Friday Flyer: Budget Comment- Resilience under Fire

The resilience of output following the referendum has been most welcome and has led to many forecasters gradually cranking up their central views for 2017.  On Wednesday, the OBR plumped for a central case of 2% this year compared to 1.4% in November.  The Institute itself also published an upward revision in February and thought that output would be most likely to grow by some 1.7% this year.  But it is the composition of that growth and the risks present a great concern.

So we cannot roll out the bunting yet because caveats need to be stressed.  First, the central cases for growth remain below what we tend to think of as potential growth at just over 2%.  And in a world of spare capacity we might reasonably expect significantly faster growth – so this is not an economy in rude health.  When we look at income growth per head, which is one measure of productivity, the story is even worse at around 1% to 1.5%.  Of course, the average growth in incomes masks considerable heterogeneity across the income distribution and many families will experience little or no increase in their real purchasing powers.  We might argue that this is a reasonable outcome compared to an alternative of higher levels of unemployment but that counterfactual cannot be observed and may the cause of less frustration than expected income growth forgone. 

Consumption expenditure provided the main contribution to last year’s resilience in output and was driven by robust real wage growth and a higher propensity to consume from income.  As a result of the depreciation-induced inflation, the fall in real wage growth this year will correspondingly reduce the purchasing power of households and next.  This reduction may be even sharper should households decide to increase their savings rate this year and next.

Indeed the prospective fall in consumption growth is a direct result of the sharp move to a lower exchange rate, which are then both explained by a lower long run level of income.  A reduction in the quantity of trade still seems likely to reduce income relative to the alternative in the long run.  The risks even to this central case are skewed to the downside from the confirmation of a hard Brexit and a prolonged period of uncertainty whilst we work out our trade agreements and these may well bear down further on activity. 

The OBR suggests that there is a significant possibility of a recession from 2017H2 out over the forecast horizon.  We can observe this because, as with the Institute’s recent calculations, the OBR’s output fan chart has a significant fraction of the density below zero for much of the forecast horizon.  The contribution to output from consumption is set to fall this year and next with insufficient investment to plug the gap.  The poor performance of business investment remains a further major concern.  Lack of investment continues to signal insufficient churning of new firms and ideas, which are the key to productivity growth.  Even worse the stabilising effect of net trade, which we would expect given the exchange rate depreciation, seems to come more from the suppression of imports, which is consistent with falling consumption, rather than a large expansion in exports. 

The Chancellor therefore has an incentive to provide more stimulus by a loosening of the purse strings but with the full force of an exit from the European Union yet to be felt, without clarity on the exact projects for public investment and concerns about the long run sustainability of the fiscal position, giving the demographics, it seems right to keep those strings tied.  Precautionary savings in the public purse seem to me to be needed for the possibility of a firestorm ahead.