House of Commons - Budget 2011

Budget 2011 - Treasury Contents

2 Economy

Economic growth

7. Since its forecast in November 2010, the OBR has revised down its forecast for growth in the near term, so that the central forecast for economic growth in 2011 is now 1.7% rather than 2.4%. It has slightly increased its forecast for growth in 2014 and 2015 by 0.1 percentage points in both years (there is no change to the 2013 forecast).[5] The OBR gave the following reasons for the downward revision of growth in the near term:

Higher-than-expected inflation is likely to squeeze household disposable income in the coming months and thereby weaken consumer spending growth. Recent data also show that the economy had less momentum than we expected entering 2011, even after adjusting for the temporary impact of December's heavy snowfall.[6]

The OBR then explained why it had increased growth in the later years:

Below-trend growth will increase the amount of spare capacity in the economy this year, with the output gap then beginning to close in 2012. The downward revision to our near-term growth forecast increases the amount of spare capacity and thus creates scope for slightly stronger growth in later years. But not all the lost ground is made up and GDP is expected to be lower - and the output gap bigger - at the end of the forecast than we predicted in November.[7]

8. The latest ONS release states that GDP fell by 0.5% in Q4 2010.[8] The preliminary GDP release by the ONS in January estimated that 0.5 percentage points of the fall in Q4 GDP came about due to the extreme weather conditions in that quarter.[9] Robert Chote, the Chair of the Budget Responsibility Committee also explained though that even without the snow, there was a weakening pattern within the growth figures. He told us that:

the striking thing was not so much the impact of the snow but the weakness of the underlying path, and I think what we have tried to do here is spell out, looking back to the figures from the middle part of last year, what the underlying path has been. If you take into account not just the snow but the construction data that has been particularly erratic, and also the anticipated effect of VAT, what you basically find is a slowing in this underlying profile from the middle part of last year through towards the end of last year. We are now assuming that that picks up during the course of the coming year, but I am not going to put my hand on my heart and say I can forecast quarterly growth.[10]

9. Despite the OBR reducing its consumption forecast, several of our expert witnesses pointed to consumption as a potential weakness in the OBR growth forecasts. Mr Roger Bootle noted that "It is quite noticeable that consumption, although it's weak in the forecast, it is nothing like as weak as it could be. Our own forecasts are much weaker".[11] Mr Simon Hayes of Barclays Capital agreed, telling us that "The OBR's forecasts [...] in terms of domestic consumption in particular, are stronger than we have in there."[12] Mr Barrell pointed to the reasons why consumption may be weaker:

All the factors I see that might affect consumption as a share of income over the next few years should be forcing it to rise more slowly than income. House prices are liable to be weak; the OBR does not think so. Equity prices are not particularly strong; the OBR does not comment on that. One has to ask quite serious questions about its consumption forecast. There is a very interesting discussion in its forecast about the role of corporate saving, and they say that, because corporate saving is so strong, consumers will realise they do not have a need to save. Now, I may be paraphrasing what they say, but I think that even those who believe in rational expectations in macroeconomic models would not go quite that far. That may eventually feed through, so we have to ask serious questions about the consumption forecasts that the OBR have produced.[13]

The Chancellor of the Exchequer though noted that "one high degree of caution in the OBR's forecast has been the rather low levels of consumption growth through the period compared historically to the past".[14]

Inflation

10. Higher than expected inflation is one of the pressures on consumption. Inflation, as measured by the consumer prices index (CPI), reached 4.4% in February 2011.[15] Inflation has now been above the 2% target since December 2009, and above 3% since January 2010.[16] When we took evidence from the Bank of England on 1 March, our witnesses explained that this inflation comes, in the main, from three factors: increases in VAT, rising commodity prices and the depreciation of Sterling.[17] The Chancellor noted that "The rise in commodity prices has clearly had an impact and of course in the UK exacerbated by the very sharp devaluation which is part of the rebalancing of the British economy but nevertheless has increased the inflationary pressure".[18]

