June 2010 Budget - Treasury Contents

 
 

 
2  Macroeconomy

The overall growth forecast

9. There have already been three UK Government economic forecasts in 2010. One forecast was produced by the previous Government in the March Budget Report (the March Budget forecast)[8], and two forecasts were produced by the newly founded Office for Budget Responsibility (OBR), on 14 June 2010 (the June Pre-Budget forecast) and 22 June 2010 (the June Budget forecast).[9] The OBR's GDP growth forecasts can be seen in Table 1 below.
Table 1: GDP growth forecast (Percentage change on a year earlier)  
   
2009
 
2010
 
2011
 
2012
 
2013
 
2014
 
2015
 
Pre-Budget Forecast  
-4.9
 
1.3
 
2.6
 
2.8
 
2.8
 
2.6
 
 
June Forecast  
-4.9
 
1.2
 
2.3
 
2.8
 
2.9
 
2.7
 
2.7
 
Source: OBR Pre-Budget forecast, June 2010, p 26, Table 3.3; June 2010 Budget, pp 4, Table C2  
          

The OBR warned however that a comparison between the June Pre-Budget forecast and the June Budget forecast may be misleading:

The pre-Budget forecast does not provide a firm basis for an estimate of the effects of the Budget measures on the economy because the pre-Budget and Budget forecasts are both based on market expectations of interest rates. These are likely to have incorporated some expectation of further fiscal tightening but it is impossible to judge how much [...]. This may have introduced an upward bias into the pre-Budget forecast and make comparison misleading.[10]

These caveats should be borne in mind in reading the following section.

IMPACT OF THE JUNE BUDGET

10. The June 2010 Budget proposed a significant fiscal consolidation above that envisaged in the March 2010 Budget of the previous Government. There is concern that such a consolidation may come too early and cut too deeply, and as such cause the economic recovery to falter, leading to a "double dip" recession. As the June 2010 Budget acknowledges, the impact of the fiscal consolidation is uncertain:

The overall economic impact of fiscal consolidation depends on the combination of:

  • direct and indirect effects, from reduced public spending or increased taxation. These will tend to reduce demand growth in the short term; and
  • wider economic effects, which depend on the reaction of the private sector and monetary policy to the changed fiscal environment. These will tend to boost demand growth, could improve the underlying performance of the economy and could even be sufficiently strong to outweigh the negative effects.[11]

11. When we questioned the OBR as to whether the June Budget had increased the chance of a "double dip" recession, Mr Dicks replied that:

We discourage, you will see in the Red Book, from making these direct comparisons but there are some Budget measures which will have reduced demand and, in aggregate, between our pre-Budget and post-Budget forecasts, we have taken 0.5% off GDP. So the near-term outlook for GDP is not as good as it was before the Budget. I still do not think that will mean a double-dip, but logically the chances of that happening have increased.[12]

Mr Barrell explained that because of the change in the central projection, the fan of possible outcomes around that central projection had also moved. And since the forecast had weakened near-term growth, slightly more of the fan would now be negative.[13] He therefore suggested that this meant that "the probability of a double-dip recession has risen by 4%, or some such number".[14]

12. Mr Bootle, of Capital Economics, considered that it was unhelpful to think of a "double dip" recession, replying that "I think the more meaningful thing is: is growth going to be significantly weaker or stronger than the forecasts over the period? I think the Budget has increased the chance that growth will be significantly weaker over the forecast period."[15] When asked to quantify by how much his central projection had changed, he replied:

You know there is no certainty in this, but, for the sake of argument, the emergency Budget forecast for next year suggests that the economy will grow by about 2.3%. My own forecast is more like 1.5%. It is difficult to be precise about how much the Budget itself has reduced growth prospects, not least because so much depends upon what happens to monetary policy and bond yields, and on that of course there can be umpteen different views.[16]

13. Mr Clarke, of BNP Paribas, told us that:

Just to keep this in context, I am forecasting 1% growth, the OBR 2.3%, and the most optimistic person in the consensus is looking for 3.2%, so the OBR is in the middle of the road. [...] for the economy to go about 2.3% and then almost 3% the year after that, the newspapers said this was going to be the most painful Budget in living memory. Well, 2.3% and then 3% is not painful at all. I think a quarter on quarter growth could get down to about zero, but then we recover from there. That is not a double dip, that is a soft patch.[17]

