The tricky bit is that the OBR’s forecasts, which feed directly into the central bank’s models, are looking at five years, but the BOE’s horizon is shorter than two years. The government now aims to balance the books within three years, although Hunt will almost certainly extend this. Any spending cuts or tax increases pushed by Hunt beyond three years are irrelevant to the BOE, as they cannot be modeled for the impact on growth or inflation. So to influence the forecasts of the BOE, fiscal tightening should be prioritized over the next two years and large enough – tens of billions of pounds – to count.
But what makes economic sense and for market credibility may be at odds with political reality, especially if a tax increase upsets a troubled Tory party. This is where realpolitik comes in for Hunt and Prime Minister Rishi Sunak: Picking their poison wisely will determine the future of not only this Conservative government but how the Tory party will look heading into the next election, because two years.
The final test will be how Thursday’s package affects the value of sterling and gilt yields. On his way to the G-20 meetings in Bali, Sunak told reporters earlier this week that putting public finances on a sustainable path is important to “deliver on the expectations of international markets.” The government knows very well that it cannot trigger the kind of gilt market meltdown that has weakened Liz Truss after only 44 days in office.
Hunt will no doubt use some sleight of hand to push spending cuts as far as is plausible in the OBR’s five-year timeline. Fiscal drag — disproportionate spending increases with inflation, and leaving tax thresholds unchanged so that real income falls — is the most hidden route. Such opaque measures are far from an honest solution; but the promise to save money after the next election will not pass.
So there should be enough short-term revenue growth from a higher tax take combined with enough spending restraint to keep the gilt market calm. The BOE should feel confident that a strong grip on public finances will complement its efforts to prevent double-digit inflation. Only then will it begin to ease the pace of interest rate hikes.
With the current energy price cap set to expire in April, the reduced but still huge cost of a tapered replacement focused on the most needy, which should be announced on Thursday, should also be included in consumer price forecasts. As Ana Andrade and Dan Hanson noted in Bloomberg Economics this week, “Hunt will have a bigger say on 2023 inflation than the BOE.”
But Hunt also wanted the chance to provide a respite from the relentless drumbeat of austerity ahead of the election. It will take some creativity not to “water down” this week’s fiscal tightening, as Hunt has repeatedly warned. He certainly set the stage for everyone to pay more taxes, and in many ways.
The gilt market will be closely watching the government’s borrowing needs for the remainder of this fiscal year. There may be a slight reduction in the net cash requirement, allowing fewer gilts to be sold through April. However, Hunt may choose not to ease debt sales, knowing that next year’s needs will be greater. A Bloomberg survey of five gilt dealers showed an average expectation of £250 billion in issuance in the next financial year; on top of this, the BOE is expected to sell around £50 billion from its QE stockpile, with a similar amount not reinvested at maturity. The OBR’s forecasts will set the tone longer term for how bond markets cope with increased supply.
The more Hunt can do now to tighten the fiscal stance, the less the BOE will have to do on the monetary side. Unfortunately, taking too much fiscal pain forward could plunge the economy into a deeper recession than it likely would, weakening the pound and deepening the hole the government is trying to escape from. It is not easy to close the fiscal gap without harming the near-term development, at the same time it is necessary to prevent rampant inflation. But having the government and the central bank on the same page, under the careful scrutiny of the OBR’s independent watchdog, is a good place to start.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was the chief market strategist for Haitong Securities in London.
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