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Economics Weekly - Chancellor needs to be careful not to jeopardise the recovery; Weekly economic data preview - BoE & Fed speakers take centre stage ahead of Friday’s GDP data;

Economics Weekly - 22 February 2010


Chancellor needs to be careful not to jeopardise the recovery


News that the UK government ran a budget deficit of £4.3bn last month has underscored concerns about the UK’s public finances. The fact that the deficit occurred in a month when inflows of tax receipts are at their peak is highly unusual. Indeed, it is the first time January has posted a deficit since the government starting compiling figures on a monthly basis in 1993.


The latest deterioration brings the cumulative budget deficit in the current fiscal year to £122bn, compared with £58bn over the same period in FY2008-09. Although a marked deterioration, the Treasury nevertheless remains on course to meet, if not slightly undershoot, its revised full-year public sector net borrowing (PSNB) projection of £178bn made in the Pre-Budget Report (see chart a). In this regard, the government has been aided by the stronger-than-expected recovery  in asset prices (both housing and equities).


The magnitude of the deficit, however, has led to calls for the Chancellor to go much further in tightening fiscal policy in the upcoming 2010 Budget. These calls have become more pressing in light of the difficulties some of the peripheral highly-indebted eurozone countries, notably Greece, have faced in recent weeks. Nevertheless, as others have argued, a further aggressive policy tightening at this stage of the economic cycle could imperil the nascent economic recovery.


A substantial tightening is already planned

Chart b shows the Treasury’s 2009 Pre-Budget Report projections for public sector net borrowing and net debt (as a percentage of gdp). As a result of the measures already announced, public sector net borrowing is projected to halve to £81bn over the next five years to 4.4% of GDP. It will be eight years, however, before PSNB is brought broadly back into balance. Clearly, there is some scope for the Chancellor to announce a swifter and more aggressive reduction through additional cuts in public spending and tax increases. We suspect he will do so, but delay their implementation until next year or beyond.


Cyclical versus structural influences

It is arguable, however, whether the Chancellor needs to announce further fiscal restraint. If the Treasury’s central estimate of the structural deterioration in the fiscal finances is correct, the Chancellor could make the case that the tightening already planned is, for now, sufficient. It is important to distinguish between the short-term hit to the public finances as a result of the cyclical downturn in growth, which should be reversed over time, and the structural loss resulting from the financial crisis. Currently, public finances look especially poor because the UK has just emerged from its deepest postwar recession. As the economy recovers, tax revenues should pick up and cyclical public sector expenditure, notably social security payments, should fall.


The nature of the shock that has befallen the UK, however, means that the economy has also suffered a permanent loss to its productive capacity. In the Pre-Budget Report, the Treasury estimated this at 5% of GDP. The Treasury assumes that this permanent loss in output will not get any worse, with trend growth projected to recover to its pre-crisis estimate of 2.75% from mid-2010 (see chart c).


The structural loss in output, coupled with lower inflation and the the hit to tax receipts from the drop in asset prices, has also led to a permanent drop in Exchequer revenues. In the Pre-Budget Report, The Treasury assumes this is also equivalent to 5% of GDP. In order words, in the absence of remedial action, public sector borrowing each and every year would be £73bn (in today’s prices) higher than it would have been had the economic downturn and the financial crisis not occurred.


Measures taken to address this gap

It is this structural gap that the various fiscal measures already announced by the Chancellor are aimed to address. Indeed, over the next eight years, the government intends to implement a fiscal tightening equivalent to 5.5% of national income (a reduction in PSNB of £77bn by 2017-18). This is slightly larger than that needed to plug the estimated hole created by the financial crisis.


While the tightening may be sufficient to stabilize the rise in public sector net debt over the medium to long term, action over and above this will be required if public sector net debt is to be reduced. Based on current projections, public sector net debt is set to rise from around 60% of GDP at present to a peak of around 80% in FY2014-15. While this is manageable, it is double the 40% debt to GDP ceiling the government previously committed to as a part of its now defunct sustainable investment rule.


Moreover, there is a clear risk that the structural loss of output and the associated hit to Exchequer revenues prove greater than the 5% of GDP the Treasury estimates. In its Green Budget, the Institute of Fiscal Studies (IFS) suggests the loss in potential output is likely to be closer to 7.5% of GDP and possibly as high as 10%. There is also the risk that cyclical public sector borrowing rises more sharply over the coming years than the Treasury anticipates if, as expected, gdp growth falls short of the Treasury’s relatively optimistic projections (see chart d). Lastly, trend growth may fail to return to its pre-crisis levels, as the Treasury currently predicts.