Mr Dicks defended his central GDP forecast, telling us that:

Our forecasts at least for this year and next are in line with the consensus, bang in line with the consensus, 1.2 this year and 2.3 next year, and I think the consensus is either 1.3 and 2.2 or something like that. In the medium term, we are a little bit more optimistic than some forecasters, but by then the recovery, we believe, will have got some momentum, not just in the UK, but elsewhere, and we do think that the forces of recovery will gather strength.[18]

14. The Chancellor strongly denied that his Budget was placing the economy at risk. He told us that:

I would say I am reducing the risk faced by the British economy. When I became Chancellor of the Exchequer the country had the highest budget deficit in the G20, the second highest in the European Union after Ireland, the credit rating agencies of the world had raised serious questions about Britain's credit rating and our market interest rates were similar to those of Spain. In the last eight or nine weeks there has been a general view around the world that Britain has taken decisive action to deal with its budget deficit. [...] I think it is worth drawing the Committee's attention to what has happened to market interest rates for the United Kingdom since the March Budget. Ours have fallen by half a per cent and Spain's have increased by half a per cent. That is a very significant monetary stimulus to the economy and also has helped to deal with the tail risk which the OBR draws everyone's attention to in its report but says it is not possible to put in its growth forecast.[19]

15. Although there are problems in comparing the OBR's two forecasts, it appears that there has been a slight increase in the chance of near-term negative growth and an increased likelihood of positive growth in the outer years. We will continue to monitor the macroeconomic environment, through our regular hearings with the Bank of England and the Office for Budget Responsibility.

Rebalancing the economy

16. Rebalancing is a term applied to a variety of distinct concepts. For example, it can be used to cover a change in allocation of resources between public and private sector; changes in the balance between imports and exports, both at a national level and between nations; changes in the extent to which consumers spend or save; changes in the relative importance of particular industries or sectors in the economy or changes in economic activity between different regions

17. In the June 2010 Budget, the Treasury noted that the OBR in its June Budget forecast suggested a rebalancing in the UK economy "with net exports and business investment making a greater contribution to growth than in the recent past, and government spending making a negative contribution to growth as fiscal consolidation is implemented".[20] The Treasury went on to assert that "This is a crucial part of the rebalancing of the economy that is required for a sustainable recovery."[21] The Chancellor reiterated his desire to rebalance the economy, telling us that he wanted "to create over the longer term an economy that is not so dependent on household debt, overleveraged banks, over indebted government, but where we invest more and we export more, and I think that is going to be a more stable economic model for this country going forward".[22]

18. Table 2 outlines how the different parts of the economy will contribute to GDP growth over the June Budget forecast horizon. As can be seen, from 2011, business investment and net trade are the drivers of this rebalancing, and so we discussed with witnesses the risks around the OBR's forecast for these two contributors to GDP growth.



Table 2: Contributions to GDP growth1  
         
   
Percentage points, unless otherwise stated
 
      
Forecasts
 
   
2009
 
2010
 
2011
 
2012
 
2013
 
2014
 
2015
 
GDP growth, per cent  
-4.9
 
1.2
 
2.3
 
2.8
 
2.9
 
2.7
 
2.7
 
Main contributions           
Private consumption  
-2.1
 
0.2
 
0.8
 
1.1
 
1.3
 
1.4
 
1.4
 
Business investment  
-2.1
 
0.1
 
0.8
 
1.0
 
1.1
 
1.1
 
1.0
 
Dwellings investment2  
-0.6
 
-0.2
 
0.2
 
0.2
 
0.3
 
0.2
 
0.2
 
Government3  
0.8
 
0.3
 
-0.7
 
-0.6
 
-0.6
 
-0.6
 
-0.4
 
Change in inventories  
-1.2
 
1.2
 
0.4
 
0.0
 
0.0
 
0.0
 
0.0
 
Net trade  
0.7
 
-0.5
 
0.9
 
0.9
 
0.7
 
0.5
 
0.5
 
Source: June 2010 Budget, p 85, Table C3           
1 Components may not sum to total due to rounding, omission of transfer costs of land and existing buildings, and the statistical discrepancy  
 
2 The sum of public corporations and private sector investment in new dwellings and improvements to dwellings.   
3 The sum of government consumption and general government investment.       

