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Economics Weekly -Structural deficit poses challenge for the Chancellor; Weekly economic data preview - UK Chancellor to set out his vision for the public finances

Economics Weekly  21 June 2010


Structural deficit poses challenge for the Chancellor



The Office for Budget Responsibility’s (OBR) first report has underscored the need for significant fiscal restraint in this week’s Budget. But by how much more does fiscal policy need to be tightened? In this week’s commentary, we assess the implications of the OBR’s forecasts for the state of the UK’s fiscal finances and the UK economy.


OBR versus Budget 2010


In the March 2010 Budget, the Labour government projected that total public sector net borrowing would fall from £166.5bn (11.8% gdp) to £74bn (4.0% of gdp) by 2014-15 - a net decline of 7.8 percentage points (pp) of gdp over the next five years. Of this, 1.9pp was projected to result from an improvement in economic growth, and the remaining 5.9pp through a reduction in the structural deficit (that part of the deficit which is unaffected by the economic cycle), largely the result of the government’s deficit-cutting plans. While the plans were put in place, details over where the vast majority of cuts would fall from 2011 onwards were left to be decided.


Using the same set of policy measures as those announced in the March Budget, but adopting a

different set of economic forecasts, the OBR published its own set of fiscal forecasts last week. The comparison between the two is shown in chart a. Surprisingly, despite using weaker economic numbers, the OBR’s headline borrowing projections are £23bn lower over the next five years than projected by the Labour government. This, however, is partly explained by a more favourable starting point and less conservative assumptions regarding the growth of the tax base. The full-year budget deficit for FY09-10 came in around £10bn lower (at £156bn) than Labour projected three months ago, courtesy of tax revenues proving slightly stronger than previously assumed.


While the headline level of borrowing, however, is lower, the OBR’s assessment of the size of the structural deficit is less favourable. For the current fiscal year, the OBR projects the structural deficit will be 8.8% of GDP, 0.5 percentage points higher than assumed in the March Budget. This gap widens to 0.8% next year, before falling back to 0.3% by 2014-15 (see chart b).


The reason why the OBR’s assessment of the structural deficit is less favourable than the forecasts published in the March Budget is largely because the OBR takes a more cautious view on the degree of existing spare capacity that exists and the prospects for trend growth. In the March Budget, Labour assumed that the level of UK GDP at the end of 2009 was around 6% below its potential (the so-called output gap). By contrast, the OBR assumes it was only 4%. Moreover, the March Budget assumed that the trend rate of growth, having slowed to around 1% during the credit crisis, would recover back to its pre-recession estimate of 2.75% from the second half of this year (or 2.5% for the purposes of forecasting the fiscal finances). The OBR takes a more cautious view. It estimates that trend output will grow at just over 2.35% over the next three years, before slowing to 2.1% from 2014 onwards (see chart c).


By assuming a larger output gap and a higher trend rate of growth, the March Budget was able to present a more rapid improvement in the UK’s structural deficit. This is because in an environment of greater spare capacity and stronger trend growth, the economy benefits from higher tax revenues and lower social security spending.


By contrast, the OBR takes a more cautious view on the size of the output gap and the prospects for trend growth as it believes the UK’s supply capacity has been hit harder by the financial crisis. In particular, the OBR estimates that the rise in risk premia and more restricted access to credit have depressed trend productivity growth by more than Labour assumed. They also note that demographic changes, including a further reduction in net immigration, could lead to a weakening in the potential labour supply. There are already signs of this, with the number of net new migrants dropping from an annual peak of 220k in 2007 to around 140k in 2009.


Implications for the fiscal finances and the economy


The OBR’s view, if correct, has significant consequences for the state of the UK’s fiscal finances. If the UK has a lower output gap and a weaker trend rate of growth, then tax receipts will be lower, and social security payments higher than would otherwise be the case as the economy recovers. As such, it implies the need for a more aggressive fiscal tightening. Indeed, just to match the previous government’s plans for the= structural deficit this year will require, under the OBR’s economic projections, an additional tightening of around £10bn (this includes the £6bn of cuts that have been announced to date).


If, as expected, the new government goes beyond this, further cuts will be required. To put this into perspective, if the coalition government were to aim for a zero structural deficit over the next five years, this week’s Budget would need to deliver additional cuts of around £50bn over and above the projected £57bn already pencilled in by the previous government over the next five years. We doubt, however, that the Chancellor will be quite that ambitious.


