Sunday, November 04, 2018
Recession is a risk to these best-laid plans
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.

You might think after the week we have just had that my cup runneth over. You wait a long time for a budget, and then we have one that was bolder and more interesting than expected. Then, a few days later there is another big event for economy-watchers – we lead quite sheltered lives – the Bank of England’s quarterly inflation report.

Actually, without sounding too curmudgeonly, this has not been the finest hour for economic policymaking. Some of the budget measures came too late for the Office for Budget Responsibility (OBR) to fully assess and properly incorporate in its economic forecasts.

And all of the budget came too late for the Bank to include in its assessment. The forecasting exercise that forms the backdrop to its inflation report is not just a back of the envelope calculation. A couple of days was too short a time to do it. In that respect, the inflation report was unfinished business.

It was not, however, message-free. The big picture of the budget was that Philip Hammond was presented with a windfall for the public finances and spent it, or rather used it to pay for Theresa May’s 70th generous birthday present for the NHS and a tax cut next year in the form of more generous income tax allowances.

That should not have been too much of a surprise, despite the chancellor’s reputation as the most conservative fiscal conservative you will come across. The OBR had signalled on October 19, 10 days before the budget, that stronger tax receipts would mean borrowing at least £11bn lower this year than it had expected. These things have a habit of carrying over to future years.

The big picture from the Bank was that it would like to get on with the job of raising interest rates, but Brexit uncertainty is holding it back for the moment. Had it had a chance to incorporate Hammond’s fiscal expansionism, which will boost the economy by 0.3% next year according to the OBR, that hawkish message would have been reinforced even more in its numbers.

On this view, and assuming a smooth Brexit, the Bank remains unlikely to raise rates until after Britain leaves the EU at the end of March next year but could do so two or three times before Mark Carney quits as governor in January 2020. That would take interest rates close to the 1.5% level at which the Bank would start unwinding its quantitative easing.

Will things turn out this way, or could a growth stumble upset the best-laid plans of both Hammond on the public finances and the Bank on interest rates?

You can put a cigarette paper between the Bank and the OBR’s growth forecasts, but not much of one. Both agree that the economy will grow by just 1.3% this year, its weakest since the crisis, despite a good third quarter. The OBR then thinks growth will average 1.5% a year, the Bank 1.7%, even without including the fiscal boost. Its optimism may surprise people but Professor Costas Milas of Liverpool University points out that there has been an optimistic bias to the Bank’s recent growth forecasts, even since the referendum.

Importantly, however, it is foolhardy to get to excited about small differences in five-year official forecasts. They tell us what the two bodies, the OBR and the Bank, think the economy is capable of, its new “steady state”. The fact that one is 1.5% a year, the other 1.7%, does not disguise the disappointing reality of that. This is disturbingly slow growth by historical standards, more akin to an economy growing old gracefully than taking on the world. Only a significant revival of productivity – both predict a gradual pick-up to only half its long-run average – would do that.

These five-year projections also do not allow for the possibility of recession. What are the chances of that? About one in two over the next five years according to the OBR, even on the assumption of a smooth Brexit.

As it put it: “In the 63 years for which the ONS has published consistent quarterly real GDP data, there have been seven recessions – suggesting that the chance of a recession in any five-year period is around one in two. So the probability of a cyclical downturn occurring sometime over our forecast horizon is fairly high.” One fear it has is that in the event of a recession, and with interest rates still low, the Bank would not have the monetary ammunition to fight it.

If a recession is a serious possibility even with a smooth Brexit, it must be a nailed-on certainty in the event of a disruptive, no-deal departure from the EU. The Bank is comfortable that it got it largely right on the economic consequences of the leave vote in June 2016.

In the latest inflation report, it says: “A disruptive withdrawal from the EU would probably result in a further decline in the exchange rate and a large, immediate reduction in supply. Tariffs might also be extended. Each of these developments would tend to increase inflation. Set against that, it is likely that demand too would weaken, reflecting lost trade access, heightened uncertainty and tighter financial conditions.” People should not necessarily expect it to respond in the same way as after the referendum because, as it puts it, “there is little that monetary policy can do to offset supply shocks”.

I don’t think it would raise interest rates in those circumstances but cutting them might be the equivalent of trying to put up an umbrella in a hurricane. S & P, the ratings agency, was brave enough to put some numbers on a no-deal Brexit a few days ago, and they included a 5.5% hit to gross domestic product, a near-doubling of unemployment, a 10% drop in house prices and a £2,700 average financial hit per household.

None of this, of course, has to happen, and the mood music on Britain and the EU achieving a withdrawal agreement has improved a little in recent days, even though this appears to be mainly driven from the British side.

But it is a reminder that the budget, the accompanying OBR forecast and the Bank’s inflation report had one thing in common; they were all overshadowed by Brexit. Normal service will not be resumed for some time.