“The Wonderful Thing about Tiggers, is Tiggers are Wonderful Things” (A.A. Milne) 

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Chancellor Philip Hammond, in an avowedly “Tiggerish” mood, took issue with the Eeyores on the UK economy, and proclaimed “light at the end of the tunnel” in the new-fangled “Spring Statement”.

Although billed as a minor statement that we had been steered to believe would last only a few minutes, the Chancellor spoke at length – but said very little.

The main event was the publication of the Office of Budget Responsibility’s (OBR’s) updated forecasts published just after the statement.

Background

Although the Chancellor was at pains to talk up how rosy the new economic projections were yesterday, the OBR document shows very little has changed since last November.

Inflation

The big surprise is the OBR’s inflation forecast.

• The OBR expects Consumer Prices Index inflation to come back to the target 2% by the end of this year (2018).
• The Bank of England last month expected inflation to stay above the target until the end of 2021 at least.
• Forecasters pointedly refer to emerging capacity constraints – in other words, as Paul Johnson of the Institute of Fiscal Studies (IFS) put it – “We have had the worst decade of growth at least since the last War. The economy is at least £300bn smaller than we might have expected based on 2008 forecasts.  Yet we are now supposed to be at [full] capacity with no potential to make up for any of that loss.”

The Economy

It is hard to disguise that the economic and fiscal position is now significantly worse than the projections in March 2016, before the EU Referendum.  Most of this bad news was in the forecasts last November.

For all the bluster, the position remains extremely difficult and some very hard choices still have to be faced, as Paul Johnson was laying out yesterday.

• The OBR itself says: “the medium-term outlook for the economy and public finances looks broadly the same” as in November 2017.
• The economy has slightly more momentum in the near term, thanks to the unexpected strength of the world economy. But the OBR saw little reason to change its view of growth prospects over the medium term (see chart below).
• The OBR’s growth forecasts are significantly lower than the Bank of England’s only last month, and that is reflected in the difference in inflation forecasts.
• The revisions mean that headline Gross Domestic Product (GDP) growth is currently estimated to have slowed from 1.9% in 2016 to 1.7% in 2017, rather than from 1.8% to 1.5% as the outturn data suggested in November – a similar degree of slowdown but from a very slightly higher level.

The OBR itself emphasises how this looks in the international context: the UK economy grew by 1.4% over the latest four quarters, compared to 2% over the preceding four.   In contrast, GDP growth picked up in every other G7 economy, taking us from the top of that particular league table to the bottom.

 Brexit

The key judgements around Brexit (which was barely mentioned by the Chancellor in his entire statement) are:

• The vote to leave the European Union appears to have slowed the economy, but by less than the OBR expected immediately after the Referendum vote – thanks in part to the willingness of consumers to maintain spending by reducing their saving.
• However the OBR says it doesn’t yet have “any meaningful basis” on which to estimate the likely impact of Brexit on its forecasts – thus the elephant stays in the room.
• The OBR expected net inward migration to slow – and it has, from 336,000 in the year to June 2016 to 244,000 in the year to September 2017.
• The OBR expected the drop in sterling that preceded and followed the Referendum vote to raise inflation and squeeze consumers’ finances and their contribution to GDP growth. Inflation has indeed risen well above the March 2016 forecast, but consumption has held up a little better than expected as household saving has dropped more sharply.
• The OBR assumed that uncertainty around the Brexit negotiations would weaken business investment. The Bank of England estimates that uncertainty has indeed lowered it by 3%-4%. Business investment is weaker than forecast before the Referendum vote, but again has held up better than the OBR expected in the post-vote forecast.
• The OBR forecast that the fall in sterling would deliver an offsetting boost to the economy via a greater contribution from net trade (exports minus imports). But this offset has been smaller than expected, thanks to imports meeting a greater share of domestic demand – not a good sign.
• Overall, the Referendum vote does seem to have weakened the economy, as the OBR and most other forecasters expected, but not quite as much as forecast back in November 2016.
• The OBR has not changed any of assumptions about the impact of Brexit, but has (as signalled) quantified the financial settlement or ‘divorce bill’ that was (note) “provisionally agreed last year” – and also set out a possible time profile. The OBR estimates that the settlement will total just over £37 billion, in the middle of the range estimated by the Treasury at the time.

Fiscal Policy

• It’s true that the good news is that the budget deficit looks likely to come in almost £5 billion lower than the OBR expected for this year (2017/18) at £45.2 billion, but they see this as an average-sized revision for a March forecast. And the improvement is expected to be smaller in future years.
• The problem is that the OBR judges that much of that modest improvement looks cyclical rather than structural, at least early in the forecast, so the Chancellor’s margin for error against his fiscal targets is virtually unchanged (the fiscal targets are focused on eliminating the structural deficit, i.e. netting out the impact of the cyclical factors on revenue and expenditure). Basically the OBR is saying that the Government has not made any impact on the structural deficit its policies are targeting, it’s just benefiting from the amount of world growth around at the moment.
• So the Chancellor’s key objective of balancing the budget by 2025 still looks touch and go (in 2010 George Osborne, the previous Chancellor, had targeted achieving this by 2015.)
• Although the deficit is coming down towards more normal levels.
• The main event will be a full-scale spending review promised for 2019.

Productivity

There has been considerable press coverage in recent months along the lines that productivity growth has at long last started improving. The OBR is skeptical about this.

• The biggest economic judgement that the OBR made back in November was to assume that potential productivity growth would be weaker over the forecast than had previously been assumed ever since its creation in 2010, reflecting the sustained weakness seen in actual productivity growth since the financial crisis and the fact that this appears to be a global rather than purely domestic phenomenon.
• What has happened over the last six months? As above, growth in headline GDP was slightly stronger than expected, thanks mainly to the upwards revision by the Office for National Statistics (ONS) in Q3 of 2017.
• Meanwhile employment grew slightly less than expected, which means that productivity growth measured as output per worker was a little stronger than the OBR forecast, but not significantly so.
• Much more noticeable is that the ONS’s estimate of the average hours that each worker works per week dropped by 1 per cent in the second half of 2017, the biggest decline since the middle of 2011. This means that total hours worked also fell and that productivity measured as output per hour grew much more strongly than forecast in November.
• If this could be sustained, the outlook for GDP growth over the medium-term would be a lot rosier. But for the time being, the OBR believes it looks more likely that the drop in average hours reflects statistical sampling errors, rather than a real world development. It notes the same was true of the fall in mid-2011 – a false dawn.

Investment Implications

The Spring Statement offers very little in this regard. There is some slight improvement in public finances but little of real substance. The Chancellor is still giving away all of the windfall he is receiving from higher cyclical growth outside the UK.

The decision by the Chancellor  in the debt financing remit to reduce the proportion of debt that will be issued as index-linked gilts from around 25% closer to 20%, ostensibly on the ground of reducing the inflation risk exposure of public debt (which was the point of introducing index-linked gilts in the first place – to give politicians a vested interest in controlling inflation).  This could have implications for the relative pricing of index-linked gilts and implied inflation expectations.