NET TRADE

19. Despite a significant devaluation in sterling, Table 2 shows that net trade is forecast to make a negative contribution to GDP growth in 2010. The OBR explained that "Net trade is forecast to subtract from growth in 2010, as relatively robust import growth outweighs still-sluggish exports".[23]

20. Table 2 also shows that from 2011, net trade is forecast to make a significant positive contribution to GDP growth. Given the performance of net trade in 2010, we questioned whether the forecast contribution to GDP growth from net trade from 2011 onwards would actually materialise. Mr Barrell explored the outlook for exports:

Over the next year or two, there are serious risks from our major market, the European Community. We have seen a major decline in the value of sterling against our competitors in the last two years and that will eventually feed through into stronger volumes, and I base that not on comparisons with previous recessions, but just on the standard statistical work we do all the time on the relationship between relative prices, the level of demand and the level of exports. Exports at some point or other will take off, but it could take two or three years for the effects to feed through, so it will happen slowly, we think.[24]

21. Mr Dicks, defending the OBR's forecast, told us that, on the imports side "we have a pretty downbeat forecast for domestic demand—and particularly consumer spending—so we are not going to be sucking in imports",[25] and that on the export side:

I agree it is disappointing so far. Exporters seem to have taken the depreciation of sterling on their profit margins, but that is always—and has been in the past—the first stage under which you get a supply side response. Profitability of exports has improved; we are more competitive overseas. [...] We have looked in detail at the recovery of the 1990s and 1980s, trying to draw comparisons, and the forecast that we have this time round, generally, is a pale shadow of the recoveries we saw in the 1990s and 1980s. We are quite comfortable, given the headwinds, given problems in the financial sector, that the outlook is weaker, but only in degree. I would expect the shape of this recovery, including a strong contribution from net trade, which was your question, to be of an order of magnitude similar to what we have had before.[26]

Mr Ramsden was also sanguine about whether the increase in exports would be seen. He told us:

You were asking are there doubts that we are going to see this export performance. This is something that we monitor, as we have been doing, from one month to the next and one year to the next. Experience in the UK shows that it takes time for the volumes to adjust, but they do adjust and the UK has adjusted in the past and moved on to a stronger export trajectory.[27]

22. We also questioned whether the forecast for the contribution of net trade to the GDP growth forecast took sufficient account of the pattern of UK trade. Our major trading partners are in the more developed countries, whereas recent economic growth has been seen in the emerging market economies. Mr Dicks felt that the OBR forecast had taken account of the risk presented by this development:

Our forecasts for the euro area are below the consensus, so I agree with you there that—well, we are not getting a lot of help in terms of our export markets from our largest export market, but that is part of our central forecast.[28]

Mr Ramsden also accepted that "the emerging markets that have been growing more strongly than the developed world", and that the pattern of UK trade was not ideal :

the UK has a trade pattern which is very significantly determined by history. For example, that means one of our biggest trading partners is Ireland given our very close links with Ireland over centuries. It is a feature of the UK economy, which was something I was quite struck by when I was analysing the data, that in terms of shares of trade our share of trade with the rapidly growing and emerging economics, the BRICs—Brazil, Russia, India and China—is about 5% or 6% whereas it is about three times that with the euro periphery economies. I have mentioned Ireland but we also have strong trade links with others. That share with the emerging market economies has grown very significantly in recent years. I think it has doubled compared with 2000 when it was 2.5% and it is now just over 5%.[29]

Mr Ramsden went on to note though:

Government policy is very much focused on looking for the opportunities, and this is something that the Treasury as an economics ministry is very focused on thinking about, how can we encourage stronger growth both in terms of macro policy settings but also whether there are any micro policy interventions.[30]

The Chancellor also emphasised the Government's intention to explore trade relations with emerging economies:

The Prime Minister is leading a large delegation to India, an incredibly important export market for the future, in order to try and kick-start a better trade relationship with India. I think it is a striking fact about the British economy that we export more to Ireland than we do to Brazil, India, China and Russia put together. There is certainly scope as the world grows and these emerging economies become larger and become nations of consumers for British exports to those markets.[31]

23. We note that despite a significant sterling devaluation, net trade is currently not expected to contribute positively to GDP growth in 2010. The OBR forecasts a significant increase on the path of net trade but there are differences about the speed of change.

