97.6% in 2025/26 and in 2026/27 before falling.
Fiscal policy options
When it comes to fiscal policy, the options open to the Government are: growth, borrowing, austerity or higher taxes.
Ideally, the best way to reduce debt to GDP is growth in nominal GDP. If not, then the government can borrow. Indeed, this should be the preference in tough economic times like now. Perhaps the Chancellor felt borrowing was already high following the pandemic. Also, because of its decision to engage in quantitative tightening, the BoE will be selling gilts, too.
As a result, market expectations are for sizeable gilt issuance that will need to be digested of around 13% of GDP over the next fiscal year, much higher than the still high 10% seen in the aftermath of the GFC.
Failing that, there is austerity and higher taxes. I am not in favour of tighter fiscal policy going into a recession. Fiscal policy should, in my view, help stabilise the economy in such a situation. Also, the nature of the UK inflation shock – driven by supply-side factors and poor monetary policy, and not by a domestic economy that is overheating – suggests there is less need to tighten fiscal policy to curb inflation. But that is not the present policy focus or market narrative. Instead, Chancellor Hunt saw the need to keep fiscal policy tight, to curb inflation.
Positively, the Chancellor did not opt for austerity. It didn’t work first time around a decade ago. Thus, public spending is being relaxed by £9.5 billion in 2023/24 and by £4.7 billion in 2024/25. In contrast, in both those years, taxes are set to rise, by £7.4 billion and £14.7 billion respectively. Then, post the next election (due by January 2025), the Chancellor outlined a tightening in both planned public spending and higher taxes.
The tax take, already high, is set to rise further, largely due to stealth taxes with the income tax system not being indexed to take account of inflation, so workers are dragged into higher taxes. Plus, the top rate of tax will now hit at a lower level, and allowances such as on dividends are being squeezed.
As expected, the rate of corporation tax will rise from 19% to 25%. Previously when this rate fell, the tax base widened. Now, this higher rate will apply across a wider base, hitting business competitiveness. Alongside this there was little in terms of allowances to incentivise firms to invest.
A potential triple deficit problem
The danger is the UK may experience a triple deficit problem. We have been used to a twin deficit problem – of a high budget deficit alongside a trade (or current account) deficit. Now, the challenge is what happens to the private sector’s balance sheet? This is critical.
In the late 1980s the economic consensus and the markets were overjoyed with Chancellor Lawson’s Boom, because of the great shape of public finances – with a budget surplus. At that time, I correctly, and against the consensus, pointed out that the Boom would become a Bust, as I felt not enough attention was being focused on the huge build-up of the private sector’s liabilities. Then, there was a large rise in private sector debt, including consumer credit and mortgage equity withdrawal. Likewise, what happens to the private sector balance sheet now will be critical.
Some have excess savings that they can fall back on. Some may respond to higher taxes, which lowers take-home pay, by pushing for higher wages, which in a tight labour market they may succeed in achieving. But for many that will not happen.
The OBR, like the Bank of England, expects unemployment to rise. The squeezed middle – those on middle incomes – may experience higher energy bills, higher taxes, and have little savings to fall back on. Indeed, the telling statistic was that the OBR sees real household disposable income per person falling by 4.3% in 2022/23 and by 2.8% in 2023/24, a combined fall of over 7%, being the largest such decline since the mid-50s. Even though half of the decline in the current year may be offset by targeted government measures, this is still a huge hit to income and thus to spending.
In this environment, it is now more likely that interest rates peak at a lower level in this cycle than they would otherwise have done. Policy rates are 3% now. A hike at the next meeting to 3.5% is still likely in the wake of the latest news that inflation reached 11.1% in October, its likely peak. The market expects policy rates to peak around 4.5% late next year.
Please note, the value of your investments can go down as well as up.