11. Wage growth, however, has remained muted, so the high level of inflation is leading to a fall in real wages, and pressure on living standards and consumption. Ms Gillian Guy of Citizens Advice emphasised that families on very low incomes would be "hit by inflation".[19] Professor Stephen Nickell pointed to higher than expected inflation due to rapidly rising oil prices as the key risk to the OBR's forecast:

I think the biggest risk to this forecast, and in some sense the biggest risk to the economy, is if oil prices and food prices, but particularly oil prices keep rising faster than the average rate of inflation because, as you know, embedded in our forecast is the prediction of the forward market for oil prices, which is relatively flat and viewed somewhat downward moving. So if the oil prices continue to move up then inflation will be higher in our forecast and, under the assumption—which I think is reasonable—that wages don't adjust to this, real wages will fall and consumption will fall and growth will be lower. That in some senses is the worst of all possible worlds because we have higher inflation and lower growth as a consequence of this which means that the difficulties facing the MPC are of a very high order.[20]

12. Inflation, without a corresponding increase in wage growth, also has an impact on the fiscal position. As Roger Bootle explained:

The impact on revenue and expenditure is a complicated issue. In broad terms, I think it is probably right to think that by and large, it is fairly balanced, although there is a lot to be said for the idea that at the moment this is, as it were, the wrong sort of inflation mirroring the wrong sort of snow. It is the wrong sort because it is coming from abroad, hitting real income, depressing activity and not directly boosting employment income, which is a primary source of revenue for the Exchequer.[21]

This view was supported by Robert Chote, who told us that:

At the moment the impact in the central forecast [of inflation] is a negative one because it's dominated in large part by the impact on inflation on the cost of social security bills because of benefit up-rating and on the cost of index linked gilts. But because we're assuming it's not incorporated into wage increases it's not pushing up the total cash value of spending and incomes and therefore providing more revenue there.[22]

An OBR assessment in September 2010 also found that the impact of higher oil prices would not have a positive impact on the UK fiscal position. It stated that:

In summary and based on central estimates, a £10 a barrel higher oil price would: boost UK oil and gas revenues by £2.4 billion. However offsetting effects elsewhere on the public finances reduce the benefit to close to zero for a temporary rise in oil prices, while there would be a loss to the public finances from a permanent rise.[23]

13. The combination of high inflation, some derived from external factors, and weak income growth is affecting the living standards of many in the UK. At the moment, the costs to the Government are rising with inflation-linked benefits but revenues—such as from income tax—are not keeping pace, as wage growth remains subdued.

INFLATION FORECAST

14. Despite recent high levels, inflation is forecast to return to target in around two years. In his evidence to us in March 2011, the Governor of the Bank of England told us that "projections that we published in the 'Inflation Report' a couple of weeks ago have the characteristic that the inflationary pressures are pretty much back to target by around the middle of this year, but of course that does not show up in the 12-month measure until well into 2012".[24] The OBR makes a similar forecast.[25] Mr Chote explained why the OBR had made that forecast:

I guess I think our view of inflation over the medium term partly reflects the fact that we still see there being considerable spare capacity in the economy and that will have an underlying downward effect on inflation. There is also the fact that VAT, unless there's a policy change we're not expecting, is not going to go up again and therefore the increase in the price level as a result of that will drop out of annual comparison so that pulls the rate down. We've made the assumption that oil prices move in line with a futures curve over the period of the forecast, and since the November forecast you've seen the Sterling price jump by about 15% in the spot price but by less if you go further out. We're assuming that food prices, although higher, are not going to continue to rise and therefore there's a persistent event there. So taking all of those factors together you would expect inflation to come back down.[26]

15. When we asked our expert witnesses whether this was a credible forecast for inflation, Roger Bootle replied that:

My own view is that, although it is the standard thing to do to assume that inflation comes back to the target, if the forces are in places to bring inflation sharply down next year, and I think they probably are, I doubt actually whether it will stop at the target; we will end up with inflation much lower than 2%. Indeed, I do not by any means rule out the possibility that inflation will be driven into negative territory beyond this blip, as I still think it is.[27]

Professor Ray Barrell of NIESR noted the uncertainties in the inflation forecast, but stated that:

