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Economics Weekly - Budget deficit is focus of new UK government; Weekly economic data preview - Data to show recovery remains on track

Economics Weekly - 17 May 2010


Budget deficit is focus of new UK government


The focus of the new coalition government – the first in over 70 years - has been made crystal clear: lowering the budget deficit and reversing the rise in debt. The parties agreed that tackling the deficit is the best way to ensure economic recovery, so there needs to be: ‘a significantly accelerated reduction in the structural deficit over the course of a Parliament with the main burden of deficit reduction borne by reduced spending rather than increased taxes’. This clearly lays out the new government’s position on this. We estimate that the structural budget deficit is around £70bn, see chart c. With an 80:20 split for reducing the deficit in favour of spending to tax, this suggests total spending cuts over the next five years of £56bn and additional tax rises of £14bn.


Emergency Budget to be held in 50 days

There will be a Budget in 50 days, in other words by the end of June 2010. In an echo of the formation of the

MPC in 1997, a new Office for Budget Responsibility (OBR) has been set up. A new Spending Review has also been set in motion and will report in the autumn. The problems of Greece – a highly indebted economy with a Budget deficit close to that of the UK but with outstanding debt of 120% of gdp (well in excess of the UK’s 60% of gdp) - highlights the risk to countries of funding large debt positions. Doing nothing would lay the UK open to the same sort of selling pressure on government bonds and hence severe funding problems, even if its financial position is in reality stronger than that of Greece.


Doing nothing is not an option

Table 1 gives a summary of the coalitions’ main policy announcements so far. In the agreement reached between the two parties making up the coalition, there is a phrase that gives a good guide to what changes may be made in the next Budget, namely: ‘New forecasts of growth and borrowing should be made by an independent Office for Budget Responsibility for this emergency Budget.’ Unfortunately, this increases the chance that the forthcoming Budget could be a lot tougher than expected. The reasons are highlighted in chart a, for economic growth, and chart b, for the official path of the public finances compared to the consensus. It should be noted that whilst growth and borrowing this year are virtually the same as the latest consensus (May 2010), the projections differ sharply for next year.


Chart b shows that independent forecasters expect £12bn of more borrowing in 2011-12. The gap shows how powerful the effect of faster economic growth can be on the public finances. But equally it also highlights how devastating slower economic growth could be for the path of public sector debt. For example, if economic growth were to be 1% lower each year over the next five years than in the March Budget projection, the amount to be borrowed could be between £50-75bn higher at the end of the Parliament.


Office for Budget Responsibility likely to be tougher than the Treasury...

It is likely that the OBR will be more conservative than the Treasury was at the time of the March Budget. If so, economic growth could be revised to be more in line with the consensus. It may also assume a lower trend rate of growth for the UK economy. In addition, there is a risk that the OBR will make more conservative assumptions about tax receipts (say from the financial sector) than the Treasury did in the March Budget. That too would raise the spectre of larger deficits going forward than announced in the March Budget. Therefore, if the new government is serious about tackling the deficit in a more aggressive manner than was announced in the March Budget, then the amount of spending cuts and tax rises could be a lot higher than currently assumed.


Ultimately of course, the OBR’s figures do not have to be accepted by the Chancellor but it would be odd if

they were ignored without very good reason. In fact, the OBR could make the task of selling fiscal tightening easier, by showing that the figures come from an independent body, though one appointed by the government.


...but monetary policy could act as an offset

More aggressive tightening would weaken economic growth in the short term, though it might be partly or wholly offset by an easier monetary policy stance. This implies that there could be more QE. It also implies that interest rates could stay low for longer, despite the fact that a weakened currency could result in price inflation staying higher near term than thought previously. The Bank of England’s latest Inflation Report paints a cautious picture of the prospects for the UK economy. Although the MPC’s near-term inflation projection was revised higher - reflecting the higher starting point for the CPI - the Committee noted that inflation was likely to fall back to 2% over the medium term and acknowledged that the downside risks to GDP growth had increased. The recent volatility in asset markets, the problems in Greece, ongoing credit constraints and the prospect of major balance sheet restructuring across the public and private sectors all posed risks to the speed, magnitude and sustainability of the economic recovery.


What about sterling?

Although the currency is currently under a lot of selling pressure due to worries about overly indebted countries, a move to tighten the fiscal stance could strengthen it from its current position. One thing is for sure, the next few years look like they will be very challenging for the public finances and for the economy.


Trevor Williams, Chief Economist

Corporate Markets



Weekly economic data preview 17 May 2010


Data to show recovery remains on track


􀂄 Understandably, economic data have taken a back seat to political events recently. This is likely to be the case again this week. Focus will be honed in on Europe for further details of the substantial aid package to stem the sovereign debt crisis. In the UK, policy announcements from the new coalition government will draw attention. Having said that, it is an important week for data, which we expect largely to confirm that the global recovery remains fundamentally on track.


􀂄 The ECB appears satisfied with its efforts so far on purchases of euro-zone government bonds and will release details this week on the sterilisation required to drain liquidity from the market. The exact time of release for these details is uncertain, but seems most likely to follow the supplementary ECB Governing Council meeting on Thursday. This is likely to be closely watched by financial markets which are eager to assess the likelihood of covert quantitative easing (QE) from the ECB. To date, QE has not been preferred course of action and any U-turn could potentially make a difficult situation worse for the ECB, which in the eyes of some has already had its credibility dented following the recent decision to accept Greek government bonds as collateral in its open market operations. This week’s euro-zone data highlights include advance PMI surveys for May, along with the Ifo and ZEW surveys for Germany. Broadly speaking, the

euro-zone economies are being propelled mainly via net trade with domestic economic activity still rather anaemic. We look for the euro area manufacturing PMI to register 57.8 from 57.6 in April, with Asian demand for euro-zone exports continuing to play a key role. Similarly, we see a further improvement in the Ifo business climate index to 102.1 in May.


􀂄 The focus in the US will be on the latest gauges of inflation pressure, with both PPI and CPI data for April published on Tuesday and Wednesday, respectively. Although readings for headline annual changes are predicted to be fairly elevated at 5.7% and 2.4%, respectively, primarily reflecting higher energy prices, we expect core price pressures to remain subdued. We forecast the 12-month core CPI rate eased to just 1% in April, slowest pace for over four decades. The minutes of the April 28 FOMC meeting on Wednesday are again likely to comment on the recent deceleration in consumer prices, possibly strengthening the long-standing view that spare capacity will bear down on cost pressures and keep inflation subdued for some time. However, inflation is a lagging indicator and Committee members will also be acutely aware that economic activity has strengthened. We expect forward-looking Empire and Philadelphia Fed manufacturing

surveys this week to show further modest improvement in May. The housing market represents another key concern for policymakers. We forecast housing starts, due on Tuesday, rose for the fourth straight month to 660,000 in April, albeit still well below levels ahead of the financial crisis. A stronger rebound is unlikely until foreclosures drop back sharply.


􀂄 Last week’s dovish Bank of England Inflation Report has reduced the potential market impact of key UK data releases this week. On Wednesday, we expect the MPC minutes to show a unanimous decision to keep policy unchanged earlier this month. UK CPI inflation, due on Tuesday, has been surprisingly resilient in recent months and may have edged higher again in April. However, spare capacity and a weak recovery are likely to see the annual rate fall well below the 2% target in the year ahead. Retail sales, on Thursday, are expected to show a modest fall in April as suggested by survey and anecdotal evidence. The first public sector borrowing figures for the new fiscal year are published on Friday.


Jeavon Lolay and Mark Miller


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


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