BUSINESS INVESTMENT

24. As part of the forecast rebalancing of the economy, business investment is expected to make a significant contribution to GDP growth (see Table 2). The OBR forecasts that in 2012, business fixed investment will grow by 10.0% on a year earlier, rising to 10.9% in 2013.[32] There is a significant risk to the overall GDP growth forecast if business investment is not as robust as predicted. As Professor David Blanchflower, a former external member of the Monetary Policy Committee, wrote, "It is unclear whether firms will increase investment, but for the Government's Budget to succeed, it is vital that they do."[33]

25. Mr Dicks considered the forecast reasonable. We questioned whether there would be the bank lending available to support such strong forecasts for business investment. Mr Dicks replied that:

it is a well-known statistic that something like 80% of all investment is done by 20% of the largest companies who, typically, finance it from internal resources. You could say exactly the same question to me about the first quarter: how come business investment was up 7.5% at a time when the banks are not lending? I think that is part and parcel of the internal financing investment argument, and the private non-financial corporate sector has built up £100 billion of net assets over the last two years; they are not cash-poor. We think[...] the fact that it fell such a long way means it has got a long way to come back relative to GDP before you get to a normal investment to GDP ratio.[34]

Mr Ramsden considered the current economic environment supported business investment, noting that "We have very, very low interest rates both at the short end and the long end which businesses can borrow at. As I think you heard earlier, large businesses have rebuilt their cash positions and they are in a good position financially".[35] Mr Ramsden also felt that one of the key determinants for holding back business investment was uncertainty, and that the Budget had taken steps to reassure businesses:

There is a supportive economic environment with the surveys suggesting that quite a lot of investment is being held back because of lack of confidence about the future. That is not surprising when you think of the crisis that the UK and world economies have been through. It was a crisis of confidence through the winter of 2008 and early 2009 and businesses have been affected by that. When you look against that kind of backdrop and those kinds of drivers in 1995 UK business investment grew by 7.8%, in 1996 by 10.4% and in 1997 by 10%. You get significant growth rates in business investment for a number of years because after a shock like we have had, and which the economy saw to a lesser extent in the early 1990s, there is a need to rebuild the capital stock, there is a need to invest and if the environment is there to do it with low cost of capital it can do it. [36]

26. Mr Ramsden and Mr Dicks also thought the cuts in corporation tax would contribute to business confidence.[37] Indeed, Mr Ramsden said the Budget provided certainty about:

the business investment regime over the whole period of this Parliament and four years of cuts in the main rate of corporation tax. One thing we get back very strongly from businesses when we discuss with them is that they want stability and certainty in this kind of regime. I think that the corporation tax reforms are strategic, have given them that certainty and macro conditions stay supportive. [38]

Employment

27. On 30 June 2010, the Office for Budget Responsibility (OBR) published a forecast for General Government and private sector employment. On 13 July 2010, the day of our hearing, the OBR released further information on a change in methodology for general government employment forecasts, between the pre-Budget, and Budget forecasts, which then allowed a comparison.[39] Table 3 brings together in summary these separate forecasts.
Table 3: OBR Employment forecasts          
               2010-11  2011-12  2012-13  2013-14  2014-15  2015-16  
General Government average earnings growth  Pre-Budget forecast  2.3%  1.7%  1.9%  2.5%  2.7%     
 Budget forecast  2.3%  0.8%  0.8%  3.1%  3.1%  3.1%  
General Government employment growth  Pre-Budget forecast  -0.1%  -2.4%  -2.9%  -2.0%  -1.4%     
 Budget forecast  -0.1%  -1.2%  -1.3%  -3.0%  -3.7%  -2.4%  
General Government employment level (Millions, end of financial year)  Pre-Budget forecast  5.53  5.40  5.24  5.14  5.07     
 Pre-Budget forecast1     5.49  5.43  5.35  5.20     
 Budget forecast  5.53  5.47  5.39  5.23  5.04  4.92  
Whole economy Employment  Pre-Budget forecast  28.93  29.17  29.47  29.77  30.02     
(LFS measure, millions, end of financial year)  Budget forecast  28.89  29.08  29.36  29.69  29.97  30.23  
Source: OBR Forecast: Employment, 30 June 2010; OBR: General Government Employment Growth Forecasts, July 13 2010   
1 Hypothetical Estimated Pre-Budget Forecast under Budget assumptions       

