Slower growth from fiscal tightening will cause the Bank of England to keep interest rates lower for longer, while a further fiscal squeeze could lie ahead if the Office Budget Responsibility’s growth forecasts are too strong.
This is the key conclusion of the Budget Report analysis produced by one of the country’s economics consultancies, cebr, and released in their Emergency Budget Reaction report.
The Budget saw Chancellor Osborne follow through on his commitment to cut the public sector deficit more quickly, with £32 billon of spending cuts and £8 billion of net tax rises announced.
The Office for Budget Responsibility downwardly revised its pre‐Budget forecast for growth in 2011 from 2.6% to 2.3% but we think this and the years following could still be too strong.
The OBR expects consumer spending to grow by 1.3% and 1.7% in 2011 and 2012 respectively. At a time when we expect unemployment to still be rising, real disposable income growth to be weak and bank lending to remain constrained, this seems too strong.
Furthermore, a strong bounce back in private sector investment is expected, but we think investment will recover more slowly in the aftermath of the financial crisis due to constraints in lending. Finally, the sluggish recovery in the eurozone, the United Kingdom’s main export market, will hinder the export‐led recovery.
If growth is lower than the OBR expects, public borrowing is likely to have been underestimated and further spending cuts and / or tax rises could be necessary.
However, we expect the fiscal tightening announced will result in lower long term interest rates as bond markets react positively to clearer plans for reducing the deficit. In addition, the Bank of England may respond to slower growth by keeping interest rates lower for longer.
Charles Davis, managing economist at cebr commented:
“We think the Office for Budget Responsibility’s projections for growth are still on the high side. We see a weaker consumer recovery and more risks to the export led recovery than the OBR.
“Although inflation has been above target in early 2010, the fiscal tightening means growth in demand will be weakened, so we expect the Bank of England to keep interest rates lower for longer, on hold at 0.5% into 2012.”
Douglas McWilliams, chief executive officer at cebr commented:
“Bond markets reacted positively to the Budget today and we think long term interest rates will fall back over the coming months. This is good news for households as mortgage rates should fall back. However, with another VAT rise to stomach households will probably be feeling overwhelmed by bad news.
“The danger is that there could be more bad news to come. If the Office for Budget Responsibility’s growth forecasts turn out to be too optimistic, as we expect, then more spending cuts and tax rises could be necessary.
“Coming out of the financial crisis, we expect growth to average of one and a half percent in the UK over the next three years, whereas the OBR is forecasting a two and a quarter percent growth. If growth is lower, it could mean around £10‐£20 billion more cuts could be required.”
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