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Economics Weekly: PBR 2006: more borrowing, more spending, higher taxation/Weekly economic data preview

Economics Weekly: PBR 2006: more borrowing, more spending, higher taxation

Pattern of increased government share of the economy still firmly in place
The UK’s 2006 pre-Budget report has continued the pattern of the last five years, with increased spending, further borrowing and higher taxation. The Chancellor, in what is likely to be his last pre- Budget report before becoming prime minister in 2007, has increased economic growth in projections for this year and next. We would not disagree with the economic forecasts for this period – our view is that growth will be around 2.75% this year and just under 3% in 2007. But the Treasury also increased its trend rate of annual UK growth from 2.5% to 2.75%. This underpins the revenue projections on which the public finances are based and so reduce government spending, tax and borrowing as a share of gdp. However, we would disagree with increasing the trend rate of UK economic growth, because it is based on increased labour supply from immigration and lower inactivity rates that are unlikely to persist, especially in view of the recent restrictions placed on new migrants to the UK from Eastern Europe.

Tax increase and higher borrowing matched by spending increases
With regard to the projections for the public finances, the changes announced have accentuated the bias of high spending, high borrowing and increased taxation, and pushed this mix even further into the future, to 2010/11. The Chancellor expects to raise about £2bn net from his new tax measures, including new anti tax avoidance legislation (which will increase regulation), a doubling of air passenger duties from £5 to £10 (back to where they were before being reduced a few years ago) and an increase in petrol duty. But this has been balanced by increased spending, some £4bn between 2006/ 7 and 2007/8. Indeed, government borrowing is some £7bn higher by 2010/11 than forecast in the April Budget. Chart a shows that government borrowing so far this year is running ahead of last year's level. In terms of the overall budget deficit, the change over the five years from 2006/7 to 2010/11 is for additional borrowing of a cumulative £7bn, or roughly ½% of gdp. This is not that much taking the period as a whole and in that sense the pre-Budget report is almost neutral, but the details are still suggesting a strong tendency to borrow and spend with no real effort to cut this back over the years ahead. There is, instead, a reliance on economic growth to gradually reduce public sector debt as a share of gdp, but the absolute numbers being borrowed are still large, as shown in chart b.

Economic growth revised higher, but trend rise in growth too optimistic to us
On the economic growth assumptions for this year and next, official forecasts from the Treasury are above the consensus of economists, as shown in charts c and d. They are roughly in line with our view, of 2.6% this year and 2.9% in 2007, but the consensus is also more pessimistic than we are. The difference between the Treasury and the consensus is down to forecasts for consumer spending and investment spending growth, where the Treasury is much more optimistic than the average forecaster. On consumer spending growth next year, the Treasury is projecting an increase of 2.5% against the consensus of 2.3%. On investment spending the Treasury is looking for 5.3%, the consensus is 3.5%. There is also a big difference on consumer price inflation next year, where the Treasury is expecting it to hit the 2% target but the consensus view is that it will be 2.2%. (For this year, the Treasury is more pessimistic about price inflation than the consensus). This has implications for interest rates, of course, with an inference that the Treasury is expecting higher interest rates from the MPC to curb inflation but not hit growth. This could, however, also be explained by the Treasury assumption of faster trend growth, making it possible for it to assume that faster economic growth is compatible with lower inflation

The assumption of higher rate of long run growth has a number of important effects
Because of the assumption that revenue growth will be stronger as a result of faster economic growth, the amount borrowed from the gilt markets will be a little less this year, by £0.5bn. Total financing will be £59bn in 2006/7 rather than the £64.5bn estimated in April this year. The increase in assumed underlying economic growth for the years beyond 2008 also means that tax as a share of gdp stays below 40%, see chart e. However, it still means that by 2008/9 taxes in the UK are the highest they have been since 1981/82 when the economy was in recession. This time, of course, the economy is growing strongly. If there were to be a recession in future, tax and spending would rise very sharply as a share of gdp. This is the risk of continuing to borrow so much in future as a share of gdp, based on an assumption that the current relatively fast pace of economic growth will persist. Moreover, by increasing the trend economic growth rate assumption from 2.5% in the years ahead to 2.75%, the Chancellor is effectively able to spend an additional £2-3bn a year,every year. It has the effect of reducing current spending as a share of gdp, making it easier for the Chancellor to hit his ‘Golden rule’ of borrowing only to invest over the economic cycle. Without this increase in trend and ending the economic cycle in 2007, we estimate that he would have struggled to meet this fiscal rule. (The economic cycle is estimated to be 1997-2007, probably fitting in with Gordon Brown’s reign as chancellor). But the government just meets the rule by £8bn, a relatively small leeway. Overall, this is not a pre-Budget report that is going to cause great worries to financial markets though it has not done anything to reduce the long term risk to the UK economy from high levels of government borrowing
Trevor Williams, Chief Economist