The factors affecting the high inflation at the minute are relatively clear. When you put VAT up, the price level goes up. That is inflation. Oil prices have risen both temporarily and permanently, one might say. That is a distinction that is not clear in the OBR, as far as I can see. We have seen two oil price shocks: a permanent oil price shock that occurred before anything that happened in the Middle East, perhaps, and then a temporary one, given what has happened in the Middle East. That also puts inflation up. The temporary one, we expect to be reversed, because it is temporary. That will come out of the inflation figures quite soon. The permanent one feeds into the inflation figures for a year or so, but again, it disappears. The factors that are pushing inflation quite so high at the minute will largely disappear by 2012.[28]

16. A major risk to this forecast would be that the current higher-than-expected inflation led to employees bargaining, successfully, for higher wages to compensate for their drop in living standards. This would further raise prices, as the additional wages would raise demand. Mr Chote identified this as a risk:

There's clearly the possibility that the bad news on inflation becomes incorporated in wage increases and that you end up with greater persistence as a result of that and that's why we've included the persistent high inflation scenario as one of the two alternatives [...].[29]

Mr Bootle suggested that such wage pressures were not immediately apparent. He told us that:

If wage settlements were moving up decisively then I would be concerned. There is some evidence they have moved up a bit, and Andrew Sentence has made, I think, rather too much of this point, not least because the settlements that have shown some increase have actually been multi-year settlements tied to the RPI, so no wonder they have gone up. On the ground, the evidence seems to be pretty clear, I think, that pay inflation is extremely subdued. If you talk to business people, they will confirm this. There are some minor exceptions in manufacturing where performance has been extremely good.[30]

MONETARY POLICY

17. A further risk to the economic growth forecast stems from potential action by the Monetary Policy Committee in response to a worsening of the outlook for inflation. For its forecasts the OBR assumes that monetary policy will be set in line with market expectations.[31] Roger Bootle though highlighted the risk of even higher interest rates:

the more important thing, surely, is the extent to which higher inflation really makes it impossible for the Bank of England to maintain very low interest rates for a lot longer. I think that is the biggest threat of all. Given how fragile the economy is, I would judge that to be the biggest risk, in fact, to the fiscal framework laid out by the OBR. That is to say, the Bank of England raises interest rates fairly early and carries on raising them, and the impact of that is big on the economy, and the result of that is obviously much higher borrowing figures.[32]

18. Monetary policy remains highly accommodative, with interest rates at 0.5% and quantitative easing of £200 billion.[33] There has been an increase in the number of members of the MPC voting for increases in interest rates, but a majority has still to be reached.[34] Mr Bootle, while issuing his warning above, noted that the nature of the current inflation, and subsequent fall in real incomes, was not amenable to action by the Bank of England:

it is the result of a profound change in the terms of trade for the UK at the moment in reaction to higher commodity prices and oil prices, and actually there is nothing that workers can do to reverse that or make up for it. If they succeed in getting higher earnings then inflation will simply be correspondingly higher. Equally, there is nothing that the Governor of the Bank of England can do to prevent the squeeze on living standards that has resulted from that higher inflation. If inflation were forced down by the Bank of England by higher interest rates, then the rate of wage increases will be even lower.[35]

19. There was a discussion by our expert witnesses of whether the tight fiscal policy position adopted by the Government had constrained the MPC from a potentially tighter monetary policy. Mr Barrell told us that:

We may be in a situation where tight fiscal policy produces a monetary policy that is perhaps too loose, because the Bank has to take account of the developments in the economy and the growth of the economy. It also has to look at inflation expectations. Inflation expectations are rising, and there is case to be made for raising interest rates to try to signal that inflation will be kept under control, but growth is currently so weak, especially in the last couple of quarters, that the Monetary Policy Committee must be nervous about raising interest rates, when many of them feel they perhaps should, I suspect I think there is a worry on the part of the Bank of England. If I were at the Bank of England, I would be worried about the fact that fiscal policy is not leaving me the space for taking the appropriate monetary policy action, and therefore there are risks that inflation could rise. If inflation expectations take off, [...], inflation will at least temporarily take off. We are in a situation where it looks like oil prices have risen—it looks like permanently—and a $20 oil price rise will reduce the sustainable real wage people can have by about 1%. That has to go into bargains, but we also have to have a monetary policy that stops the inflation expectations taking off, and a slightly different balance between fiscal and monetary policy might be wise at the minute. That is, tighter monetary policy and looser fiscal policy might be wise for the economy.

