UK fiscal policy: A radical post-referendum reset – Goldman Sachs

Adrian Paul, Research Analyst at Goldman Sachs, notes that earlier this month, the Bank of England revised down its three-year-ahead forecast for real UK GDP by 2½% – the largest downgrade between successive Inflation Reports for 20 years.

Key Quotes

“Although that downgrade reflected weaker economic prospects in the aftermath of the EU referendum, it was conditioned on a substantial fiscal consolidation planned before the referendum (by the former Chancellor, George Osborne). We also downgraded our GDP forecast post-referendum, by just over 3% over the next three years (also on the assumption that Mr. Osborne’s fiscal plans were unchanged).

The new Chancellor – Philip Hammond – has stated explicitly that the new government will “reset fiscal policy if we deem it necessary…in light of the economic data that will emerge over the coming months”. BoE Governor Carney, more recently, has conceded that easier fiscal policy is required to mitigate shocks that easier monetary policy cannot offset.

Easy monetary policy complements easier fiscal policy not only because Gilt purchases help to accommodate larger fiscal deficits, but also because the government-spending multiplier is likely larger when interest rates have hit their lower bound.

Based on non-discretionary automatic stabilisers alone (that is, without incorporating any discretionary fiscal easing), our post-referendum GDP forecast downgrade increased the headline budget deficit from 3% of GDP (under pre- Brexit plans) to 3½% of GDP in 2016/17, from 2% of GDP to 3½% of GDP in 2017/18, from 1% of GDP to 2¾% of GDP in 2018/19 and from -½% of GDP to 1½% of GDP in 2019/20.

In this note, we describe the additional discretionary fiscal easing that we expect Mr. Hammond’s Autumn reset to involve. We expect a cut in the main rate of VAT from 20% to 17½%, and a substantial increase in public-sector investment. These discretionary measures increase the headline budget deficit yet further – from 3½% of GDP to 4½% of GDP in 2016/17, from 3½% of GDP to 4% of GDP in 2017/18, from 2¾% of GDP to 3½% of GDP in 2018/19 and from 1½% of GDP to 2¾% of GDP in 2019/20.

The ‘fiscal stance’ on our forecast (as measured by the cyclically-n adjusted budget deficit) is tightened by just 2.1pp of GDP over the next four fiscal years: less than half of the 4.3pp of GDP discretionary fiscal tightening pencilled in under former Chancellor Osborne’s pre-Brexit plans.

To create the institutional credibility necessary to accommodate this short-term cyclical stimulus, we expect Chancellor Hammond to commit to stabilising the debt-to-GDP ratio by the end of the current Parliament. On our forecast, net debt stabilises at just over 85% of GDP in 2019/20 (compared with just over 75% under pre-Brexit plans).

In short, we think the post-referendum reset will be quite radical. We expect it to be announced in a relatively early Autumn Statement – in early October rather than late November.”