28. We are conducting another inquiry into the formation of the Office for Budget Responsibility, where we will consider the impact of the release of these forecasts. The release on 30 June led to political controversy about the effects of Budget measures on employment, based the mistaken assumption that the first two projections were based on similar assumptions. As Sir Alan Budd noted, "In retrospect, I wish that we had provided more information and a specific warning against using the numbers to estimate Budget effects".[40] It is unfortunate that the independence of the OBR has been called into question. This makes it all the more important to get the structure and the statutory basis of the permanent organisation right, as the both the OBR and Chancellor recognise. We will consider in our inquiry into the OBR what further steps need to be taken to ensure its independence.

29. The OBR's June Budget forecast suggests that between 2010-11 and 2014-15, whole economy employment will rise by around 1.08 million. In the same period, general government employment will fall by around 0.49 million. As such, the OBR is forecasting growth in employment outside General Government of around 1.57 million, a significant rebalancing of employment between the public and private sectors.

30. Commenting on the release of the OBR's employment forecasts, Dr John Philpott, Chief Economic Adviser at the Chartered Institute of Personnel and Development (CIPD), noted that "The OBR forecast for public sector employment to 2015-16 is close to that made by the CIPD both before and after the General Election. By contrast, however, the OBR forecasts for growth in total employment look optimistic."[41] He noted that:

a dynamic economy with almost 30 million people in work, which in a normal year is capable of more than making up for the 0.5 million jobs lost as a result of annual improvements in labour productivity, should be able to cope with a phased period of large scale public sector downsizing without this resulting in higher unemployment. But a favourable outcome depends on a return to health of the wider economy and increased demand for labour from the private sector. The conditions necessary for such a favourable outcome are at present far from self-evident and unlikely to emerge simply as a consequence of swifter and tougher action to reduce the deficit. [...] the employment outlook is likely to be far weaker than the OBR forecasts and the coalition government hopes, with a rise in unemployment toward 3 million in the next two years a distinct possibility.[42]

Mr Clarke also questioned the hiring capacity of the private sector:

In what sectors will the jobs be coming? Manufacturing has done quite well for now, but a lot of the upstream indicators are turning down, so I do not think they will have such a good run over the next 12 months or so. The services sector has fared a little bit better, but I do not think there is going to be as much hiring as the OBR assumes because I do not think we will be growing in excess of the economy's trend growth and, when that is the case, you tend to have job losses.[43]

However Mr Dicks strongly defended the forecast of the OBR, and explained that:

[...] we have had fiscal consolidations before, a relatively minor one in the 1980s and a stronger one in the 1990s. If you look at our employment forecast as an example, we are forecasting 5% employment growth over the next six years. In the fiscal consolidation of the 1990s, which was similar in magnitude, the deficit went from 7.7% of GDP to a small surplus, so a similar sort of deficit reduction programme, we had employment growth of 7%, and in the 1980s we had 13%. Now, I am sorry to keep coming back to what has happened before, but it is the best guide. We are in a big fiscal consolidation and previous fiscal consolidations have not derailed the recovery, and I do not think this one will either.[44]

Sir Nicholas Macpherson, Permanent Secretary to the Treasury, also told us that "The economy is now recovering and employment, as the figures released yesterday confirmed, is rising and the conditions look pretty good for the labour market. There are good grounds for confidence."[45]

31. The OBR's publication of forecasts for employment is new and welcome. We note the forecast of both considerable public sector job losses, and strong private sector hiring. This forecast depends on the assumptions in the wider forecasts, and is subject to the same risks. We will continue to monitor the impact of reforms on the labour market.