20. However the Chancellor robustly defended his decision to maintain a tight fiscal policy:

I think if we were to loosen fiscal policy now—of course this would be a judgement for the independent MPC, but I think, in all other things being equal—there would be a monetary response almost immediately with a tightening of monetary policy and an increase in interest rates. Now, I don't see how that would particularly help the economy, if that was the direct trade. What I am able to do, by providing a credible plan to deal with the budget deficit that has earned that credibility in the market, is give the space to the MPC to make the decisions that it needs to make. I know I have made this point before on appearances before this Committee, but it is worth noting today the UK market interest rates are 3.6%. In Germany, they are 3.3%, so we have very similar market interest rates to Germany, but in Spain, they are 5%, Portugal they are 8%, Ireland they are 10%. That is the monetary stimulus that a credible fiscal policy can provide.[36]

Employment

21. The OBR's March 2011 Economic and Fiscal Outlook provided the following overview of its labour market forecast:

the labour market is likely to weaken further over the next few months before strengthening as economic growth picks up. LFS [labour force survey] unemployment is forecast to rise from its current 8.0 per cent to 8.3 per cent of the labour force by the second quarter, falling back to 6.4 per cent by 2015. The claimant count rises from 1.45 million to 1.56 million by the second quarter, falling back to 1.18 million by 2015. We expect market sector employment to rise by around 1.3 million by 2015, partly offset by a fall of around 400,000 in general government employment.[37]

Total employment is now forecast to be 100,000 less every year from 2011 to 2015 than in its previous forecast. Within that, general government employment is now forecast to be around 200,000 people higher every financial year than in comparison with the November forecast.[38] On the ILO unemployment rate, the OBR has raised its forecast for unemployment by 0.2 percentage points in 2011, and by 0.4 percentage points for 2012 to 2014, while the increase for 2015 was 0.3 percentage points.[39]

22. Mr Chote explained why the OBR had made these forecast changes, telling us that:

We are more pessimistic about growth in the short term and so therefore you have less overall employment growth and a slightly worse picture for unemployment. On the Government side, we have obviously taken into account the latest data that we have had from ONS, the reclassification decisions there, and at the moment we continue to have to use this top-down approach, essentially trying to derive a path of general Government employment from the overall pool of money available to spend on it and assumptions about pay bills, so that is where that change has come about.[40]

23. Mr Barrell was more pessimistic than the OBR on the overall forecast for unemployment, telling us that he suspected that "unemployment will rise rather more than the OBR currently suggests; however, we have always been rather more optimistic than the economic commentator average on trends in unemployment".[41] He told us that NIESR expected "unemployment to rise by 200,000 to 300,000 more than [the OBR does] in the next six to nine months and then start falling".[42] Mr Bootle made the following comments:

One of the reasons, I think, why private sector job losses have not been greater is that we have not yet seen the full impact of the squeeze. I do not just mean the public sector squeeze; also, the squeeze on consumer real incomes. This is a vulnerability in the OBR's forecast. It is quite noticeable that consumption, although it's weak in the forecast, it is nothing like as weak as it could be. Our own forecasts are much weaker. This is particularly sensitive for the unemployment issue, because a large number of people in the private sector are employed in consumer-facing activities, retail and support activities. That is where I suspect the outturn will be weaker for unemployment, if that indeed does happen.[43]

YOUTH UNEMPLOYMENT

24. One worrying aspect of the aftermath of the financial crisis has been the increase in youth unemployment. There are concerns that those who suffer unemployment while young, may have far more difficulty entering the workforce in later life. Mr Barrell told us that he thought that the OBR "have a rather optimistic projection for long-term unemployment because they are not necessarily taking into account all the evidence we have of the loss of skills from long periods of unemployment, especially for youths and those without particularly high skills".[44] Mr Chote though told us:

