The Chancellor, Kwasi Kwarteng, has promised a Fiscal Plan ‘to get debt falling in the medium-term’.
The core conclusion of this year’s IFS Green Budget, funded by the Nuffield Foundation and in association with Citi, is that, on a central forecast, he would need to announce a fiscal tightening of more than £60 billion just to stabilise debt as a fraction of national income in 2026–27.
Cuts on this scale would require some big choices. By way of illustration, given current economic forecasts, even indexing working-age benefits to growth in earnings for two years (£13 billion cut) and returning investment spending to 2% of national income (£14 billion cut) would leave him needing to cut 15% from non-NHS, non-defence day-to-day public service spending to deliver the required tightening through spending cuts alone.
The Chancellor might, through some such combination, find a way to have debt stabilised in the final year of his forecast without rowing back on any more of his recently announced tax cuts. But promising a tightening on this scale through spending cuts alone, without actually specifying which budgets would be cut, risks stretching credulity to breaking point at a time when the government’s fiscal strategy is under intense external scrutiny, not least from the financial markets on which government borrowing depends.
There is, of course, huge uncertainty around exactly how much policy action will be needed given that forecasts for economic growth are highly uncertain in current turbulent times. Faster growth would definitely help, and the government’s focus on this is welcome. But even if the OBR were to assume an additional 0.25 percentage points of growth each year – a big increase – a tightening of approximately £40 billion would still be needed by 2026–27 (equivalent to reversing almost all the ‘mini-Budget’ tax cuts).
The precise figures here are less important than the need for a credible strategy and plan for fiscal sustainability. Growth could turn out better than expected, and there is a case to be made that decisions would be better delayed until things settle down. That might have been a more credible strategy, though, if the Chancellor had not already announced such big permanent tax cuts. His problem is that financial markets are not likely to be impressed by plans predicated either on an unlikely uptick in growth or on vague promises of public spending cuts far into the future.
While we should hope and aim for better growth, the rationale for an independent OBR is to ensure that politically motivated wishful thinking is not incorporated into economic and fiscal forecasts.
Citi’s forecasts suggest slow economic growth over the next five years averaging just 0.8% a year. That reflects a severe terms-of-trade shock which has raised import prices much more quickly than export prices, a historically big squeeze on household budgets, and a supply of both labour and capital that is struggling to respond to swift economic change. A big fall in gas prices could make the outlook significantly rosier. But there are risks on the downside too if inflationary expectations become embedded.
Citi believes that inflation will peak near 12% but that the Bank of England’s policy rate may peak at just 4.5%, below what markets are pricing in. The fact that fiscal and monetary policy are now in clear conflict increases uncertainty and makes the job of the Bank of England harder.
This inflationary episode has been driven largely by a supply-side shock. That makes big hikes in interest rates less appropriate for controlling inflation. Managing it down must remain the key economic objective in the short run. The likelihood of supply shocks hitting more frequently may mean it is time to reassess the framework for economic policymaking and the relative roles of fiscal and monetary policy.
These are among the headline findings of the 2022 IFS Green Budget, funded by the Nuffield Foundation and produced in association with Citi. Further details can be found below the following quotes.
Paul Johnson, Director of IFS, said:
‘Uncertainties about the path of the economy over the next few years make public financeforecasts very difficult indeed. We project borrowing of £100 billion a year in the medium term – but that could be wrong by tens of billions in either direction. A credible fiscal plan will recognise that uncertainty, but cannot ignore the fact that, on a reasonable central forecast, debt is forecast to continue rising in the medium term. The Chancellor has acknowledged that we should be striving to reduce it.
‘It is just about possible to see how Mr Kwarteng could get debt on a stable, or ever-so-slightly falling, path in the final year of his forecast. He could, for example, announce some combination of cuts to working-age benefits and capital investment, plus some unspecified cuts to public services pencilled in for the years after 2025. That might work on paper and spare him having to row back on any more of his mini-Budget tax cuts. But the specifics of the UK government’s fiscal strategy are under more scrutiny by financial markets than at any point in the recent past. The Chancellor should not rely on over-optimistic growth forecasts or promises of unspecified spending cuts. To do so would risk his plans lacking the credibility which recent events have shown to be so important.
‘All that said, we would have sympathy with the Chancellor if he decided that the uncertainties of the present moment are too great to be promising specific future action around public spending. But the same would apply to his recent package of tax cuts. He should not apply that argument asymmetrically.’
Benjamin Nabarro, Chief UK Economist at Citigroup, said:
‘The UK faces a difficult economic outlook with few easy policy answers. Over the coming months, the terms-of-trade shock associated with the conflict in Ukraine will squeeze both firms and households. For the former, the regressive nature of the hit increases the macroeconomic risks. The medium-term outlook for investment remains strikingly weak. Aggressive monetary tightening suggests any meaningful recovery is likely to be pushed into 2025.
‘For policy, the outlook is complicated by ongoing supply disruption. In the near term, further demand stimulus merely risks aggravating the near-term challenges. And with monetary and fiscal policy now working in opposite directions, we think the broader risks around UK monetary-financial stability are growing. In the years ahead, ‘supply shocks’ such as those seen in recent months seem likely to grow more frequent. That may require profound changes in the manner macroeconomic policy is conducted if we are to avoid another decade of stagnation. The UK can ill afford further policy mistakes.’
Mark Franks, Director of Welfare at the Nuffield Foundation, said:
‘The UK is experiencing very high rates of inflation, rising interest rates, growing national debt and intense pressure on many government services. The IFS Green Budget sets out the huge scale of the challenge and the tough choices and trade-offs involved. It also shows that the least-well-off are most vulnerable to the current crisis. There is an urgent need for a serious strategy for economic growth which also supports vital public services and responds to the immediate pressures on people and families most under strain from rocketing food and energy costs.’