PART-TIME AND YOUTH EMPLOYMENT

32. We questioned the Chancellor on the impact of the recession on full-time employment. The Office for National Statistics released its Labour Market Statistics on 14 July 2010.[46] It noted that while part-time employment increased, there was a fall in full-time employment:

The number of people in employment increased by 160,000 on the quarter to reach 28.98 million. The quarterly increase in total employment was mainly driven by part-time employees, which increased by 117,000 on the quarter to reach 6.63 million, and self-employment, which rose by 59,000 on the quarter to reach 3.93 million. The number of full-time employees fell by 22,000 on the quarter to reach 18.20 million.[47]

Responding on the rise in part-time working against the fall in full-time working, the Chancellor noted that:

A feature of any recession is that people move on to part-time work and partly that is a reflection of labour market flexibility. Of course, coming out of recession into recovery you want people who are working part-time who want to be able to work full-time, and of course there are people who want to stay working part-time, to have the opportunity to do that. One of the measures which I have not mentioned so far, but essentially one of the largest items that we had in the Budget, is an increase in the employers' National Insurance threshold by £21 which will make it cheaper to employ people earning less than £20,000 than it is today and, indeed, cheaper across the income spectrum compared to the plans that I inherited from the previous government. We are making it easier for employers to take people on and reducing the burdens on employment and as we come out of recession into recovery we want to see people who want to move into full-time work.[48]

When questioned on the steps that need to be taken to tackle youth employment, he noted that:

The big policy change here is a more effective welfare system. My colleagues in the Department for Work and Pensions are working on the Work Programme which we believe will provide more effective help than existing schemes have to help in particular young people get into sustainable jobs, in other words not to find themselves constantly recycled through government training programmes and possibly hold work for 13 weeks only to drop back into unemployment in the 14th or 15th week. Using the plan that was originally developed by Lord Freud for the previous government, but not implemented, and being less theological about the division between DEL and AME, and by increasing the diversity of providers for Welfare to Work schemes and increasing the incentives on them, I think we will have better targeted and more effective support for younger people who are currently unemployed. You are quite right to draw everyone's attention to them because we have one of the highest youth unemployment rates in Europe.[49]

MIGRATION

33. We also sought information on the level of migration forecast over the period, and its impact on trend output. Mr Dicks told us that the OBR's migration figure was "based on the ONS's best migration projection statistics". He noted that "It was as high as 190,000 before, so we are assuming that the overall economic environment will not be so conducive to inward migration, but 140,000 or thereabouts will still be coming."[50] Mr Barrell told us that:

We judge that perhaps the recession and the scar on output will reduce the stock of migrants in the UK by about 350,000, and that is a permanent shock and there are two reasons for that. Countries such as Poland, Australia and the Indian Sub-Continent have actually suffered less in this crisis than we have and people are less willing to come. Secondly, the Poles who have gone back, and it is the Poles in particular who are interesting, came here because we, the Irish and the Swedes were the only people who allowed them to work. When they start to come back as the whole of the European economy recovers, they will have the German, the French, the Italian and the other markets open to them, so they will not all come back here, so we are unlikely to see such a large rise in the number of migrants after the recession as we have seen beforehand, so I suspect a lot of those jobs will not be taken by Poles because they can earn more in Germany than they can in the UK [...] I personally would revise my projection downwards and, if downwards, that is a larger impact on the stock of migrants than we previously thought.[51]

34. When the Chancellor was asked whether migration was the "stimulant for growth", he told us that "I am working on the assumption of is that our Welfare to Work reforms will increase the incentives to work in this economy, will get people off out of work benefits, on which too many people sit permanently, and ensure there are British people of the skills and ability to take on some of the jobs that previously went to people who came as economic migrants to this country".[52] The Chancellor also noted that the Government "has a plan to put a cap on economic migration", and Mr Barrell concluded that changes in policy to reduce migration would also have an effect.[53]

Inflation and Monetary Policy

35. Monetary policy remains loose in the United Kingdom. The official Bank Rate is currently set at 0.5%, and has been since 5 March 2009.[54] Quantitative easing remains in place, as the Monetary Policy Committee (MPC) of the Bank of England decided to keep the "stock of asset purchases financed by the issuance of central bank reserves at £200 billion" in July 2010.[55] Mr Dicks outlined the role played by the Bank of England in maintaining a loose monetary policy:

the Bank of England has taken extraordinary measures to try and keep the economy moving ahead, and one would imagine that, as long as inflation remains under control, the Bank of England will be supportive.[56]

