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UK Budget Balancing Act Has to Be Credible to Markets


UK Chancellor of the Exchequer Jeremy Hunt has the unenviable task in Thursday’s Autumn statement of balancing the nation’s books without plunging it into recession. The reaction of the bond market will tell us whether he got the equilibrium right.

The size of Britain’s fiscal hole, purportedly as deep as £50 billion ($59 billion), will be revealed with the concomitant release of the Office for Budgetary Responsibility’s financial estimates. Satisfying the watchdog’s basic requirement to balance government spending with income over a prescribed time period, so that the ratio of debt-to-gross domestic product doesn’t rise, is Hunt’s primary aim. The OBR’s verdict will make or break this latest iteration of a Conservative government, as riding roughshod over economic competency was what condemned the previous Truss administration. But there is another public body Hunt has to coordinate closely with to restore stability and prosperity: The Bank of England.

The tricky bit is that the OBR’s forecasts, which feed directly into the central bank’s models, look out over five years, but the BOE’s horizon is shorter by two years. The government currently aims to balance the books over three years, though Hunt almost certainly will extend this. Any spending cuts or tax increases that Hunt pushes out beyond three years are basically irrelevant for the BOE, as it cannot model for the impact of either on growth or inflation. So to influence the BOE’s forecasts, fiscal tightening has to be front-loaded into the next two years and be large enough — tens of billions of pounds — to count.

But what makes sense economically and for market credibility may conflict with political reality, particularly if tax increases rile an already turbulent Tory party. This is where realpolitik comes in for both Hunt and Prime Minister Rishi Sunak: Choosing their poison wisely will determine the future not just of this Conservative government but how the Tory party is perceived heading into the next election, due in two years.

The ultimate test will be how Thursday’s package affects the value of sterling and gilt yields. On his way to the G-20 meetings in Bali, Sunak told reporters earlier this week that putting public finances on a sustainable trajectory is essential to “deliver on the expectations of international markets.” The government is well aware that it can’t afford to trigger the kind of gilt market meltdown that brought down Liz Truss after just 44 days in office.  

Hunt will no doubt use some sleight of hand to push out spending cuts as far out as is credible on the OBR’s five-year timeline. Fiscal drag — not matching spending rises to inflation, and leaving tax thresholds unchanged so real incomes fall — is the stealthiest route. Such opaque measures are far from an honest solution; but promising to be frugal after the next election won’t pass muster. 

So there needs to be a sufficient increase in short-term revenue from a higher tax take combined with enough spending restraint to keep the gilt market calm. The BOE needs to feel confident that a firm grip on public finances will complement its efforts to restrain double-digit inflation. Only then can it start to ease up on the pace of interest-rate increases.  

With the current energy-price cap scheduled to expire in April, the reduced but still substantial cost of a tapered replacement focused on the most needy, which should be announced on Thursday, will also have to be factored in to consumer price forecasts. As Ana Andrade and Dan Hanson of Bloomberg Economics put it this week, “Hunt has a bigger say over 2023 inflation than the BOE.”

But Hunt will also want the opportunity to offer some relaxation from the relentless drumbeat of austerity ahead of the election. It’s going to take some ingenuity not to be too “eye-watering” with this week’s fiscal tightening, as Hunt has repeatedly warned. He has certainly prepared the ground that everyone will be paying more tax, and in a multitude of ways. 

The gilt market will be keeping a close eye on the government’s borrowing needs for the remainder of this fiscal year. There may be some small reduction in the net cash requirement, allowing fewer gilts to be sold up to April. However, Hunt may choose not to ease up on debt sales, knowing next year’s needs will be far greater. A Bloomberg survey of five gilt dealers showed an average expectation of £250 billion of issuance in the next financial year; on top of this, the BOE is expected to sell around £50 billion from its QE stockpile, with a similar amount not reinvested on maturity. The OBR’s forecasts will set the tone longer-term for how the bond markets cope with increased supply. 

The more Hunt can do now to tighten the fiscal stance, the less the BOE will need to do on the monetary side. Unfortunately, taking too much fiscal pain up front will crash the economy into a worse recession than it is already likely in, weakening the pound and deepening the hole the government is trying to escape from. It won’t be easy to close the fiscal gap without damaging near-term growth, at the same time as rampant inflation needs to be curbed. But having the government and the central bank on the same page, under the careful scrutiny of the independent OBR watchdog, would be a good place to start. 

More From Bloomberg Opinion:

• Will Sunak Test the Love of Britain’s Top 1%?: Therese Raphael

• Cost-of-Living Crisis Is a Slow Burn for UK Consumers: Andrea Felsted

• British Families Are Being Hit by Stealth Taxes: Stuart Trow

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.

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