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Monday December 4, 2006 - 11:06:11 GMT
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Economics Weekly:What will the UK 2006 pre-Budget say about the UK/Commentary on economic data in the week

Economics Weekly:
What will the UK 2006 pre-Budget say about the UK
public finances?

Pre Budget reports set out the UK government’s financial plans for the years ahead, with the Budget itself in the following spring setting out the revenue raising measures required to meet those spending commitments. The 2006 pre Budget report, due on Wednesday, is likely to be the 10th and last one from Gordon Brown, the Chancellor of the Exchequer. With Tony Blair set to step down in May 2007, he is widely expected to be replaced as Prime Minister by Gordon Brown. So what will this report say about his legacy as Chancellor? We look for an upbeat economic outlook for this year and next, but the public finances will be more difficult for the Chancellor to talk up. Although economic growth has been quicker than expected and tax revenues are up strongly, so is growth in public spending. This means that net borrowing may still breach his projections.

Growth outlook looking good…
The UK economy is recovering well from last year’s slowdown to growth of just 1.9%, with an average of 2.7% in the year to the third quarter of 2006. The Pre Budget report is therefore likely to see an upward revision to the Treasury forecast of 2.25%, possibly up to 2.5%. As chart a shows, such a figure would be in line with the current consensus view, but may still be a slight underestimate of the final outcome, which we estimate could be 2.7%. Why has UK economic growth recovered so strongly in 2006? The short answer is that faster economic growth in the eurozone has boosted UK manufacturing output and that, combined with continued recovery in the housing market, has underpinned service sector activity as well. This is translating primarily into faster growth in investment spending, but consumer spending growth this year is likely to be up by 2.2% against a rise of just 1.4% in 2005. In fact, we suspect that if not for high levels of personal debt, UK consumer spending would be more like the 2.8% average of the last 10 years than the current rate of just over 2% a year. Official forecasts for UK economic growth in 2007 and 2008 are in our opinion likely to be held at 3%, well above the consensus view of 2.4% for 2007 and 2.6% for 2008.

…but the fiscal numbers are not so rosy
Despite faster economic growth than expected in the spring 2006 Budget, we look for the fiscal projections in this Pre Budget report to remain unchanged from those made earlier in the year. The main reason for this is that government spending is rising quite strongly, as shown in chart b. Growth in spending is up by some 7% a year, well up from the official projection of 5.2%. By comparison, although revenues are also rising faster than projected the gap is smaller, with an actual increase 6.5% in the year so far against the official projection of 6.1%. It is this growth gap in favour of public spending that will in our view cause there to be an overshoot of government borrowing for this fiscal year. We look for £39bn rather than the Treasury projection of £36bn, see chart c. For the projection to be met, public spending growth will have to slow sharply, but there are huge pressures from health and education that make this unlikely in the near or medium term. In the short term, there may also be pressure
from the defence budget. As chart d shows, UK public sector net borrowing is projected by the Treasury to fall gradually over the next fiscal year to about £30bn, from £36bn in the current fiscal year of 2006/07, although these figures were revised much higher last year than in the projections that preceded them. One question is, will this happen again this year? The answer has got to be no because of faster economic growth. But this does leave the fiscal projections very vulnerable to the vagaries of the economic cycle and so could easily be higher if there is some unforeseen future shock. Moreover, as chart e shows, the share of the economy accounted for by government tax is set to rise over the coming three years to the highest level since the early 1980s when the economy was much weaker than it is today. This outcome will be a negative drag for UK economic activity, as it is likely to reduce private sector productivity by diverting resources to the public sector.

