Sunday, May 23, 2010
Vat hike would be one more headache for the Bank
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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There are a couple of things people want to know about this week. What will the changes announced by the new government mean for the "emergency" budget on June 22? And how will the Bank of England respond to another disappointing inflation number, with retail prices rising at their fastest rate since July 1991?

Tomorrow, the government will announce a net 6 billion of spending cuts for this year. If the announcement is in line with Tory pre-election plans, there will be a cut of 12 billion, but half will be ploughed back into frontline services.

Of greater long-term significance was the announcement by George Osborne, the chancellor, of a new Office for Budget Responsibility (OBR), headed by Sir Alan Budd. He will be joined by Geoffrey Dicks and Graham Parker the new three wise men of fiscal policy.

It may sound like just another new quango, but this is a revolutionary change. The Treasury has had its wings clipped, and the new chancellor has voluntarily clipped his own wings. No longer will he publish his own economic and fiscal forecasts and act as judge and jury on whether the government's fiscal forecasts will be met. That task will be handed over to the OBR.

The three wise men have the power to influence people's lives, just as the nine members of the Bank's monetary policy committee (MPC) do. So how hardline will the new budget committee be? Younger readers may be unaware that Budd and Dicks were once the backbone of the London Business School's Centre for Economic Forecasting, and provided a regular economic forecast for this newspaper, a tradition dating back to the mid-1960s.

I don't propose to trawl through those articles for clues, because more recent material is available. Last month Budd wrote an article, Fiscal Policy Under Labour, in the National Institute of Economic and Social Research's review.

He was there at the start of New Labour's economic experiment, having been inherited by Gordon Brown as government chief economic adviser in 1997, though he quickly moved to the MPC. His article was more forgiving of Labour's fiscal policy than many who know a lot less about the subject. The Treasury could not have been expected to have built up a contingency against the biggest crisis and largest fall in gross domestic product for 70 years, he wrote.

Nevertheless, one lesson was that the Treasury's fiscal forecasts had been overoptimistic since 2001-2. Another was that, given the sharp rise in debt as a result of the crisis, it would be sensible to aim for a lower level of debt than the 40% of GDP of Labour's sustainable investment rule.

Dicks has written regularly here, most recently on February 21. Then he said that growth during recoveries tends to be faster than people fear; that it is sensible to delay serious work on the deficit until recovery is well-established; and that the 1990s demonstrated it is possible to get out of a deep fiscal hole quite quickly. "In terms of assuring any government's credibility, the size of the deficit by the end of the parliament will probably be more important than the path by which we get there," he wrote.

What this tells me is that the new committee, while it will want to see decisive action to get the deficit down, is not a trio of headbangers. They will take a reasonable view of what is needed, and how quickly it needs to be put into place.

Will it include the rise in Vat to 20% we have all been writing about? That is the big question. It is important in terms of the credibility of the coalition's fiscal policy. It is also rather important for the Bank.

A big divergence of views is emerging on inflation, following last week's figures. Ross Walker, Dicks's former colleague at Royal Bank of Scotland, assumes Vat will be increased, and that the rise will take effect this autumn.

His forecasts suggest consumer price inflation, currently 3.7%, will end this year at 3.3% and next year at 2.3%. Retail price inflation, currently 5.3%, is predicted to be a touch higher at the end of the year, 5.4%, and 3.9% at the end of next year.

The Bank's inflation forecasts, by contrast, have consumer price inflation dropping to 2.3% by the end of this year and then below 2% right through to the middle of 2013, hitting a low of 1.3% during 2011.

Much of the difference, as far as consumer price inflation is concerned, is to do with the assumption of the Vat rise. But it is supplemented in Walker's forecast by the expectation that the MPC will start to raise rates in November, taking them up to 2.5% by the end of 2011 and pushing up the retail prices index.

The Bank faces a dilemma. Though its forecasts have been poor, it can take comfort from the fact that if you take away tax changes, consumer price inflation is marginally below the 2% target (1.9%). The inflation the Bank can control is generated from the economy, not Treasury tax hikes.

On the other hand, a prolonged period in which retail price inflation is between 4% and 6% will be hard to square with the 2% target. For households and businesses, higher inflation is higher inflation. That is the Bank's worry, that inflation expectations get dislodged from the target.

It is a worry. If the Bank raises rates it will add to the squeeze on the economy from tax hikes and spending cuts. If it does not, people will doubt the declaration a few days ago by Mervyn King, the Bank governor, of the MPC as "the cornerstone of the UK's commitment to price stability".

The way out of the dilemma is for inflation to start falling, and at a pace that means inflation can absorb a rise in Vat without moving too far from the target.

The fall in the oil price in recent days will help (though sterling has moved lower against the dollar). The factors that should mean low inflation, however, are spare capacity left over from the recession, very weak money-supply growth and subdued private-sector pay increases.

The Bank is puzzled that these factors have not already given us lower inflation than the figures show. Its hope, and ours, is that the puzzle is soon resolved in its favour. That will allow it to avoid the rate increases it is reluctant to make.

PS: The Treasury will have to get used to the tall figure of George Osborne and the less tall figure of David Laws, his Liberal Democrat Treasury chief secretary. It can only be a matter of time before the two are known as Osborne & Little.

It will be interesting to see when the chancellor starts claiming the economy as his own. His first speech in the job, launching the Office for Budget Responsibility, backfired because he spoke as if he was still fighting the election.
Comparing Britain with Greece and predicting Britain's budget deficit will be the world's largest, which it won't be, was daft. Friday saw a downward revision in the 2009-10 deficit to 156 billion. I hope a lesson has been learnt. His second, to the CBI, promising the most competitive corporate tax regime in the G20 within five years, was better.

Early speeches from chancellors often do not age well. Consider this: "There will be no more hiding behind obscure forecasting assumptions. We will not leave ourselves open to accusations of accounting tricks, dubious figures, or rigging the rules. I believe not only in sound public finance but in honesty and openness in public finance. It is time to rebuild public trust about the management and use of public money."

That was Gordon Brown's first speech as chancellor, to the CBI's annual dinner in May 1997. I was there. He established the "no dinner jacket" rule for formal occasions, a tradition surprisingly maintained by Osborne last week. It seems a long, long time ago.

From The Sunday Times, May 23 2010