It is obviously a concern. At the moment the evidence on detachment would suggest that the level of long-term unemployment, and the level of long-term unemployment amongst relatively young people, is lower than it was in the 1990s. But it clearly is a risk to the forecast and when we produced our persistent low growth scenario last time around you will recall that we had a different view of the long-term rate of unemployment in that it reflects exactly that sort of risk.[45]

FORECASTING GENERAL GOVERNMENT EMPLOYMENT

25. In its March 2011 Economic and Fiscal Outlook, the OBR noted that "For our projection of general government employment we have maintained the same topdown approach we used for our November forecast, combining estimates of paybill growth and the growth of paybill per head to generate a forecast for employment growth".[46] The OBR went on to state:

The sensitivity of these projections to relatively small adjustments to government expenditure forecasts is one drawback of using a top-down approach to forecast general government employment. But this is the best approach available until the Government obviates the need for a forecast by publishing specific workforce plans.[47]

26. We asked the OBR whether we should ask the Treasury to provide a bottom-up forecast for general government employment. Mr Chote replied "If you were able to encourage them to do that, I would be delighted".[48] However, when we asked the Treasury whether such a bottom-up approach was possible, Mr Schofield replied:

Apart from the Spending Review, we require departments to make administrative savings of at least 33%, which they did, or they have set out plans that imply that, but precisely how they do that, well, these are decisions that are taken by different managers at different levels across the whole public sector. So I don't think we are in a position to provide the Committee with any sort of detailed workforce plans or numbers area by area across the whole public sector.[49]

When we continued to question the Treasury officials on whether such workforce plans would be forthcoming, after various answers, Mr Ramsden replied that "Well, as more and more of these plans become available, it will be possible to build them up to see what they imply."[50]

27. We understand that the collection of workforce planning data across Government is difficult, particularly when radical changes are in progress. The Government is the best source of workforce plans to enable bottom-up forecasting of general government employment. Such information, if collated, would be of use to the Treasury in monitoring implementation and achievement of the consolidation, as much as it would be of assistance to the OBR in employment forecasting. We recommend that the Treasury does what it can to collect this information in a timely fashion, so that more is available before the next OBR forecast round.

Output gap

28. The output gap is the difference between the potential output of the economy, and the actual level of activity within the economy. When the output gap is negative, there is less activity than potential. The output gap is however unobservable, since the potential output of the economy is unmeasurable. It is simply an estimate based on the judgements of economists, and as such is inherently imprecise. The estimate of the output gap is important for assessments of the fiscal position, as the larger the output gap, the more of the deficit is regarded as cyclical, rather than structural. As the OBR notes, the output gap is of key importance to the fiscal mandate:

The Charter for Budget Responsibility defines the fiscal mandate as "a forward looking target to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period". For the purposes of the current Outlook, this means that total public sector receipts need to exceed total public sector spending (minus spending on net investment) in 2015-16, after adjusting for the impact on receipts and spending of any remaining spare capacity in the economy.[51]

29. In its March 2011 Economic and Fiscal Outlook, the OBR estimated that the output gap had declined. It noted that "based on our assessment of a number of cyclical indicators, we estimate that activity in the economy was running around 3% below potential in the third quarter of 2010, the output gap having narrowed from around -3¼% of potential GDP in the second quarter".[52] To provide a comparator, the OBR provided the following external comparisons:

in its January Economic Review, the National Institute of Economic and Social Research (NIESR) estimated that output was 4% or more below potential;
in its Autumn Forecast, the European Commission estimated that output was just over 5% below potential in 2010, compared to 5½% in 2009;
in its October 2010 World Economic Outlook, the IMF estimated that output was 2.7% below potential in 2010;
in its latest Economic Survey of the United Kingdom, the OECD estimated that output was 4.6% below potential in 2010; and
a number of external members of the Bank of England's Monetary Policy Committee (MPC) have expressed views on the size of the output gap. In speeches made in the final quarter of 2010, Adam Posen suggested that output was at least 3% below potential and probably more than 4% below, and Dr Martin Weale estimated that output was 4-6½% below potential.[53]

