Spring Budget: Sound in theory, but execution may be more difficult
The chancellor's Spring Budget was probably a little more generous than expected, but the Bank of England (BoE) Monetary Policy Committee (MPC) won’t need to worry about tightening policy to offset it given most of the extra spending focused on boosting the medium term supply side of the economy. Indeed, the MPC is probably far more concerned about the short term financial market volatility associated with Credit Suisse than it is about a little bit of extra government spending.
If the supply side reforms to boost labour market participation and business investment are successful (a big if) then it should support economic growth, reduce inflation and lower the need for the BoE to keep interest rates higher for longer.
The risk is that, with a razor thin margin in the chancellor’s headroom, any underperformance against the Office of Budget Responsibility’s (OBR) forecasts means Hunt will have to row back on some of these measures in the next Budget.
Has the UK avoided a recession?
According to the OBR – yes.
The fiscal watchdog now expects growth to flatline in Q2 after falling in Q1, meaning that the UK would avoid a technical recession (two consecutive quarters of falling growth). This means the peak-to-trough fall in GDP is just a quarter of the 2.1% fall assumed in the November forecast. However, output still doesn’t regain its pre-pandemic peak until the middle of 2024.
Admittedly, the economy has been much more resilient than anyone thought it would be and a recession is certainly not guaranteed. But given most estimates suggest less than half of the impact of interest rate rises has been felt so far and the extreme tightening in financial conditions over the last week, a mild and short recession remains our base case.
The OBR expects inflation to fall back more quickly now, mainly as a result of lower energy prices being passed through to consumers. It now expects inflation to fall back to about 3% by the end of the year, in line with our own forecasts.
The most surprising bit of the change in the OBR forecast was probably its expectation that the unemployment rate will only rise to a peak of just 4.4% in 2024. While this is certainly possible given the resilience of the labour market, an unemployment rate this low would probably not be enough to get wage growth down to the 3% the MPC would like, making further interest rates more likely, which would in turn push the unemployment rate up.
Supply side reforms will boost growth, if they work
The theory here is sound, which is more than can be said for all recent Budgets. The improvements in the economic outlook mean that before the new policy measures, the OBR judged that chancellor Hunt would have headroom of £14.5bn against the main fiscal rule of underlying debt as a percent of GDP falling in five years' time (ie 2027/28) compared to the £9.2bn of headroom he had back in November. The chancellor used 55% of that and banked the rest, leaving the final headroom at a slim £6.5bn (0.3% of GDP).
Mr Hunt’s most significant measure was the announcement of full capital expensing for companies for the next three years, which will cost the exchequer £9bn a year and likely boost business investment by about 3%, relative to the counterfactual. This measure alone accounted for nearly half of the £22bn discretionary loosening in 2023/24 that he announced. Given the UK’s dire record on business investment – and that this is one of the key reasons why the UK’s productivity has been poor – any boost to business investment is to be heartily welcomed.
Similarly, efforts to improve childcare and get more people back into work should be applauded given that the UK workforce is still about 1% smaller than before the pandemic – significantly holding back growth.
However, previous efforts to encourage business investment have disappointed lofty OBR forecasts. What’s more, the CBI estimates that it would take funding of almost £9bn a year to properly extend childcare – about three times more than the £3bn the government has budgeted for next year. The risk is that without proper funding any improvement in labour participation is muted.
Policy implications
In theory, the Budget argues for a bit more tightening by the BoE at next week’s MPC meeting. Further support for businesses and households around energy prices, more defence spending and tax breaks for business investment will boost demand this year. However, the MPC is unlikely to be too concerned about the inflationary impact of these commitments. Lower energy bills will help headline inflation fall and extra defence spending is unlikely to boost demand in the broader economy.
By far the biggest issue at next week’s MPC meeting will be inflation verses financial stability. We had already thought the chances of a rate hike next week were probably at 50%, but the flare up of risks around Credit Suisse on Budget day and associated moves in financial markets makes that probability even smaller. It now looks like the MPC will press pause one meeting earlier than we previously expected.
In the medium term, the measures announced should boost the supply side of the economy. Getting more inactive people back into work will be crucial to bringing down wage growth - and by association services inflation - and reduce the need for further rate hikes. Any boost to business investment should improve productivity and reduce inflationary pressures.
