Hollywood or bust Budget

This is a Hollywood or bust Budget, providing some broad-based crowd pleasers ahead of an election next year, but sailing very close to the wind with the public finances. Any small adverse changes to the forecast, or unforeseen economic shocks, could see the Chancellor scrambling to meet his target to have debt falling as a percentage of GDP in five years’ time, which would likely mean tax rises or public spending cuts in the medium term. The Exchequer has left itself just £6.5 billion of headroom, the smallest any Chancellor has had since the OBR was created in 2010, which the watchdog reckons leaves him with a 52% chance of meeting his primary fiscal target. Jeremy Hunt will therefore have both his fingers and toes crossed that this coin toss lands in his favour.

The dials of the UK economy have definitely turned in the right direction since November, with the OBR now forecasting the UK will avoid a technical recession this year. In five years’ time the economy is also forecast to be a bit bigger, though that is because of better growth in the immediate future, with longer-term growth actually being downgraded. The improvement in the short-term outlook is partly a reflection of the crisis the country faced when the Chancellor delivered the Autumn Statement, in the wake of the dramatic market movements precipitated by the mini-budget. Since then, interest rate expectations have fallen, as have wholesale energy prices, and both the economy and tax revenues have proved more resilient than expected. The result is a little pot of money the Government can now spend without quite breaching its latest set of fiscal rules, which themselves are a little less stringent than their previous incarnation.

Inflation clearly remains a key challenge for the UK economy right now, but the OBR actually thinks this trend is going to reverse pretty spectacularly, with CPI inflation hitting 2.9% by the end of this year, falling to 0.1% in 2025. After double-digit rates of inflation, this might sound like a nice cold shower to someone who’s been stuck in a sweatbox for a year, but, in fact, such low inflation suggests wider weakness within the UK economy. CPI inflation falling almost 2% below target also implies that the Bank of England is overegging the pudding when it comes to slowing the economy through interest rate rises. The SVB collapse last week has caused some to lower their expectations for interest rate rises here and in the United States. But while the SVB failure will no doubt give pause for thought, it would be strange for this to cause central banks to take their eyes off the prize of containing inflation. It would effectively be an admission that banking regulation isn’t robust enough to withstand tighter monetary policy, even if that is what the economy requires.

However, the rate-hiking cycle is drawing to a close of its own accord in any case, and we are now largely left to wait and watch the effect of the dramatic interest rate rises of the last year, as they ripple out into the real economy. SVB, LDI pension funds, and annuity-hedging funds are all casualties of the interest rate tide going out, and in time we may well find others have been swimming naked too. Indeed, the 4 million UK households who are expected to face higher mortgage payments this year are no doubt feeling pretty exposed. We also shouldn’t forget that a raft of tax rises is still heading down the track toward UK consumers. Income Tax thresholds will continue to be frozen this year, and cuts to tax-free dividend and capital gains allowances are arriving from April too. The OBR is still projecting that the tax burden will reach a post-war high of 37.7% of GDP in 2027-28. Interestingly the Treasury is also stepping up its targeting of crypto asset profits, adding in a specific section for crypto on the self-assessment tax return. This suggests the taxman thinks not enough people are paying tax on their crypto profits, though the changes to the tax return might have been a tad more lucrative when Bitcoin was trading at record highs.

The Treasury may also feel pretty vulnerable to interest rate risk, because higher rates also increase the cost of fresh borrowing for the Government, and more consequentially the interest payable on the £826 billion of gilts held within the QE scheme by the Bank of England. Despite the improvement in tax revenues and lower borrowing, the Government is still hugely indebted, and this hangs a millstone around their neck which is even heavier now interest rates have climbed from historical lows.

The series of economic shocks endured in the last few years clearly plays a large part in the sizeable debt burden assumed by the Exchequer. But the rolling nature of the fiscal targets set by the Government don’t help either, because the day of financial reckoning never actually arrives, allowing Chancellors to continually play lefty-loosey with spending in the short term, and righty-tighty in the long grass. Significantly reducing the debt pile is desperately difficult, and arguably not politically or economically feasible during a cost-of-living crisis. But the debt itself is not inert, requiring interest to be paid, which is taxpayer money that could be spent elsewhere. The OBR reckons that servicing debt interest will rise to 7.8% of Government revenues by 2027-28, up from 3.1% in 2020-21. Grasping this nettle is going to be extremely painful, but at some point, someone is going to have to do it.

You can find further information in the latest Budget and OBR report.