Chancellor gambles on interest rates and tax receipts to hit fiscal targets
The current fiscal mandate’s target is an absolute budget surplus by 2019-20, maintaining this surplus for each subsequent year. In the Office for Budget Responsibility’s (OBR) forecast, published today, this target is met, with public sector net borrowing (PSNB) reaching £10.1bn (0.5 per cent of nominal GDP) in 2019-20.
Achieving this target implies a fiscal consolidation this parliament broadly equivalent to that experienced in the last, of roughly 6 per cent of GDP, although the composition is somewhat changed.
Improvements driven by lower interest rate assumptions and higher revenue forecasts
A large part of the story underlying this Autumn Statement is in the macroeconomic assumptions and projections of the OBR.
The economic outlook which underpins their forecast contains a number of factors which ease the path to achieving the fiscal mandate. Both weak inflation and a continuation of the current low interest rate environment are contributing positively to the fiscal outlook. The latter has been having a sizeable effect since early 2009, as discussed in Kirby and Meaning (2015). However, since the OBR’s last forecast, the market expectations of monetary policy, which condition their fiscal projections, have fallen back significantly with Bank rate in 2020-2021 now expected to reach just 1.8 per cent, 40 basis points lower than was assumed in their July forecast.
Figure 1: Changing assumptions for Bank Rate
Source: NIESR, OBR
Note: The OBR's path for Bank rate is backed out from a 10 day average of forward OIS rates.
What is more, PSNB is flattered by the Bank of England’s other big policy tool, Quantitative Easing. The shallower and delayed tightening of Bank Rate pushes back the point at which the Asset Purchase Facility is unwound. As such, the fiscal boon accruing to the public sector from netting out of interest payments between HM Treasury and the Bank of England lasts longer. The wider interest rate differential improves the fiscal position, lowering PSNB by roughly £3bn a year on average in 2018-2019 and 2020-21. Adding this to the £1.2bn impact of the looser path for Bank Rate and almost half of the £10.1bn absolute surplus projected for 2019-20 is a result of the changing assumption on monetary policy.
The OBR has also significantly increased its forecasts for government receipts, which lowers PSNB by £2.8 billion in 2019-20, and a cumulative £21.4 billion over the period 2016-17 to 2020-21.
Combining these two large factors with other changes in the OBR’s macroeconomic forecasts and assumptions improved PSNB between 2016-17 and 2020-21 by a cumulative £27billion. This granted the Chancellor a degree of additional fiscal space, which enabled him to present an Autumn Statement that was not fiscally neutral (adding a cumulative £18.7 billion to PSNB), delivering significant spending increases compared to the summer projections. That he did not go further, relates, at least partly, to the increase in borrowing that stems from the reclassification of Housing Associations to the public sector.
As shown by Figure 2, there exists a large degree of uncertainty around this central forecast. The confidence bands which surround the OBR’s projection imply just under a 50 per cent chance that the Chancellor will miss his fiscal mandate under current spending plans.
Figure 2: Public sector net borrowing fan
Source: NIESR NIER November 2015 and OBR EFO November 2015
This highlights the vulnerability of the Chancellor’s fiscal plans to the range of shocks that may strike the UK economy, and in particular any shocks which may adversely affect the key assumptions in the OBR’s forecast concerning interest rates, productivity and tax receipts. For instance, a tightening of monetary policy in the United States this December could lead to markets bringing forward quite significantly their expectation of when UK interest rates will rise, which would act to substantially reduce the probability of the Chancellor hitting the primary target of his fiscal mandate.
What if achieving the target is threatened?
With this amount of uncertainty around the ability of the Chancellor to meet the fiscal mandate, the obvious question arises, what will happen if downside risks to the economic forecast play out and the fiscal target looks to be threatened? The concern here is that the “easiest” candidate may be capital expenditure as the impact of this is less immediately visible. This would be an option given that the capital expenditure budget is inside the primary target of the current fiscal rule. It is such cuts, that would, however, have negative implications for longer term productivity growth and living standards.