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Monday December 1, 2008 - 11:14:15 GMT
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Weekly economic data preview - Bank of England and ECB set to lower interest rates sharply; Economics Weekly - Government borrowing to rise sharpl

Economics Weekly1 December 2008


Government borrowing to rise sharply


Borrowing to rise sharply with a stimulus package of £20bn…

The Chancellor confirmed in the 2008 Pre-Budget Report (PBR) that the budget deficit is to rise to £118bn next year, or 8% of gdp, a ratio not seen since 1993, and with the sharpest rise in the ratio seen since the 1970s. But the global financial crisis means that the government has little choice but to take debt onto the public sector balance sheet, otherwise the economic slowdown will be even worse and the financial sector could be put at unacceptable risk of systemic failure. But slower economic growth and the inability to therefore raise taxes will push up borrowing to very high levels. The ‘golden rule’ to borrow over an economic cycle only to invest is officially discarded until 2016, when the current budget is expected to balance, but in reality it may not return to that steady state even then. On official projections, net debt will rise to 57% of gdp from 36.3% last year, or more than £1trillion, before starting to decline in 2015/16. In order to stop debt rising, tax increases are planned and slower growth of public spending relative to gdp in the period after the recession ends, expected to be in 2010. However, the tax rise seems small set against the big rise in debt that is expected to take place and the public spending constraint of just 1.2% real growth a year may be difficult to achieve (though in its first two years after being elected in 1997, the current government managed to stick to even tougher spending plans inherited from the conservatives).


…leading to worries about how it will be financed in the long term…

These are amongst the highest borrowing figures to be announced since the early 1990s recession, but they are in line with consensus estimates and so likely to be viewed as realistic. Chart b shows that the rise to 57% in the debt/gdp ratio over the period takes it up from very low levels, marking the end of the recent period of historically subdued government borrowing. It will stay high in the years ahead, taking UK debt levels closer to the OECD average of 75% (though still well below). Tax cuts become tax increases after economic recovery is underway in 2010, but in the next financial year (2009/10) borrowing will be £118bn, or 8% of gdp, see chart a. Taxes on households will rise, but only from 2011, and the burden will fall mainly on those earning over £100,000 a year. The fiscal rules – to borrow only to invest and to keep debt below 40% of gdp - have been set aside, see chart b, and may not return as planned in 2015/16, since the tax increases necessary to help make that happens seem small as a share of gdp, see chart d, relative to the sharp increase in borrowing, see chart c. This means that the days of strong increases in public spending in real terms are now over, and spending is planned to grow by just 1.2% a year in real terms, well down on the near 4% pace under the government in the last 10 years. Even so, the strong rise in debt suggests that pressure on the public sector will be intense, as assumptions about efficiency savings and sustained trend economic growth of 2.75% a year from 2011 onwards may be difficult to achieve.


…especially since the base line view is dependent on an unlikely quick return to trend economic growth in the medium term once recession is over

Official projections of economic growth are pretty much in line with consensus for this year and next, at 0.8% this year and minus 1% next year. The projection of recovery to about 1¾% in 2010 may be seen as optimistic currently, and trend growth of 2¾% after that as even more unlikely, given the fact of tighter regulation, deleveraging and weaker growth in financial services and the property market. However, a return to trend growth is possible and well within margins of error on forecasts of economic growth that far ahead. The big risk is that if they are wrong, then public sector debt will be even higher and the potential for tax increases even greater, see chart c. Indeed, UK public sector debt will head firmly up towards the international average in the years ahead - though it may take a decade or so to get there, on current trends this is much more likely than not.


Company and financial market impact

Companies will overall like the many small measures that were announced in the PBR, but the economic impact of the cut VAT of 2½% to 15% is not clear. Small firms will likely gain more than large from the measures announced. Debt issuance will rise quite sharply and could steepen the yield curve. Initial financial markets reaction was positive, however, with equities up, yields down and the currency stronger. Expectations of official interest rate cuts were largely unaffected. This favourable market view continued in the days immediately after the PBR, see chart e.

Trevor Williams, Chief Economist, Corporate Markets


Weekly economic data preview W/c 1 December 2008


Bank of England and ECB set to lower interest rates sharply


The Bank of England and ECB are poised to reduce interest rates this week, with the respective central banks of Australia and New Zealand also expected to ease policy. In the UK, we expect interest rates to come down by 100bps to 2%, though consensus forecasts range from 1.5% to 2.5%. UK mortgage approvals will confirm weakness in the housing sector, while the PMI surveys will be closely examined to assess the extent to which economic activity and pricing pressures have fallen further. The ECB is expected to cut rates by 50bps to 2.75%, though recent poor business sentiment surveys and the sharp fall in EU-15 CPI to 2.1% in November increase the risk of a larger reduction. The RBA and RBNZ are forecast to cut rates by 75bps and 150bps to 4.5% and 5%, respectively. On Friday, all eyes will be on the US employment report, with non-farm payrolls forecast to fall by 275,000 (consensus: 323,000) and the jobless rate expected to rise to a 15-year high of 6.7%. This should cement further Fed policy easing when the FOMC next meets on December 15/16, perhaps

by 0.5%.


We expect the Bank of England MPC to cut interest rates by a further 100bps this week to leave official rates at 2%, matching the all-time low. The economy is expected to have contracted again in the current quarter and is forecast to continue shrinking in every quarter until the second half of next year. Mortgage approvals are predicted to have remained near recent lows of around 30k in October, while growth in mortgage lending and consumer credit will remain weak. The manufacturing and services PMI surveys provide a timely indication of growth and pricing pressures in November and should pave the way for the MPC to cut interest rates aggressively. More generally, a significantly weaker growth outlook, resulting from the risk of widespread insolvency in the global financial system, and sharply lower commodity prices (none of which was generally anticipated and certainly not by any MPC member) mean that CPI inflation is expected to fall below the 2% target next year, providing leeway for further interest rate reductions in early 2009. As chart 1 shows, UK interest rates last month fell below eurozone rates for the first time since the euro's inception and are expected to remain lower throughout 2009.


The ECB will lower interest rates from the current 3.25% level this week, but the question is by how much. A reduction to at least 2.75% is likely, though the recent rapid deterioration in business sentiment and the surprisingly large fall in eurozone CPI inflation in November have raised the risk of a larger reduction, perhaps to 2.5% or even 2.25%. Eurostat is expected to confirm that eurozone growth in Q3 fell by 0.2%, the second consecutive quarterly decline, while latest survey evidence, including this week's manufacturing and services PMI, points to further contraction in the current quarter. As usual, markets will focus on ECB President Trichet's comments following the interest rate announcement, including a new set of growth and inflation forecasts, which are expected to be revised down significantly from the previous projections in September.


The US Federal Reserve next meets on December 15/16, with incoming data pointing to further reductions in interest rates from the current 1% level, in our view of half a percent to 0.5%. The release of ADP employment figures and ISM surveys may provide clues to the outturn of the official employment report on Friday. We forecast a fall of 275,000 in November non-farm payrolls, which would be the eleventh consecutive decline, with the recent pace of net job losses accelerating from around 75,000 a month in the first half of 2008. The market consensus forecast is for a slightly larger fall of 323,000. The unemployment rate is expected to rise to 6.7% from 6.5%, the highest for 15 years. Weak factory orders data, due for October, will confirm a weak start to the fourth quarter.

Hann-Ju Ho, Senior Economist



Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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