The Autumn Statement
The UK’s Chancellor of the
Exchequer presented his Autumn Statement last Tuesday.
His independent Office for Budget Responsibility (OBR)
downgraded economic growth prospects, partly due to
higher than expected energy prices and their effect on
the GDP deflator. He made much play about why his
sensible approach ensured interest rates remained low,
unlike those in most European countries.
Interest rates are a wild-card, and
in this respect the Chancellor is surely tempting
providence. For the fact is that interest rates are only
as low as they are because the Bank of England is
funding the Government’s borrowing more cheaply than the
free market would on its own, given the size of the
borrowing requirement. That is the difference between
Italy and Britain, not as the Treasury tells us. But
then the Treasury has a long history of not
understanding markets, as those of us who were around in
the 1970s will remember.
In that socialist era the
government of the day frequently maxed-out its credit
with the markets. This would encourage sharp slides in
sterling which would disrupt the sales of gilts. The
result was that money supply, without the sterilisation
of bond sales, would take off, driving sterling yet
lower and making it harder for the government to borrow.
The Bank of England, which in those days was under
direct Treasury control, would respond with interest
rate rises, which were always too little too late.
Eventually, the Treasury would give in and sanction a
rise in interest rates high enough to satisfy the most
bearish expectations. That is how we ended up with 12%,
13½% and 15¼% coupons on twenty year gilts and a poorly
performing economy which staggered from crisis to
crisis.
The solution was only resolved by
gilt yields rocketing to sufficiently high real rates
adjusted for inflation. How different it is today! The
market turns a blind eye to negative real yields for
gilts against a background of record debt issuance, but
this will not continue for ever. The budget deficit is
forecast to be 8.4% of GDP in the current year, and
outstanding government debt will be at 67.5% and rising.
Compared with European states and with a reasonable debt
maturity profile it perhaps doesn’t look so bad. But as
Italy found out, the fact that there are countries in a
worse position does not guarantee you will escape the
market’s attention for long.
Tucked away in the Statement was an
extraordinary bit of wishful thinking, which perhaps
explains the Treasury’s optimism about interest rates:
the rate of CPI-measured inflation is forecast to fall
from 4.6% in the current fiscal year to 2.4% next, and
2% thereafter. These estimates are central to
everything, but so far the forecasting record for price
inflation has been very poor. If inflation turns out
higher than forecast, the GDP deflator will again be
higher than expected, to the detriment of real GDP. And
if real GDP undershoots, the budget deficit will not
fall as forecast.
The set-up for a repeat of the
funding crises of thirty years ago is in place, and it
is only a matter of time before markets understand this.
The OBR’s inflation forecasts are exposed to +further
rises in energy and food prices, and sterling weakness.
All we need is for Europe to slip out of the headlines,
which it eventually will, for the focus to swing to
Britain.
Alasdair Macleod
1 December 2011