And the Chancellor emphasised to us that "It has always been my view that monetary stimulus is the most powerful tool available to stimulating growth".[57]

36. In its forecast, the OBR noted that one impact of the Budget was to slow the return of the inflation rate to target in the short term:

CPI inflation stays around 3 per cent in the near term. It then declines more gradually than in the pre-Budget forecast because of the rise in the standard rate of VAT to 20 per cent in January 2011 and the higher oil price assumed in the Budget forecast. Once the short-term effects of the VAT increase have passed through, the larger output gap and cuts in public spending place downward pressure on inflation in line with the pre-Budget forecast. CPI inflation falls back to a little under 2 per cent in early 2012 and then settles at the 2 per cent target over the medium term.[58]

Mr Bootle warned of the dangers if the OBR's inflation forecast proved incorrect:

There is, however, an underlying uncertainty about how co-operative, as it were, the economy will be in producing that sort of inflation rate. I think the point is that, if it is not very co-operative, the implicit assumption in the OBR's document is that the Bank of England will take monetary policy action to bring inflation to the target, and that of course could make things very uncomfortable for the growth environment.[59]

Mr Bootle's warning came after the minutes of the June 2010 MPC meeting showed that Andrew Sentance, an external member of the MPC, had voted to raise interest rates by 0.25 percentage points, the first vote for an interest rate rise since 7 August 2008.[60] The MPC minutes record that:

For one member, developments over the past month were consistent with a pattern which had been developing over the past year. Inflation had proved resilient in the aftermath of the recession, casting doubt on the future dampening impact of spare capacity on inflation. Demand had recovered at home and abroad, and the average growth of the main measures of UK nominal demand in recent quarters had been above typical pre-recession rates. Despite current uncertainties, for this member, it was appropriate to begin to withdraw gradually some of the exceptional monetary stimulus provided by the easing in policy in late 2008 and 2009.[61]

Professor Blanchflower emphasised the sensitivity of the economy to any potential rise in interest rates, but also warned that further Quantitative Easing would have an uncertain effect:

Monetary policy of course is playing a large part, with interest rates at 0.5%. Over four million households on tracker mortgages have ridden out the storm pretty well as the payments on their mortgages have dropped substantially. Increases in interest rates would be extremely harmful to the economy in general and to home owners in particular. There is no room to cut rates further and it is unclear what impact additional amounts of quantitative easing would have.[62]

37. The economic recovery in the OBR forecast will depend, in part, on supportive monetary policy. However, in the short term, Budget measures such as the VAT increase will affect inflation. We look forward to discussing this in more detail with the Monetary Policy Committee very soon.

Trend Growth

38. The forecast for trend growth is important, as it impacts on the assessment of the level of the output gap, which then feeds into the assessment of the level of the structural deficit. Table 4 highlights the differences in assumptions on trend growth between the March Budget and the June pre-Budget forecast.

Table 4: OBR and March Budget trend growth and output gap assumptions (per cent)  
 
 
Trend growth
 
Output gap at end of 2009
 
Implied levels adjustment 20151
 
 
2010 Q3 to 2013 Q4
 
201 4 Q1 to 2015 Q1
 
  
March Budget (economy)  
2.75
 
2.75
 
-6.25
 
-5.25
 
March Budget (public finances)  
2.50
 
2.50
 
-6.25
 
-6.50
 
OBR  
2.35
 
2.10
 
-4.00
 
-8.75
 
1Level of trend output at the start of 2015 relative to the level implied by trend growth of 2.75 per cent from the end of 2006  
Source: OBR, Pre-Budget forecast, p73, Table B.1       

39. In its June pre-Budget forecast, the OBR explained that it had reduced trend growth due to changes in assumptions on the impact of the financial crisis, and demographic changes. [63] In the June Budget forecast, the OBR then explained that "It is possible for policy changes to have permanent effects to the extent that they improve or worsen the supply-side performance of the economy. Our judgement on the effect of the [June] Budget policy package is based on the assumption that trend output will not be changed."[64]

