Budget 2016: the macroeconomic outlook

The Office for Budget Responsibility (OBR) published their macroeconomic forecast today. The outlook is one of continued, albeit moderate, economic growth but more subdued than in their November 2015 forecast. This implies the OBR expect the nation to be around 1½ per cent poorer than they had previously thought by the end of this Parliamentary term[1]. The bulk of the downgrade is explained by domestic factors: a downward revision to potential productivity growth and investment volumes.

Business investment has been revised down 5 per cent for 2016 alone, and more than 8 per cent by the end of 2020. They attribute this to the weak data outturn for the end of last year and stress this predates any referendum related uncertainty. However, the weak data outturn does not seem to be able to account for the entirety of the downward revisions, suggesting a role for heightening uncertainty weighing on investment intentions for a few years.

Despite the aforementioned revisions, the OBR’s current projection is not out of line with many other macroeconomic forecasts for the UK economy. Figure 1 compares the OBR’s growth forecasts against those published most recently by NIESR and the Bank of England. As can be seen, differences between the three are relatively modest, especially when taking in to account the range of uncertainties which surround such forecasts.

Figure 1. GDP growth forecast and fan chart (per cent per annum)

The fiscal outlook

Downward revisions to nominal GDP have already ensured that the second fiscal target[2] of the current framework has now been missed, unceremoniously joining the third fiscal target (the welfare cap). The OBR’s downgrade to the economic outlook has unsurprisingly resulted in a noticeable shortfall in tax revenues putting pressure on the Chancellor’s ability to meet his primary fiscal rule of achieving an absolute surplus in 2019-20[3]. In the absence of any discretionary fiscal policy changes the OBR suggest that the primary target would have been missed by almost £3.2 billion in 2019-20 (compared to a November forecast for a surplus of £10.1 billion).

In order to re-establish a surplus in 2019-20, the Chancellor has announced discretionary policy changes that tighten fiscal policy by around £14 billion in that year alone. Reductions in spending via government consumption and changes to investment plans play a role, but the majority of the additional consolidation (£6.3 billion) is almost all due to a delay in the timing of previously announced corporation tax changes. These additional fiscal policy changes, focused on just one year, highlight the ‘dramatic inflexibility’ of the current fiscal rule (see the recent Treasury Select Committee report).

A rule requiring a surplus does help avoid deficit bias; however, as Portes and Wren-Lewis (2014) point out, there is a tradeoff in the design of fiscal rules between optimal policy and avoiding deficit bias.  A rule that specifically targets a surplus in the near term is severely sub-optimal because it leaves very little scope to respond to shocks and to stabilise the economy; in this case the cost of this inflexibility seems likely to far outweigh the benefits[4]. 

The fiscal outlook and the effect of monetary policy

One of the key assumptions the OBR has to make is over the path of interest rates. Their assumption of the future path of Bank Rate informs their projection for the burden on the government of interest payments due on gilts issued over the forecast horizon.

The OBR, as with the Bank of England, base their interest rate assumption on the path implied by market contracts, known as overnight index swaps. Between the July 2015 and November 2015 OBR forecasts, these contracts pushed back the moment they expected the Bank of England to increase interest rates significantly. As we discussed in November this lowered the interest rate burden on the government and was one of the key causes of the fiscal space which became available to the Chancellor.

Since November, markets have shifted seismically, with the implication being that they do not expect the Bank of England to increase rates until the end of 2019 (figure 2). There are a number of technical reasons why OIS contracts may not currently be an accurate portrayal of market expectations and may be overestimating the delay, but none the less the OBR is bound to use them in its forecast. This extremely loose path for monetary policy provides the Chancellor with an additional approximately £24 billion over the current Parliamentary term, compared the OBR’s November forecast. The latest survey by Markit, suggests that 45 per cent of households expect the Bank of England to tighten within the next 12 months. In our most recent quarterly forecast, Bank Rate begins rising in late 2016, and reaches just over 2 per cent by the end of 2019.

Figure 2. the evolution of the OBR’s Bank Rate conditioning assumption

Source: OBR Economic and Fiscal Outlooks (various editions).

The key here is that, if the OBR has doubts that the market implied path for Bank Rate is not the most likely, and is in fact too loose they must also feel that the current central path for the government finances is also too optimistic.

A final point to make is that, under the budget announced today, the government will have to issue, via the UK Debt Management Office, £190 billion of gilts over the life of this Parliament (figure 3). As part of its quantitative easing programme, the Bank of England holds around £375bn of gilts and has pledged to maintain this stock until Bank rate reaches approximately 2 per cent. Under the OBR’s forecast this does not happen in this Parliament. This means that as gilts currently held by the Bank of England mature, the Bank will use the money it receives to buy more gilts as replacements, to keep the value of its stock constant. Over the course of this Parliament this will amount to around £146 billion of additional purchases of gilts, almost entirely offsetting the issuance made by DMO. As such, the quantity of gilts available to the market in 2019 will be almost unchanged from today, despite this cumulative net issuance by the government.

Figure 3. Projections of gilt issuance and re-investment purchases by the Bank of England’s Asset Purchase Facility (APF)

Source: DMO, Bank of England and author’s calculations.

Note: This estimate is calculated by taking the nominal value of redemptions on the Bank of England’s Asset Purchase Facility’s (APF) balance sheet and multiplying it by the average price paid for the gilts bought by the APF, to date, to give an approximation of the price paid for those maturing gilts, and thus the value of purchases required for replacement.