Additional fiscal restraint likely to avoid undermining recovery

Given all these uncertainties, and with an eye on placating the credit rating agencies, the Chancellor is likely to announce further measures to rein in the public finances in the upcoming Budget. Various measures have been mooted: an increase in VAT; changes to inheritance tax; further reductions in public spending (most likely through seeking additional efficiency savings); as well as further increases in sin and environmental taxes. So far, two-thirds of the burden of fiscal tightening has fallen on public spending restraint and the other third on tax increases. It is possible that the Chancellor could stick to this mix.


Given the fragility of the recovery, however, the bulk of any additional restraint is likely to be focused on the medium to long term. There is already a substantial fiscal tightening scheduled from 2011 onwards. To front-load further measures while the consumer and business sectors remain fragile would risk undermining the economic recovery.

Adam Chester Senior UK Macroeconomist


Weekly economic data preview - 22 February 2010


BoE & Fed speakers take centre stage ahead of Friday’s GDP data


􀂄 Amid economist in-fighting in the UK media over the timing of future fiscal tightening, Bank of England MPC members will impart their wisdom in a series of speeches next week, with the appearance of Governor King, as well as members Bean, Dale, Miles and Barker at a Treasury Select Committee hearing on Tuesday. They will justify their decision to keep asset purchases unchanged at £200bn, while acknowledging that it was a finely-balanced decision for some. Indeed, with unemployment rising again, at least on the claimant count measure, and retail sales plunging in January, some MPC members may yet vote for more QE in the future, but may have decided against this for ‘presentational’ reasons, given the sharp but likely temporary rise in inflation. The data release calendar includes the second estimate of Q4 GDP, which is expected to be revised up to 0.2%q/q, still showing the economy barely emerging from recession. The figures will also be interesting since they will contain the first expenditure breakdown, including consumer spending. More forward-looking indicators include Gfk consumer confidence and the CBI’s Distributive Trades survey, providing an early snapshot of February retail activity.


􀂄 After the Fed raised its discount rate last week, signalling another step towards the eventual normalisation of monetary conditions, the focus this week understandably falls on Fed chairman Bernanke’s semi-annual testimonies to the House Financial Services Committee (on Wednesday) and Senate Banking Committee (Thursday). The first increase in the discount rate since 2006, from 0.5% to 0.75%, was clearly flagged as a risk after Mr. Bernanke said it would have to be raised ‘before long’ at his testimony to Congress on 10 February. The surprise was its timing. Although the Fed has said that its recent actions ‘do not signal a change in the outlook for the economy or for monetary policy’, financial markets will be alert for any changes in Mr. Bernanke’s language or guidance this week. There are also a host of other prominent Fed speakers this week. The data calendar is headed by the second estimate of Q4 GDP on Friday and a series of housing market releases. We expect only a small downgrade to Q4 GDP growth, to 5.5% from 5.7%, with the rebuilding of inventories largely behind the fastest annualized growth rate for six years. Recent housing market data have been volatile, reflecting both the inclement weather and the impact of government measures. We forecast modest gains in both the level of January new home (Wednesday) and existing home sales (Friday), to 350k and 5.49mn respectively. The performance of the housing market is likely to remain a major factor in discussions at the Fed on its ‘exit strategy’. A key influence will be the labour market and consumer confidence,

where latest readings are also published this week. After a larger-than-expected gain in initial jobless claims last week, we look for a pull-back to 455k (w/e February 20) this Thursday. Consumer confidence is forecast to have posted a fourth successive rise to 56.6 in February, from 55.9 in January. In other key events, the US will also sell $126 billion of notes this week


􀂄 The spread of 10-year Greek government bond yields over equivalent German bunds has widened to around 320bp, suggesting that markets have little faith in Greece’s ability to address its problems with its own fiscal consolidation plan. Markets remain convinced that some form of direct assistance – at the very least, additional fiscal measures under the supervision of the European Commission – is required to safeguard the stability of the euro-zone. Greece effectively has a one-month ‘grace period’ in which to change this negative market sentiment – a challenge indeed. This week features a heavy euro-zone data calendar including February’s German Ifo report, the European Commission confidence surveys and euro-zone M3 money supply figures. We look for only a modest improvement in the German Ifo business climate index, to 96.0 in February from 95.8 previously, driven by the current conditions component. Meanwhile, we expect the M3 data to feature a further deterioration in euro-zone bank lending to non-financial corporations, despite an improving supply of secured credit to households. Elsewhere, final euro-zone CPI data for January are published this week, where we look for an unrevised outturn of 1.0% year-on- year. Finally, German unemployment figures for February, on Thursday, are expected to show a broadly flat reading.

Hann-Ju Ho, Jeavon Lolay, Mark Miller


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


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