Growth optimism, fiscal hangover

11 March 2024

Britain’s recession is over, inflation is beaten and interest rates are heading down. That, in a nutshell, was the upbeat message from last week’s UK Budget. But delve into the Budget numbers and a more daunting picture emerges.

First the good news. The independent Office for Budget Responsibility (OBR) thinks that the UK’s recession, which saw growth contracting in the second half of last year, is over and that activity will pick up from here. Rather than stagnation or a sluggish recovery, the OBR forecasts that by the end of this year the UK economy will be growing at an above-trend rate, a performance that will be maintained through 2025, 2026 and 2027.

Inflation, the UK’s central problem for the last two years, is in retreat. In the coming months the OBR sees inflation dropping below the Bank of England’s target of 2.0% and staying around this level for the next three years. On this view inflation is beaten and interest rates and mortgage rates should decline this year.

Faster growth and lower inflation will help consumer firepower. Rather than contracting by 0.8% in 2024 as the OBR thought in November, the latest OBR forecast shows real household incomes rising by 1.0% this year.

There are caveats. These are forecasts, fallible as always, and optimistic too, projecting faster growth and lower inflation than most economists. The OBR growth forecasts are partly dependent on quite high levels of immigration. Disappointingly, they assume that the proportion of the working-age population who work will continue to decline. Real incomes are set to rise but, after the ravages of inflation and slow growth, are unlikely to reach pre-pandemic levels until 2025 or later. Indeed, real incomes are likely to end this Parliament at lower levels than at the start in 2019. This would represent by some margin the worst outcome for households of any of the 18 Parliaments since records began in 1955.

But it is the picture on fiscal policy – on tax, public spending and debt – that looks most challenging.

Countering the effect of the pandemic on jobs and incomes obliged the government to spend on a vast scale, driving an expansion in the size of the state and pushing borrowing to 60-year highs.

The pandemic passed, but was followed by the energy price shock of 2022, to which the government responded with energy subsidies and help for lower-income consumers. There’s been no breathing space from crises. As a result the government has not embraced the sort of public sector austerity that George Osborne adopted to repair the public finances in the wake of the financial crisis. On the contrary, since October 2021 each successive Budget has loosened fiscal policy.

This activism has protected the economy and consumers, but at a cost. Public sector debt now stands at the highest levels in 60 years. Returning debt to pre-pandemic levels will be a Herculean task. You get a sense of the mismatch between public spending and our ability to pay for it, from the fact that the UK will need to borrow to fund spending in each of the next five years – despite historically high levels of taxation and the OBR’s forecast of growth returning to normal levels. The pandemic and the energy crisis have left the UK with a fiscal hangover.

Ever since the late 1990s successive UK governments have adopted fiscal rules that seek to contain levels of public sector debt. When shocks have hit, these rules have been broken or eased, giving the government the freedom to raise spending and borrowing. It is an irony that the age of fiscal rules has seen levels of public sector debt rise from around 30% to over 90% of GDP. When a crisis hits, plans go out of the window. Or, as Mike Tyson put it: “Everybody has a plan until they get punched in the mouth”.

The current fiscal target is hardly onerous. It requires that at the end of the forecast horizon, in five years’ time, the ratio of public debt to GDP should be falling. That allows a government to raise debt levels for the next four years, and leave it above levels when they come into office, as long as it falls in the final year of the Parliament. That is exactly what the Budget envisages. The OBR forecasts that public debt will increase for the three of the next four years – reaching a new high of 93.2% of GDP, before falling in 2028-29.

Even achieving this will be a stretch. Doing so depends on making large cuts to public spending in areas that account for almost one-third of all spending. These include local government, transport, justice and further and higher education, all of which have already seen their spending squeezed. Cuts of the necessary magnitude – which would need to occur through the next Parliament – may not be politically viable given the demands on public services. The fiscal arithmetic also assumes, improbably, that the government will end the freeze on fuel duties. As the Institute for Fiscal Studies puts it, “fuel duties indexation has become something of a joke, with a succession of one-year freezes announced every single year since 2011, while Chancellors insist on…maintaining the pretence that in a year’s time the rate would indeed be indexed”. No wonder the OBR itself only attributes a 54% probability to the fiscal rule being hit.