30. Given that the fiscal mandate is based on a cyclically-adjusted current balance, the estimate of the output gap can be a source of uncertainty in estimating whether the fiscal mandate will be met. In fact, the OBR's March 2011 Economic and Fiscal Forecast highlighted it as a key risk:

The biggest threat is the possibility that we have over-estimated the amount of spare capacity in the economy, now or in the future. If the output gap was roughly 1.5 per cent of potential output smaller than our central estimate then the Government would no longer be on course to balance the cyclically-adjusted current budget in five years' time.[54]

Mr Chote also emphasised to us the importance the output gap. He reiterated, when asked what the greatest risk to meeting the fiscal target:

the biggest uncertainty is whether we have the amount of spare capacity in the economy correct because essentially the amount of spare capacity you have determines how far the economy can grow in a sustainable way and therefore how much of the deficit that we have at the moment will be soaked up naturally as the economy recovers and how much, as it were, is left for policy to deal with.[55]

31. Given this risk to the fiscal mandate, we questioned Mr Ramsden on whether he thought measures of the output gap were "worth much". He replied:

I do, actually. [...] I think it is really important to have an analytical approach that enables you to work out how much of borrowing of any point in time and prospectively, and indeed, over the past, is cyclical and how much is structural. I think the history of the UK, particularly in the late 1980s and early 1990s was a time when what was a cyclical improvement in the economy was taken to be structural, and that led to the problems that the UK public finances had in the early 1990s.[56]

He then went on to emphasise how measures of the output gap had been used to analyse the impact of the crisis. He explained that:

What I think is really important in the UK context throughout the last two or three years really—this is not just about the current plans—is that the UK recognised very early on that the crisis was going to have a structural impact on the UK economy and on the UK public finances, which is something that I have talked to this Committee about in the past. There is still not much recognition of that, for example, in the United States, where this is seen as very much still a cyclical event, and I think that has framed successive Governments' [...] approach to thinking about what the fiscal response needs to be. If the output gap is not as big as it would otherwise be because some structural output has been lost, that means that the structural deficit—other things equal—is a bigger component of the overall deficit. That structural deficit needs to be addressed through discretionary measures, such as were announced last year and have been reinforced by this budget.[57]

The Chancellor was also robust in his defence of the use of the output gap, despite the difficulties in its estimation:

When it comes to the fiscal mandate, I think it is important to recognise that there is an economic cycle and that there is a structural element to your deficit and that there is a cyclical element. You need the output gap to enable you to calculate the structural deficit. There is often a sort of black and white debate about John Maynard Keynes at the moment, but one of Keynes' important insights was of the role of automatic stabilisers and that is where we are in a very different place from the 1930s as a country and as a Government. I want the automatic stabilisers to operate while at the same time having a fiscal deficit which does not undermine our credibility in bond markets. So that is why the fiscal mandate is a cyclical one and if you want a cyclical one, then you need to have an idea of what the output gap is.[58]

32. We recognise the importance of estimates of the output gap for assessments of the size of the structural deficit but we note the risks inherent in overreliance on this uncertain and imprecise measure as a basis for fiscal policy.

5 Office for Budget Responsibility, Economic and Fiscal Forecast, November 2010, Table 3.5, p 41; Office for Budget Responsibility, Economic and Fiscal Forecast, March 2011, p 53, Table 3.5 Back

6 Office for Budget Responsibility, Economic and Fiscal Forecast, March 2011, p 5, para 1.4 Back

7 Ibid., pp 5- 6, para 1.5 Back

8 Office for National Statistics, GDP Growth, 29 March 2011 Back

9 Office for National Statistics, GDP preliminary estimate Statistical Bulletin - Q4 2010, 25 January 2011 Back

10 Q 323 Back

11 Q 28 Back

12 Q 71 Back

13 Q 72 Back

14 Q 430 Back

15 Office for National Statistics, Consumer Price Indices, Statistical Bulletin, February 2011, p 1 Back

16 Office for National Statistics, Consumer Price Indices, Statistical Bulletin, February 2011, p 16 Back