40. We asked Treasury officials what measures in the Budget would enhance the supply side and trend growth rate of the economy. Mr Ramsden replied:

This was something we thought about quite seriously [...] The reductions in the main rate of corporation tax over a sustained period will have potential implications for the supply side. The increase in VAT, moving VAT to 20%, will contribute to rebalancing the economy, and you see that indeed in the OBR's forecast. Whilst the OBR's assumption is that there is no impact, overall this is an assumption. I think this is an area that over the months ahead requires a lot more work from within the Treasury and with the OBR as they become more established to assess both the individual impacts of these measures and the overall impact on the UK economy.[65]

The Chancellor told us that raising the growth trend rate was achieved by "trying to improve our education system, make our tax system competitive, make our regulatory system appropriate and so on. There are big structural reforms to the British economy which are required and which all parts of the Government are engaged in: educational reform, welfare reform and so on."[66]

41. We note the OBR's assumption that the June Budget had no impact on trend output. We also note that the Budget did not set out a policy for improving trend growth. The Treasury recognises the need to do more work on assessing the impact of Budget measures on trend growth and we look forward to seeing it.


8   HM Treasury, Budget 2010, March 2010  Back

9   Office for Budget Responsibility, Pre-Budget forecast, June 2010; HM Treasury, Budget 2010, June 2010, p 93, para C.53 Back

10   HM Treasury, Budget 2010, June 2010, p 93, para C.53 Back

11   HM Treasury, Budget 2010, June 2010, p 19 , Box 1.3 Back

12   Q 28 Back

13   Q 99 Back

14   Q 98  Back

15   Q 92 Back

16   Q 93 Back

17   Q 95 Back

18   Q 50 Back

19   Q 216 Back

20   HM Treasury, Budget 2010, June 2010, p 18, para 1.48 Back

21   Ibid. Back

22   Q 217 Back

23   HM Treasury, Budget 2010, June 2010, p 83, para C.28 Back

24   Q 108 Back

25   Q 43 Back

26   Q 41 Back

27   Q 143 Back

28   Q 42 Back

29   Q 141 Back

30   Q 141 Back

31   Q 237 Back

32   HM Treasury, Budget 2010, June 2010, p 84, Table C.2 Back

33   Ev 48 Back

34   Q 46 Back

35   Q 145 Back

36   Q 145 Back

37   Qq 46, 145 Back

38   Q 145 Back

39   Office for Budget Responsibility, General Government Employment Growth Forecasts, 13 July 2010 Back

40   Q 1 Back

41   CIPD, CIPD responds to 'optimistic' Office for Budget Responsibility employment forecasts, 30 June 2010 Back

42   CIPD, CIPD responds to 'optimistic' Office for Budget Responsibility employment forecasts, 30 June 2010 Back

43   Q 102 Back

44   Q 49 Back

45   Q 233 Back

46   Office for National Statistics, Labour market statistics, July 2010 Back

47   Office for National Statistics, Labour market statistics, July 2010, p 2 Back

48   Q 235 Back

49   Q 236 Back

50   Q 61 Back

51   Q 107 Back

52   Q 263 Back

53   Qq 260, 107 Back

54   Bank of England, News Release: Bank of England Maintains Bank Rate at 0.5% and the Size of the Asset Purchase Programme at £200 billion, 8 July 2010 Back

55   Bank of England, News Release: Bank of England Maintains Bank Rate at 0.5% and the Size of the Asset Purchase Programme at £200 billion, 8 July 2010 Back

56   Q 50 Back

57   Q 219 Back

58   HM Treasury, Budget 2010, June 2010, p 81, para C.19 Back

59   Q 101 Back

60   Bank of England, Minutes of the Monetary Policy Committee meeting, 9 and 10 June 2010, p 9  Back

61   Bank of England, Minutes of the Monetary Policy Committee meeting, 9 and 10 June 2010, p 8 Back

62   Ev 48  Back

63   Office for Budget Responsibility, Pre-Budget forecast, June 2010, p 12, para 3.9 Back

64   HM Treasury, Budget 2010, June 2010, p 96, para C.60 Back

65   Q 134 Back

66   Q 276 Back


 

 
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