Treasury and BoE pulling in opposite directions

22 June 2022

The new Chancellor’s “mini Budget” turned out to be more like the full fat version. Admittedly, the tax cuts announced today will give a boost to the economy of roughly 1% over the next year compared to under the previous fiscal plans. That reduces the risk of a protracted recession over the winter. However, they will also boost inflation by almost as much in the medium term and will almost certainly result in higher interest rates. We now expect interest rates to peak at closer to 4% than the 3% we previously envisioned.

What’s more, by financing these tax cuts through additional borrowing, the UK public finances are looking increasingly unsustainable. Public borrowing now looks set to surge to over 9% of GDP in 2022/23 and the debt-to-GDP ratio is likely to be on an upward path. This raises the risks of damaging cuts to spending in later years or an even larger fall in the pound.

Finally, there was nothing in the Budget that makes us more optimistic about the long-term growth trend of the economy. Trend growth is currently probably half of the 2.5% the Chancellor has set as his new target. It will take significantly more than tax cuts to get the UK economy going at that speed.

Lower taxes and higher spending

The new Chancellor of the Exchequer, Kwasi Kwarteng, took a chainsaw to the UK’s tax take today, announcing cuts in income taxes, corporation taxes and stamp duty, among others. All this adds up to a loosening in fiscal policy of about £45bn, a little bigger than was expected.

The Chancellor also set out his growth target of 2.5% a year.

There are two big impacts for the economy. First, there will be a short-term boost to growth. Taken together with the energy price cap, GDP growth in 2023 will be about 1.5% stronger than if the government hadn’t taken any action. So even though the UK is probably already in a recession due to the extra bank holiday for the Queen’s funeral, the chances of a protracted recession over the next year have fallen sharply.

There was also a nod to some supply side reform, with aims to implement some much needed reforms of the planning system and setting up investment zones with preferential tax treatment and cuts to corporation tax.

However, reforming the planning system has been the aim of many governments over recent years, though much more difficult to do in practice. Indeed, previous cuts in corporation tax, which fell from 28% to 20% in 2015 (and 19% subsequently), lifted business investment, but not by nearly as much as expected.

Investment zones are similar in principle to the “enterprise zones” announced by then-Chancellor George Osborne. The evidence, both domestically and internationally, is that special economic zones don’t result in a material step change in economic performance. A more reasonable assumption is that they will displace activity from elsewhere, rather than significantly boost overall GDP.

And most of the policies announced today focused on boosting demand. As such, we doubt that this Budget has done much to lift the UK’s trend rate of growth, which is currently hovering somewhere around 1.5% per year.

The second impact is that a massive fiscal stimulus is coming at a time when the labour market is exceptionally tight, and that will lead to higher inflation in the medium term. This will cause the Bank of England to raise interest rates by even more. We expect rates to reach between 3.5% and 4% by early next year, but financial markets are pricing in a return to 5%.

Public finances looking unsustainable

The Chancellor has taken a big bet that his tax cuts will spur growth. But in the short term, at least, as the fiscal expansion is not fully funded by tax rises or spending cuts elsewhere, borrowing will surge.

All the way back in March, the independent Office for Budget Responsibility (OBR) predicted that borrowing would fall from £133.7bn (5.6% of GDP) in 2022, to just £36.5bn by 2025 (1.3% of GDP). That downward trajectory now looks to be reversed: Public borrowing will now be around £240bn (9.3% of GDP) in 2022/23 and will still be over £100bn in 2025. As a result, the debt-to-GDP ratio is likely to reach 100% by 2030.

That risks putting the public finances on an unsustainable path, which could result in another round of painful and damaging austerity after the general election. It’s either that, or a further deterioration in the value of the pound – which is already at its lowest level in almost 50 years.