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Looser fiscal reins blamed on productivity and Brexit

Neil Williams, Group Chief Economist at Hermes Investment Management, sets out his reaction to today’s autumn Budget:

With splits in the Party, Brexit looming, and disappointing UK productivity growth, two things from today’s Budget were inevitable: that it was going to be more political than economic; and that lower growth assumptions would involve higher borrowing ratios further out. With Brexit yet to be financed, Mr Hammond was today never going to show other EU governments watching unbridled fiscal largesse.

Through lower growth assumptions (a cumulative 2.2 percentage points), he has effectively had to loosen the fiscal reins again relative to plan, and, depending on how Brexit plays out, may have to kick further down the road the goal he set out last spring to return the deficit to surplus “...sometime in the next Parliament” scheduled for 2022/23. His predecessor, Mr Osborne, had wanted that surplus for three years earlier.

By remaining vague, ‘when’ in the next Parliament remains an open target. From a macro perspective at least, markets may be reassured he may be keeping some fiscal powder dry as a buffer should Brexit darken the finances.

There were admittedly some ‘rabbits out of hats’ for the lower-income end and housing supply, including stamp duty, measures to help cities, and indexation of business rates. However, these together are not enough in the OBR’s forecast to lift GDP growth much beyond ‘potential’ (about 1½%yoy).

So, let’s not get carried away. Depending on Brexit and future growth, the fiscal screw may yet have to be re-tightened later if he is to hit the OBR’s fiscal targets.

First, the deficit. Even including special items like bank sales, QE proceeds, and low interest-rate assumptions, the UK’s 2.4%-of-GDP headline deficit for 2017/18 lies around the middle of the G7 range.

Second, the recovery should have squeezed the debt more than it has. Only in 2017/18 is the net-debt-to-GDP ratio expected to peak – disappointing given real GDP is about 10% up on its pre-crisis peak. This ratio, at 87%, is more than twice Japan’s was, when Japan limped into a ‘lost decade’ in the mid 1990s.

Financing this debt may become more troublesome if we struggle with Brexit, given about one third of gilts outstanding is backed by international investors who will care about currency and ratings risk. This would disrupt the OBR’s low gilt-yield assumptions.

In which case, the risk is the BoE keeps QE running, by reinvesting its maturing bonds, for too long - with the unintended consequences of further asset price distortions, suppressed saving, and increased funding strains on many pension schemes.

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