If the OBR is right the recovery has already started. Some things haven’t changed. The UK is a heavily taxed economy, one where, despite high levels of public debt and expenditure, public services are under pressure. Weak growth lies at the heart of all of these problems. These are challenges for the Budgets that will come after the general election.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index closed the week down 0.4% at 7,660.

Economics

The UK chancellor Jeremy Hunt delivered his Spring Budget, announcing a 2p cut to National Insurance, a one-year freeze of fuel duty and a 1% real-term increase in department budgets, including a £900m a year public sector productivity initiative
The Spring Budget also coined revenue-raising measures including tax increases on e-cigarettes, carbon imports and a more stringent non-dom tax regime
The UK chancellor was able to ease fiscal policy thanks to a brighter outlook forecasted by the Office for Budget Responsibility, which sees the economy growing this year by 0.8% and 1.9% next year
UK businesses reported the lowest inflation expectations in two-and-a-half years, as they expect consumer prices to rise by 4.1% this year, according to the Decision Maker Panel survey by the Bank of England
UK house prices rose for the fifth consecutive month, registering an increase of 0.4% in February according to Halifax
The number of foreign merger and acquisition deals targeting UK companies dropped to its lowest level since the pandemic in Q4 2023
London’s rental market is set to “normalise” after a mix of high demand and low supply saw rents accelerate last year, according to real estate Foxtons
US Federal Reserve chair Jay Powell said that the central bank is “not far” from cutting interest rates and easing monetary policy as consumer inflation hit 2.4% in January
CEO confidence in the US economic outlook reached the highest level since 2022 as businesses look to increase hiring and investments in the next six months, according to the Business Roundtable
US job openings remained almost unchanged at 9m in January while 144,000 jobs were added in February, an indication that the labour market in the US is still strong
Gold prices surged to record levels above $2,150 per troy ounce as uncertainty increased and concerns about US regional banking troubles returned
The European Central Bank kept interest rates unchanged but lowered its inflation forecast from 2.7% to 2.3% for this year noting that it “is seeing sufficient evidence to turn less restrictive”
German factory orders fell by 11.3% between December and January, a bigger fall than expected as the manufacturing sector continued to struggle
The number of babies born in the euro area in 2022 dropped to below 4m for the first time, adding fears that demographic trends may hamper future growth
The Chinese government announced a 5% economic growth target for 2024, which has been described as “ambitious” by economists given the challenges ranging from the property slowdown to weak investor confidence
China’s service sector activity growth slowed more than expected in February, according to the Caixin PMI survey

Business

US regional bank New York Community Bancorp raised more than $1bn in capital to shore up its finances after revealing a surprise loss of hundreds of millions of dollars and a $8bn fall in core deposits
The number of US banks at risk of failure rose by 18% in the final quarter of 2023, an increase concentrated in smaller and medium-sized banks, according to the Federal Deposit Insurance Corporation
US carmaker Ford announced that sales rose by 11% in the year to February thanks to demand for SUVs and hybrid vehicles
The EU competition authority fined tech giant Apple by more than €1.8bn for stifling competition from rival music streaming services
Electric carmaker Tesla revealed that production in China slowed to a 14-month low in February due to national holidays and a slowdown in demand
UK bank Nationwide agreed to acquire Virgin Money for £2.9bn, creating a potential new competitor for the UK’s biggest four banks

Global and political developments

The US Supreme Court ruled Donald Trump can remain on the presidential primary ballot in Colorado, paving the way for his candidacy as Republican contender Nikki Haley dropped out of the race without endorsing the former US president
Sweden formally joined NATO, strengthening the western military alliance in the Baltic Sea
Ukraine was reported to agree on restrictions on its trade with the EU to solve ongoing disputes with Poland, however, Kyiv urged the bloc to ban Russian grain imports
Ukraine announced that it would not allow Russian gas to flow through Ukraine after the current contract ends
China stepped up military efforts around Taiwan as Taipei’s defence ministry noted that the areas around the island were "saturated" with balloons, drones and civilian boats

And finally… a Vietjet pilot moonlighted as a doctor after helping to deliver a baby when a passenger suddenly went into labour in the plane’s toilet – air-born

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