On the broader macroeconomic outlook, Citi analysis finds:
- Real-terms GDP is forecast to grow by an average of just 0.8% per year over the next five years. That is well below growth experienced over the last decade. The near-term outlook for both consumption and investment is weighed down by a large terms-of-trade shock – an increase in the price of imports relative to exports. This adds to prices today, but crimps incomes and demand tomorrow. We now expect GDP to fall across both 2023 and 2024.
- A weak outlook for demand sits alongside major supply-side problems. We have experienced a reduction in labour supply, due to lower net immigration and rising rates of inactivity and ill health. The economy is also struggling to adapt to changes that mean the demand for both labour and capital across different sectors is not well matched by supply.
- Inflation is forecast to peak at just under 12% over the coming months, and fall back only gradually. For the Bank of England, the risk is that higher inflation becomes embedded and feeds through into higher domestic inflation. Given the sheer level of inflation, and the absence of evidence from recent historical experience, uncertainty around this is particularly high. More monetary tightening seems inevitable.
- Monetary policy is now in acute conflict with looser fiscal policy. This is destabilising and could well make recovery more painful and more delayed. Given the level of uncertainty, the Monetary Policy Committee may effectively be forced to ‘overcompensate’ for any short-term fiscal support – driving weaker outcomes in the medium term.
- For households in particular, the outlook looks tough. Spending power will be hit in the near term by soaring energy and food prices, with the poorest households struggling most. Food inflation is forecast to reach 17% in early 2023.
- Then, just as the terms-of-trade shock subsides, households will be hit by rising mortgage costs, as increasing numbers roll off their fixed-rate deals. Rising interest rates will also make it more expensive for households to borrow their way through the storm. COVID savings – concentrated as they are among the wealthiest households – are unlikely to ride to the rescue. This will mean a delayed recovery.
- Beyond the UK, the economic outlook is also far from rosy. The war in Ukraine and the stand-off with Russia have aggravated the inflation crisis by eliminating 40% of the EU’s gas supply, triggering a severe energy crisis in most of Europe. The increase in gas prices alone is imposing a burden of up to 8% of GDP on European households and firms. It would be remarkable if this shock price increase did not trigger a recession, and also lead to structural changes in the European economy that weigh on growth for many years.
- The Ukraine conflict also raises questions about the West’s reliance on China. Reducing dependence on the 22% of EU goods imports coming from China, including even higher shares for technology and consumer goods imports, may be an even greater challenge than reducing dependence on Russian energy.
On the public finances, IFS analysis finds:
- Borrowing this year is likely to hit almost £200 billion, its third-highest peak since the war, below only the peaks associated with COVID and with the financial crisis. This would be nearly £100 billion higher than the £99 billion forecast by the OBR in March.
- Looking beyond the next few years, after the government’s vast energy support packages are assumed to expire, borrowing is still set to remain substantially elevated. There is huge uncertainty around the exact magnitude, but under a central forecast in 2026–27 we expect borrowing of around £100 billion, which would be £70 billion higher than forecast in March.Much of this increase is uncertain – it will in particular depend on the path of the economy, inflation and interest rates. Less uncertain is £43 billion of the increase in borrowing, which is explained by the direct impact of the permanent tax cuts announced by the new Chancellor, Kwasi Kwarteng.
- Those tax cuts, combined with a modestly weaker outlook for growth in the cash size of the economy (with higher inflation more than offset by reduced levels of real activity), act to depress government revenues (by around £44 billion in 2026–27 under Citi’s central forecast, relative to what was forecast by the OBR in March). An extra 0.5 percentage points of growth each year would boost revenues by around £28 billion in 2026–27; the flip side is that if growth were to be 0.5 percentage points a year weaker, revenues would be £28 billion lower.
- Rising inflation and interest rates will push up spending on working-age benefits, state pensions and debt interest in both the short and medium term. We forecast that spending on debt interest next year (2023–24) will be £103 billion, which is £10 billion more than we forecast just before the mini-Budget. It is double the £51 billion forecast by the OBR in March, which was already an increase on the £39 billion forecast by the OBR last October. Even in 2026–27 we forecast that debt interest spending will be £66 billion, some £18 billion higher than forecast by the OBR in March, as a result of higher interest rates and a higher level of accumulated debt.
- Rising inflation is also eating into the real-terms generosity of the departmental spending plans set out a year ago. Stated government policy is to leave these plans unchanged despite rising pressures. Restoring their generosity would require an additional £14 billion of spending in 2023–24 and £23 billion in 2024–25, under Citi’s forecasts for the relevant measure of inflation (the GDP deflator).
- The Chancellor has promised a ‘fully costed plan to get debt falling in the medium-term’. Pushing back the definition of the medium term from three years to five years could make this aim easier, but still far from easy, to meet. Under Citi’s central forecast, it would require a fiscal tightening of £62 billion in 2026–27 to stabilise debt as a fraction of national income – so even reversing Mr Kwarteng’s entire £43 billion of ‘mini-Budget’ tax cuts would not be enough.
- One way to tighten by £62 billion without announcing tax rises would be to cut day-to-day public service spending in 2026–27 by 14% (relative to what has been provisionally pencilled in). If the NHS and defence budgets were exempt from any cuts (and instead frozen in real terms after 2025), the required cuts to everything else would rise to more than a quarter (27%). Cuts on that scale would pose severe challenges, to put it mildly.
- Another option to help bring down borrowing would be to cut the capital (investment) budget – though this would hardly be a growth-friendly move. Cutting investment spending back to 2% of national income would save £14 billion in 2026–27. Indexing working-age benefits in line with growth in average earnings rather prices in April 2023 and April 2024 would cut spending by £13 billion. These could be combined with cuts to day-to-day spending on public services.