Sunday, November 05, 2017
A bad news budget will follow this bad news rate hike
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

So it happened. The Bank of England was not crying wolf this time and this time the boyfriend was not unreliable. There has been a wailing and gnashing of teeth from some in response to the first rise in interest rates for more than 10 years but that seems overdone.

A quarter-point rate hike is both small and fully reversible. The Bank’s credibility would have been damaged had it not acted. It cut rates last year when the purchasing managers' surveys for construction, services and manufacturing were plunging. It has raised them at a time when those surveys are stronger than expected, though confidence is weak. It was the right thing to do.

Beyond that, I do not want to dwell on it too much. The arguments were set out here last week. One thing that is worth of comment, however, is that this was a “bad news” rate hike. In the long fallow period since the last time interest rates went up there was an understanding that, when the moment came, it should be greeted as good news.

This is not because savers outnumber borrowers, which they do, but because it would be a signal that the economy was strong enough to come off emergency support. The start of normalisation would be something to celebrate.

This was not that rate hike. It came because inflation is above the official 2% target and set to stay there for some time. It came, more importantly, because the supply-side of Britain’s economy has been so badly damaged – now capable of growing by only 1.5% a year without generating inflation – that it had to happen even though growth is weak.

Through the fallow years, similarly, there was an implicit understanding that it deficit reduction – austerity – meant that fiscal policy was contractionary, it was appropriate for monetary policy, as set by the Bank, to be aggressively expansionary.

Members of the monetary policy committee (MPC) would argue that it still is; they like to use the analogy of easing off on the accelerator rather than slamming on the brakes. But the idea that monetary policy would only be tightened after the task of deficit reduction was complete, and austerity over and down with, has also taken a knock.

We will have to wait a few months for the next increase in interest rates but the next big economic policy announcements, in Philip Hammond’s budget on November 22nd, are only 17 days away.

I doubt if any budget could cure the Tory party’s ills, and the budget relaunch that was being talked about until recently would look risky for a government that is in danger of being holed below the waterline.

The difficulty for the chancellor is that the same bad news that drove the Bank’s decision to raise interest rates hangs over the budget, as Mark Carney, the Bank governor, came close to admitting. Economists at the Bank and at the Office for Budget Responsibility (OBR) share the same gloom about productivity. In the case of the budget, it means that the outlook for the public finances has worsened significantly.

The Institute for Fiscal Studies put flesh on this the other day. It looked at the chancellor’s options for easing the squeeze, for easing austerity, but it noted that Hammond is caught “between a rock and a hard place”.

It modelled scenarios for the budget deficit and government debt based on how big the downgrade is in the OBR’s productivity assumption. As the IFS put it: “Any substantial downgrade to productivity forecasts would easily dwarf the other factors affecting borrowing.” If the OBR assumes that productivity growth in future is in line with its average over the past seven years of just 0.4% a year for output per hour, what the IFS describes as a “very poor” outlook, the consequences for the public finances are pretty dreadful.

Instead of the budget deficit falling below £17bn by 2021-22, on its way to an eventual budget surplus by the mid-2020s, the budget deficit would rise to £70bn by the early part of the next decade, just as the demographic pressures for higher spending are kicking in.

Even on a slightly less scary “weak” productivity assumption, under which it grows by just over 1% a year, which is more likely, borrowing would be running at something like double the prediction the OBR made in March. This is the “bloodbath” for the public finances that has been doing the rounds in Whitehall. On the very poor scenario public sector debt stays above 90% of GDP. Under weak growth it falls, but only at a snail’s pace.

In a different era a chancellor under intense political pressure to deliver some popular measures in his budget would ignore the warnings from economists. Chancellors, famously, used to tear up forecasts and tell officials to come back with something better.

And the OBR, it should be said, has been too gloomy over public borrowing in the past couple of years; spectacularly so in its forecast a year ago for the budget deficit in 2016-17. Some Tories would like the forecasts to be ignored.

But Hammond cannot do that, without abandoning the framework established in 2010. The purpose of having a fiscal watchdog is that it barks occasionally. The government’s fiscal rules are looser than they used to be. They are to secure a return to budget balance as soon as possible in the next parliament and, in the meantime, reduce the structural or underlying deficit to less than 2% of GDP and have debt falling as a percentage of GDP by 2020-21.

Hammond has been telling his cabinet colleagues that he intends to stick to those rules, which when he set them did not look too onerous. He has rejected the idea, put forward by the communities secretary Sajid Javid, to borrow tens of billions more to fund a mass social housing programme.

He will no doubt avoid anything unpopular. Even the IFS has given up on the idea that the long and costly freeze on fuel duty will come to an end.

The question for Hammond is whether he uses some of the diminishing amount of elbow room he will be left after the OBR’s productivity downgrades to throw a few bones to his hungry colleagues. When the cost of Brexit is rising, measured in extra civil servants and lawyers, and when the outlook is deteriorating, the scope for anything but a few bits and pieces is limited. Don’t expect a bad news rate hike to be followed by a good news budget.

Weak productivity is doing what you would expect it do. adversely affecting monetary policy and blighting the public finances, while undermining living standards. Until the economy breaks out of it, there will be plenty more bad news to come.