The OBR’s assessment of the output gap and trend growth also has other important implications. Not only does it mean that longer-term growth prospects are weaker, but also that the UK may be more vulnerable to inflation pressures. With the degree of spare capacity estimated to be less than Labour thought, and the ability of the UK to increase its supply impaired, the UK could be more susceptible to emerging capacity constraints over the medium term.


Although the OBR acknowledges these risks, over the coming years it believes inflation will remain contained. Even though it expects GDP to grow above trend from 2011, it estimates that a negative output gap will persist for the next five years - i.e. some degree of spare capacity will persist. As chart d shows, its central expectation is that CPI inflation will fall below 3% in 2011, and gravitate back towards the government’s 2% target further out.


Inflation risks have risen


We share this relatively sanguine view of inflation over the next two years. Nevertheless, we believe that the longer-term risks are rising. Both our, and the OBR’s, inflation assessment is highly contingent on the evolution of the output gap and trend growth. In practice these variables are almost impossible to estimate accurately. If, anything, we suspect the OBR may still be slightly overstating the trend rate of growth.


Uncertainty over the size of the output gap and the trend rate leaves the inflation outlook particularly vulnerable to any upside surprise to UK growth over the coming years. This, in turn, is likely to have important implications for the conduct of monetary policy. If the UK is indeed more susceptible to inflation pressures over the medium to longer term, the MPC will have to be ready to act aggressively.

Adam Chester, Head of UK Macroeconomics


Weekly economic data preview 21 June 2010


UK Chancellor to set out his vision for the public finances


􀂄 The key economic event in the UK will be the Emergency Budget on Tuesday 22 June. Last week’s report from the Office for Budget Responsibility has set the scene in terms of what the Treasury will probably assume about the level of future economic growth and the starting point for the mix between the structural and cyclical components of the deficit. What we don’t know, is how quickly the new government will try to close that structural deficit. If, as expected, the new plans will call for a faster balancing of the books than was laid out in the March Budget, then up to £50bn in new measures over and above what is already planned will need to be introduced over the next five years. Undoubtedly will we see a mix of cuts to spending and tax increases, with a rise in the VAT rate and an increase in capital gains tax potentially on the agenda. In terms of government spending, the Budget will provide an estimate of the overall level of expenditure over the next few years, but we will have to wait until the next Spending Review (probably in the autumn), to get a more complete picture of where precisely, and by how much, spending will fall across individual government departments.


􀂄 On Wednesday, the BoE publishes the Minutes of the June Monetary Policy Committee meeting. In the Mansion House speech Mervyn King reaffirmed his commitment to the inflation target. Elevated levels of inflation and a recent jump in household inflationary expectations could make some MPC members uneasy about the very low level of official interest rates. A warning shot of sorts was fired when the Governor said that rates will begin to rise before the Bank begins to unwind the asset purchase program. But it is probably too early for even the most hawkish members to move on rates given the fragile state of the economy and the uncertainty about the size of the fiscal squeeze yet to come. We expect a unanimous vote on the level of the Bank Rate and the size of the QE program.


􀂄 In the US, although no change in policy is expected at Wednesday’s FOMC meeting, the press statement will be dissected for clues about what the future holds. We expect only limited changes to the language, with the key phrases ‘exceptionally low’ and ‘extended period’ with reference to interest rates left in place. Kansas City Fed president Hoenig is expected to remain the sole dissenter against the statement for the fourth successive meeting. The expiration of the homebuyer tax credit in April is likely to be reflected in a steep fall in new home sales in May, potentially by more than the 14.8% jump in the previous month. However, existing home sales, on Tuesday, should show a further robust gain as buyers act ahead of the June expiration of a federal tax credit. Also published this week is the final estimate of Q1 GDP and May durable goods orders.


􀂄 The latter part of last week saw further volatility in euro-zone financial markets, prompted by speculation of an imminent stability package for Spain involving the EU, IMF and the US Treasury. This was subsequently denied officially, but was nonetheless sufficient to widen Spanish government bond yield spreads over Germany. This week sees a wave of business

survey data including “flash” euro-zone PMI data for June and the latest German Ifo business climate index. After a particularly poor ZEW report, we look for a pull-back in the Ifo business climate to 100.5 in June from 101.5 previously, following a largely uninterrupted spell of improvements since March last year. The impetus for economic activity in Germany continues to be mainly export-driven. But recent volatility in markets combined with significant fiscal tightening measures (e.g. the proposed unwinding of some generous social security initiatives), is starting to compromise wider confidence.

Marchel Alexandrovich, Jeavon Lolay and Mark Miller





Economic Research,
Lloyds TSB Corporate Markets,
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London EC2V 7AE
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