Weekly economic data preview

Another challenging week for economic data

• In the UK this week, consumer and producer prices, retail sales, unemployment and global trade data will all be released. Base effects may lead to a rise in CPI inflation to 2.6% from 2.4% in October, the highest level since April 1996. This implies continued pressure for higher UK interest rates. But downbeat anecdotal evidence point to a lacklustre month for retail sales, though the volume increase so far in recent months has been strong. Hence, unemployment is forecast to have stabilised, with the claimant count showing only a marginal increase in November.

• In the US, the Federal Reserve is forecast on Tuesday to keep interest rates unchanged at 5.25%. But one question is whether voting member Lacker stuck to his call for higher interest rates and if the accompanying statement changes its opinion on the economy and inflation. Recent employment data suggest Lacker may be right. October trade figures will be published on Tuesday. Consumer prices, retail sales and industrial production figures for November are due later in the week. US treasury secretary Paulson and Fed chairman Bernanke visit China to negotiate on monetary and currency policy reform.

• Following the rise in interest rates to 3.50% last week, the euro zone will this week see the release of the German ZEW survey, EU-12 consumer prices and the monthly ECB bulletin. The Q4 Tankan business survey is the highlight in Japan ahead of the BoJ interest rate meeting next week, where we look for interest rates to stay on hold. Interest rates are forecast to rise 0.25% this week in Switzerland, Sweden and Norway to 2.0%, 3.0% and 3.50%, respectively.


Conflicting signals from UK CPI inflation and retail sales could cloud the near-term interest rate outlook, and this could put additional focus on the UK labour market and trade figures. We forecast annual CPI resumed its upward trend in November, accelerating to 2.6% from 2.4% in October. The increase would essentially be explained by favourable base effects dating from last year falling out of the index this year. Because the Bank of England last month forecast inflation would be higher in the near term, a stronger CPI outcome tomorrow should not necessarily alter perceptions of where base rates are headed. The trend in wage growth and unit labour costs, due Wednesday, may at this juncture be of more relevance to the interest rate debate. Average earnings growth, still below the Bank's 4.5% reference target, and the level of wage settlements next year could become an important driver for monetary policy in early 2007. The high level of RPI inflation could result in higher than average wage increases next year which could force the Bank to raise interest rates to 5.25%. Official retail sales data on Thursday is expected to echo the downbeat message conveyed by anecdotal evidence in recent weeks. Both the CBI and the BRC reported sluggish retail turnover in November due to mild weather conditions and waning consumer optimism following the latest increase in the cost of borrowing to 5.0%.

We expect the US Federal Reserve on Tuesday to keep interest rates on hold at 5.25%, but one question is whether Mr Lacker dissented from the majority and stuck to his call for higher interest rates for a 4th successive meeting. Chairman Bernanke two weeks ago acknowledged that US economic growth has slowed in the second half of this year but he similarly warned that inflation remains 'uncomfortably high'. With this in mind, we do not believe the Fed will make big changes to the accompanying FOMC text. Later in the week, retail sales data may give some indication about the pace of household spending and economic growth in the fourth quarter. Retail sales fell in October and are forecast to have rebounded in November. November CPI data will be published on Friday and may show no change in the annual core rate from last month at 2.7%.

The German ZEW survey of economic sentiment will be published Tuesday and may for the first time show some stabilisation after 10 successive months of decline. The 1.1point fall in the index last month was the smallest since May and suggests pessimism over business expectations may have peaked.

The Q4 Tankan survey in Japan on Friday comes just two days before the Bank of Japan interest rate meeting. Low inflation figures and mixed economic activity data in recent weeks suggest the Bank of Japan may keep interest rates on hold next week at 0.25%.
Kenneth Broux, Economist

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