Sunday, March 27, 2011
Inflation, not cuts, is the biggest threat to Osborne's growth plan
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

inflation-sign.jpg

My regular piece is available to subscribers on www.thesundaytimes.co.uk - this is an excerpt.

Wednesday's budget was, in macro-fiscal terms, a non-event, as suggested last week. None of us would mind a net giveaway of £10m individually. Spread across the population, it doesn’t count as small change, given tax revenues for the coming year of £589 billion and public spending of £710 billion.

We are, of course, in between two big tax hikes, January’s Vat rise and April’s national insurance increase. The biggest public spending cuts in decades kick off in earnest next month. The budget provided a peg for a renewed focus on that squeeze.

One of the themes underlining that squeeze is that government has to get more for less. So Osborne set a pretty good example by getting quite a lot for nothing.

Cutting fuel duty by getting North Sea firms to pay was politically astute, even if oil companies are left ruing Britain’s unstable tax regime once again. The chancellor’s version of the fair fuel stabiliser will probably be unworkable. I can’t think of another tax which specifies a price, in this case oil at $75 a barrel, to trigger changes. But there will be time to fix that.

In tone and content, business had much to be happy about. Accelerating the reduction in corporation tax to a new target of 23% when voters are facing a huge fiscal squeeze was politically brave and judging by the limited criticism, well-judged.

Last week I said we needed a signal that the 50% income tax rate would not last and we got it, together with an HMRC (Her Majesty’s Revenue & Customs) review of whether it brings in any net revenue. Such a review is good, though I’m not sure HMRC is the body to do it.

The budget was neutral in fiscal terms. What about growth? Labour had some knockabout fun with a budget that set out a plan for growth while at the same time downgrading the official growth forecast.

It was clear when they were published those poor weather-affected fourth quarter gross domestic product figures were inconvenient. They cast a very long shadow.

Most people, sensibly, do not spend their time deconstructing gross domestic numbers. If they did, they would know that a very weak fourth quarter of 2010 has the effect of undermining the growth number in 2011. So the OBR’s new forecast for this year went down from 2.1% to 1.7%.

What is much more difficult to explain is that the OBR also revised up its prediction of growth through the year - GDP at the end of 2011 compared with the start - because of its prediction of a strong 0.8% bounce this current quarter. Incidentally, the OBR does not believe that the economy ground to a halt at the end of 2010 even leaving aside the snow, though it accepts it slowed to just a 0.2% quarterly expansion.

Growth is the key, now and in future. The OBR predicts 2.5% growth next year and 2.9% in both 2013 and 2014. This is not implausible in relation to past recoveries, but an early forecast downgrade, even for explicable reasons, means the new body has to work building credibility.

There are plenty of threats, most of which the economy can see off. The unexpected one, for the Bank of England and the Treasury, is inflation. Higher than expected inflation was responsible for disappointing new OBR projections for the budget deficit. This year’s net borrowing figure of £145.9 billion, is only £2.6 billion below its previous forecast, against City expectations of a bigger undershoot.

For 2011-12 and beyond, the official forecasts are for persistent overshoots, starting with £4 billion (and a borrowing total of £122 billion) for the coming year and averaging annual £10-11 billion overshoots from 2012, as result of the impact of higher inflation on benefit upratings, public sector pensions and debt interest. Infglation also, as the Institute for Fiscal Studies noted. makes the real cuts in public spending deeper, assuming the government sticks to its cash plans.

This matters. The way Osborne has framed his rather curious fiscal rules should, in theory, be immune to growth coming in slower. He is targeting the cyclically-adjusted budget deficit.

In practice, as the ratings agency Moody pointed out, these things are connected. If slower growth were to force the government to slow the pace of deficit reduction, this “could cause the UK’s debt metrics to deteriorate to a point that would be inconsistent with a AAA rating,” it warned.

The dangers of inflation eating into growth are real. The OBR does not expect average earnings to be rising faster than inflation until 2013. It is assuming Bank rate will start to creep up later this year and average 1.8% in 2012 and 2.8% in 2013.

But it also sets out an alternative “persistent inflation” scenario in which inflation does not fall much next year and averages over 4% in 2012 and 2013 (roughly 6% on the retail prices index). Average earnings respond, and so does Bank rate, pushing up to more than 6% in 2013.

This would be pretty disastrous. The government, when it embarked on its aggressive deficit-cutting programme, expected this to be the squeeze, offset by ultra-low interest rates. High inflation is providing an equally powerful squeeze. For the Treasury - and the Bank - fingers will be resolutely crossed for a sharp drop in inflation next year as Vat and other factors drop out. If not, Osborne’s third budget will be a lot less comfortable than his second.