The economy seems to have picked up, but we have yet to earn tax cuts
All of a sudden, the narrative on the economy has shifted. Things may even be looking up. One swallow does not a summer make, so we should be careful not to read too much into January’s better-thanexpected outcome for the public finances.
January is the deadline for the previous financial year’s tax returns, and is therefore always a bumper month for receipts. None the less, the £5.4bn surplus unveiled last week completely blindsided most analysts, who had widely expected a deficit. If you really want to know what’s going on in the economy, look at tax receipts, which will give you a better idea than almost anything else. And right now they tell you that maybe things are not quite as bad as they seem.
Jeremy Hunt, the Chancellor, rushed to downplay the surge, but it didn’t stop the usual chorus of calls for immediate tax cuts.
Among loyalists of the former prime minister Liz Truss, there is a growing sense of vindication. “We told you that the public finances were not nearly as bad as the Office for Budget Responsibility and others were saying,” one tells me. “And we were right.”
Compounding the sense of vindication was the OBR’s admission that it had made a mistake in its November forecasts in the way it had accounted for profits and losses on the Bank of England’s quantitative easing programmes.
The details – accounting mumbo jumbo that makes no practical difference to the still dire overall state of the public finances – needn’t concern us here. All the same, the mistake explains a significant part of the error in forecasting, and has therefore given ammunition to those who argue that by limiting the Chancellor’s scope for action, the OBR is a destructive influence on public policy.
Nor is it just the public finances that are looking better than expected; there is a definite spring-like feeling in much of the data right now.
Stocks are up, consumer confidence is recovering, house prices are proving amazingly resilient in the face of rising mortgage rates, inflation and energy prices are falling, the jobs market remains relatively buoyant and there is even some prospect of an easing in trade tensions with Europe, resolution to Northern Ireland Protocol talks allowing.
It is possibly still too early to say with any conviction “that was the recession that never was”, but the shift in narrative is undeniable. How come?
Primarily it’s about two things: energy prices have come right back down again, and so have market interest rates. These factors alone ought to very considerably ease the pressures on household balance sheets, leaving more money to spend than was feared.
We narrowly escaped a technical recession in the second half of last year, and it is now eminently possible there won’t be one this year either. But whether the economy is again off to the races is, unfortunately, a lot more questionable. The immediate outlook is still for very low growth, if any at all.
Wholesale gas and electricity prices have indeed come down a lot. Regrettably, this will make no immediate difference to household energy bills, which are still set to rise from an average of £2,500 to £3,000 at the end of next month regardless. The Ofgem price cap works with a lag effect.
But it does make a difference to the amount of government subsidy, which no longer needs to be as big as previously thought. As those lower wholesale prices work their way through to the retail market, bills ought to fall rapidly, possibly sinking to not much more than £2,000 from mid-year onwards. This would still be well above what used to be the norm before Putin’s war, but is none the less quite a fall from current levels.
As for interest rates, that’s a little more complicated. Market rates are well below the levels they surged to after last autumn’s disastrous miniBudget. But Bank Rate may not yet have reached its peak. According to calculations by Capital Economics, moreover, only about a third of the dampening effect of increases in Bank Rate has so far been felt.
This is because many mortgage holders are on fixed-rate deals. For now, they are protected from rising rates. That cushion will progressively disappear as fixed terms expire.
What’s more, if the economy turns out to be somewhat better than expected, then the Bank of England will have to work harder to rein in excessive inflation. Bank Rate will have to be higher for longer.
Even in the short term, then, you’d be unwise to bet on a rapid rebound in the economy. Household budgets will remain squeezed at least until the middle of the year.
The further into the future we look, the more unreliable the forecasts become. Yet one thing the OBR will certainly be doing ahead of next month’s Budget is adjusting its assumptions on the size of the labour force.
The old premise was that labour market participation would slowly recover to where it was before the pandemic. And there has indeed been some improvement of late – but not by nearly as much as expected.
For a variety of reasons, many people of working age appear to have left the labour market for good. Whatever the Chancellor does by way of measures to tempt them back in again, eventually it has to be accepted that the pandemic permanently shrank the workforce.
The already poor outlook for business investment has also quite plainly deteriorated further. The great hope for the future was investment in the green energy transition, but what chance for Britain against Joe Biden’s Inflation Reduction Act, which is sucking up all the available capital.
It may be unwarranted, but as I have remarked before, the mood music around Britain’s long-term growth prospects is particularly bad right now. With international capital increasingly giving the UK a wide berth, there could scarcely be a worse time for either the planned rise in corporation tax, or the related expiry of the so-called “super deductions” regime.
These factors are important because they affect economic potential, or the country’s ability to grow without triggering inflation. The OBR’s medium-term growth forecasts will be adversely affected accordingly.
Hunt could reasonably take these predictions with a pinch of salt. They are almost bound to be wrong in some regard. But he would be ill advised to do so given the recent experience of Trussonomics.
He desperately needs to do something to revive business investment, but if he does it through unfunded tax cuts, he risks the very same surge in interest rates that doomed Truss. He’s damned if he does and damned if he doesn’t.
Last month’s improvement in the public finances appeared to offer a glimmer of hope. But until wider structural deficiencies in the UK economy are fixed, it is all too likely to prove a mirage.
‘The further into the future we look, the more unreliable the forecasts become’