Little room for any further fiscal loosening as tax share of the economy rises
There is now little room for any additional fiscal loosening should it be required, since tax is such a large share of the economy. Thus, the UK economy has less flexibility going forward to meet a crisis than at any time since the 1980s. This is reflected to some extent in the fact that the government may breach its own fiscal rules, to borrow only to invest over the economic cycle (the golden rule) and to keep public debt to a prudent level (the sustainable investment rule), below 40% of gdp, see chart f. But net government debt outstanding in the UK is still close to 40% of gdp, compared with the EU average of 70% of gdp. However, net annual borrowing, the budget deficit, is around 3% of gdp though likely to fall as economic growth remains at or above trend, even if the absolute amounts borrowed may breach the government’s projections. The government could make it easier to meet these rules by changing the starting point of the economic cycle (something it has already done before) and by increasing the trend of growth of the economy (something the Bank of England did recently), so delivering higher revenues in the years ahead. As a result, the Pre Budget report will be closely watched for what it says about these issues, green taxes and about the amount of gilts to be issued to fund any additional borrowing.

Trevor Williams, Chief Economist

Commentary on economic data in the week
A pivotal week for the dollar?

• UK Chancellor of the Exchequer Gordon Brown will on Wednesday present the 2006 Pre- Budget Report. He is likely to revise up his projections for economic growth this year but is likely to leave the fiscal projections alone. Stronger than forecast growth and tax revenues do not mean the Chancellor is on target to meet his 2006/07 public borrowing forecast of £36bn because of strong spending growth. We expect the Bank of England on Thursday to leave interest rates on hold at 5.0%.

• US employment data on Friday may hold the key to whether the dollar remains sold. We forecast payrolls growth of 110,000 in November and the unemployment rate to have edged up to 4.5%. The ISM services survey and weekly initial claims will also attract market attention.

• Interest rates in the euro zone are set to rise on Thursday for a fifth time this year. We expect the ECB to raise the refi rate by 0.25% to 3.50%. The ECB will also publish its latest projections for growth and inflation in 2007. The focus of the press conference will be any comments on how the ECB thinks the appreciation of the euro may impact the economy and, hence monetary policy next year.

• Interest rate decisions are also scheduled this week in Canada, Australia and New Zealand.

In the UK, the 2006 Pre-Budget Report on Wednesday is likely to overshadow the Bank of England interest rate decision on Thursday. Stronger than expected economic growth this year means Chancellor Brown, probably delivering his last Pre-Budget Report, will be in a position to revise up his growth estimates from the 2.25% forecast in the spring Budget. Healthy growth in tax revenues thanks to the strong manufacturing recovery and buoyant services industry mean the Chancellor should be on target to meet his 2006/07 PSNCR public borrowing projection of £36bn. However, public spending is also up strongly so he may yet breach his targets. The Bank of England only last month raised interest rates to 5.0% and is forecast to make no change to the cost of borrowing on Thursday. This will allow the Bank to consider incoming inflation and activity data before deciding its next move early in 2007. We still believe interest rates may rise to 5.25% in February next year, despite last week's appreciation in sterling.

After the heavy sell off last week, will negative dollar momentum continue this week? The next move is likely to be impacted by the US employment report on Friday. We forecast November employment growth of 110,000 and a small rise in the unemployment rate to 4.5%. We do, however, recognise that downside risks exist to this scenario due to a sharp rise in initial claims last week to the highest level since October 2005. Initial claims have risen for the last two weeks, a sign that the US labour market could gradually be loosening. Speculation about a reduction in US interest rates next year would intensify if the employment report is poor, even after Fed chairman Bernanke's remark last week that inflation remains 'troublesome'.

Interest rates next week are extremely likely to go up in the euro zone for the fifth time this year. The ECB last month flagged its intention to increase rates by 25bps to 3.50%, leaving very little suspense ahead of Thursday's announcement. Strong activity and confidence data complemented with brisk money supply and falling unemployment point to sustained economic growth in Q4. Data on Friday showed rising euro zone exports orders, despite the recent appreciation of the euro. With consumer confidence near multi-year highs, this will reassure the ECB that economic growth can hold up in the face of economic slowdown in the U.S. The ECB on Thursday will also publish its latest growth and inflation forecasts which will offer some insight about the trajectory of interest rates in 2007.

Interest rates this week are forecast to stay on hold in Canada at 4.25%, at 6.25% in Australia and at 7.25% in New Zealand.

Kenneth Broux, Economist
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.


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