Forget the Budget, it's the Government's monetary policy that counts

Forget the Budget, it's the Government's monetary policy that counts

by Ewen Stewart
article from Monday 20, March, 2017

Now that the dust has settled on Philip Hammond’s budget – and the immediate reaction to the now dropped NIC increase for the self-employed has subsided – we can see that it was a quiet affair with little change. Any thoughts of a punishment budget were long since banished as this budget is about as benign as it gets.

While the growth outlook looks reasonable  it remains highly consumer focused with deficit reduction targets dependent on continuing economic strength. The real issue is not Hammond’s budget but the future direction of monetary policy and the maintenance of a super-low yield curve.

The individual OBR forecasts were largely predictable with little change on previous forecasts save for a material 0.6 per cent upgrade to current year GDP with growth upgraded to 2 per cent from 1.4 per cent. However expectations were slightly moderated in 2018 and 2019 to 1.6 per cent and 1.7 per cent respectively, with 1.9 per cent in 2020 resulting in a reducing fiscal deficit of 2.3 per cent GDP in the next fiscal year with the debt/GDP ratio due to peak in 2018/9 at 88.8 per cent. Inflationary forecast remain broadly unchanged at 2.4 per cent in 2017 followed by 2.3 per cent and 2 per cent.

These OBR forecasts seem reasonable, save I am slightly more optimistic on lower inflation than the OBR, and if they come to pass will result in a dozen consistent years of growth from 2009. Given the degree of global uncertainty that is quite a feat.

In terms of individual measures there is very little of note which is perhaps a blessing given the constant tinkering in recent years. Overall this budget was mildly positive for the consumer with no new material taxes, increases in personal allowances as expected, a universal £2000 tax free childcare allowance, expected extra end of life care cash and most excise duties frozen.

As expected the national living wage will increase to £7.50 in April, with £9.00 (or £18,000pa for a 40 hour week equivalent) by 2020. This remains a concern as, while employment growth has remained strong, it remains to be seen what impact such a high minimum wage relative to other EU countries would have, should there be a downturn.

I suspect a rising minimum wage will increase economic volatility being absorbable in the good times but lead to higher unemployment in a downturn.

Structural growth in spending continues to be a longer term concern

The budget may well have been calm but in reality Government spending is very hard to control. The three big departments (social protection, health and education) account for 66 per cent of all public spending and have grown consistently and structurally, in real terms, over the last 40 years. The reasons for this are obvious but include expectations, longevity and medical discovery. Public spending has increased by 71 per cent in real terms since 1993 with the social protection budget up 159 per cent.

It is hard to see these structural trends reversing unless there was a major shift in public opinion towards a greater private sector involvement, which given the current political environment, seems unlikely.

As I have argued previously, the economy needs to grow at a minimum of trend (2 per cent+) to fund this, or deficit normalisation becomes near impossible and although the annual deficit has reduced markedly from a peak of 10.2 per cent GDP to a current 3.8 per cent it remains stubbornly high and vulnerable to future shocks.

However if we look at spending from the year before the credit crisis we see a different and more ambiguous picture of spending growth. Talk of austerity in aggregate is, very wide of the mark.

Despite an explosion of public debt since 2006/07 real spending has increased by 13.8 per cent with a 28 per cent rise in Social Protection and 26 per cent in health. However outside these big departments spending, in real terms, has been broadly flat. Against historic norms this could be described as selective austerity.

This creates significant long term challenges because further constraints to housing, education, social care and public order budgets will be increasingly politically difficult. Add together a social protection budget which is also hard to reduce as the state pensions account for broadly 50 per cent of the budget – with Increasing longevity and, in my view, the unsustainable pensions triple lock and ever rising health expectations – and you create an environment where Government’s require near perpetual growth, particularly at a time when the level of Government debt is high leaving little margin for error. (It should be noted social protection increased by 28 per cent real since 2007 over a period of low unemployment)

As I have previously argued, while Philip Hammond may have had a better hand than he may have feared nine months ago he remains a prisoner requiring growth. His assumptions of growth suggest the annual deficit will be all but eliminated by 2021, however should growth fade the fiscal deficit would quickly pick up. My recent paper, The real challenges facing the UK economy, of February 2017, demonstrated even a stagnation in growth for two years would see the deficit rise to over £90bn while a 2 per cent recession could lead to a £130bn deficit, or 7 per cent of GDP, a level that would be very uncomfortable indeed.

Thus, in a nutshell, the deficit normalisation programme looks fine today but it remains a very cyclical calculation and any growth hiccup would have a material negative impact.

While the budget is fine as it goes, the real issue is the yield curve. The maintenance of super low yields has done more to fund the fiscal deficit, re-fuel the consumer and agitate asset prices than any budget, or fiscal measure HMG may decree. Intriguingly, however, the yield discount that the UK long bond trades at, relative to similar US Treasury’s, has exploded in recent months from a stable 20-40bp to a current 120bp. This is despite increasing domestic inflationary expectations, signs of overseas selling of UK gilts, and a recent end to the additional £60bn post EU referendum QE.

Undoubtedly this benign yield curve has given a shot in the arm to both asset prices and consumer confidence. I suspect the yield gap with US Treasury’s has peaked. However any upshift in this curve could threaten growth and indeed asset prices.

This surely remains the Treasury’s and Bank of England’s primary concern, thus don’t be surprised if more QE is not announced in the medium term, particularly if there is any sign of a growth slowdown. Economy fine, all well. Economy slows, monetary easing, fuelling asset prices and consumer debt. It remain tails you win, heads you win.

Ewen Stewart is Chief Economist at Walbrook Economics.

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