Austerity in the UK

Irresponsible OBR analysis contributes to gilt market confusion

WATCHING MACRO POLICY unfold in the United Kingdom is painful at the best of times.

But the Office for Budget Responsibility’s (OBR) interpretation of the October Budget as expansionary, an interpretation unchallenged a week later in the Bank of England’s (BOE) November Monetary Policy Report (MPR), is surely a low point.

This interpretation has been repeated by many since.

Roughly, the OBR claimed the expenditure uplift in Reeves’ Budget will contribute to a positive output gap—thus higher projected inflation alongside a mechanical increase in prices in response to cost pressures on businesses from revenue raising measures.

The Budget was expansionary and therefore required tighter monetary policy.

This interpretation contributed meaningfully to a gilt sell off on Budget day, most of which happened after Chancellor Reeves finished speaking and only following publication of the OBR’s Economic and Fiscal Outlook—while gilt prices sold off more during the OBR press conference.

The OBR therefore contributed to higher rates since the Budget, impacting the front end of the yield curve and the cost of mortgage resets in the UK—further weighing on households during a period of emerging fiscal austerity.

But their understanding is flawed at best.

Oddest of all, the BOE’s response a week later, during the November MPR update, was to largely endorse the OBR’s analysis—doing so, effectively delegating monetary conditions to their fiscal counterparts.

In other words, the two major macro-policy institutions in the UK endorsed a combined fiscal and monetary tightening in the last quarter of 2024—and we should not be surprised to discover that tighter policy weighs on the macroeconomy.

To explain all this, we begin by asking what was really in Reeves’ first Budget last October?

a pre-budget baseline

To evaluate the Budget, we first need a baseline against which it can be judged.

To this end, we adjust the March Budget for expenditure and revenues not related to new policy announcements.

• Expenditure. The OBR revealed GBP23.8bn in current spending pressures across various departments known by HM Treasury in February for FY2024-25 but not revealed for inclusion in the March forecast. In addition, Chancellor Reeves signed off on a number of public sector wage agreements shortly after the election that reasonably should have been included in this baseline. These agreements are estimated at an additional GBP9.4bn. Together, this meant about GBP33bn recurring public expenditures that should reasonably have been in the previous projection.

• Revenues. In addition, the OBR revised their projected tax revenues not related to new measures announced in the Budget, contributing about GBP30bn on average over the next 4 years. Income tax was projected to be higher across the forecast horizon, for example, as wage growth drives taxes.

• Interest adjustments. In addition, interest expenditure and receipts have also been adjusted across the horizon—contributing to a larger deficit throughout.

With these tweaks, shown in the chart below and measured relative to the revised nominal GDP path, we get a pre-measures fiscal path.

Roughly speaking, the overall deficit in FY2024-25 with these adjustments is hardly changed on the previous year. In other words, there was very little fiscal adjustment heading into the election, despite contrary forecasts in the March Budget. This is mainly due to the expenditure slippage noted above—the “black hole” inherited from the Conservative government.

But the baseline fiscal adjustment to follow in 2025-26 would be remarkable: above 1.2ppts of GDP, with a further adjustment of about 0.6ppts in both 2026-27 and 2027-28.

The overall fiscal deficit, before Budget measures, would adjust about 2½ppts of GDP through 2028-29 to reach 1¾% of GDP.

By any reasonable assessment, this is a substantial fiscal contraction.

Flawed reporting to the OBR at the time of the March Budget helped conceal the fact that fiscal adjustment was delayed in the election year, while an even larger adjustment was baked in the cake for the incoming Chancellor.

budget measures and fiscal path

What about the Budget measures themselves?

The next chart adjusts this pre-measures baseline for the (net) Budget measures announced by Reeves.

The change in the overall deficit in the coming financial year is reduced from nearly 1.3ppts to 0.9ppts, so the adjustment is slowed by 0.4ppts of GDP. But the adjustment in 2026-27 and 2027-28 is roughly unchanged.

So overall, Reeves’ budget takes the sting out of the year ahead. But adjustment there will be, withdrawing spending power from the private sector.

To be sure, Reeves indeed announced additional expenditure measures of nearly GBP50bn on average over the next four years (roughly split in half between new current and capital expenditure commitments.) But this is offset by new tax measures of GBP35bn per year on average, most notably the employer national insurance increase, so the net expansion from new measures is about GBP15bn per year on average—or about 0.5% of GDP per year.

This eats only marginally into the roughly GBP65bn adjustment projected by the end of the forecast horizon due to an uplift in tax receipts of GBP115bn only marginally offset by an increase in spending of GBP50bn before new measures.

It’s strange to watch, but while in the Eurozone countries are encouraged to adjust their overall deficit to 3% of GDP gently over 7 years under their new fiscal rules, in the UK this adjustment is being undertaken in only 2 years—and yet is being spun as expansionary!

primary adjustment

The situation is even starker when cast in terms of the primary fiscal balance adjustment.

Removing interest expenditure and interest and dividend receipts, neither of which contribute directly to spending or taxation, we get a modified primary fiscal balance. Compared to the March 2024 Budget, the UK’s modified primary fiscal balance will contract by more in the next 12 months than previously planned.

That is, despite new expenditures, the increase in revenues projected by the OBR, including new measures, contributes to a reduction in spending power of the private sector over the next three financial years by a larger amount than previously expected under Chancellor Hunt in March.

Again, this is a substantial and sustained fiscal contraction by most reasonable interpretations.

the OBR’s interpretation

It’s worth recalling how this substantial fiscal contraction was presented on the day of the Budget by the OBR.

The OBR prominently noted:

• “this Budget delivers one of the largest increases in spending, tax, and borrowing of any single fiscal event in history.”

• “Relative to the plans of the previous Government, this Chancellor has added

  around £70 billion per year to public spending over the next five years.”

• “We expect the economy to grow faster in the near term, at 1.1 percent this year and 2 per cent in 2025, supported by stronger outturn data and the net fiscal stimulus in this Budget which … pushes GDP about ½ a per cent above its potential level.”

• “Inflation is also higher in the near term… [including due to]… the inflationary impact of the fiscal loosening.”

• “Bank Rate expectations are also about ½ a percentage point higher in the near term and a ¼ percentage point higher in the medium term than in our March forecast… [including due to] the fiscal loosening in this Budget, not all of which would have been anticipated [by markets when the forecasts were finalised.]”

It’s difficult to make sense of this interpretation except if the OBR think a Budget is expansionary is the deficit is higher than a previous (specious) projection.

However, assessing the new fiscal path relative to the March projection does not change the fact that it is contractionary compared to the previous year’s outcome. The fiscal impulse is determined by the change in the fiscal balance—and the change in this case is a huge contractionary impulse.

gilt prices on Budget day

With this in mind, it’s worth bearing witness to gilt price action on the day of the Budget back in October. The chart below shows intraday price action from Bloomberg for the 2Y gilt on 30th October.

Reeves began speaking just after 12:30 in London. The speech lasted around 77 minutes, concluding shortly after 13:45.

At that time, the Economic and Fiscal Outlook was published. A tweet from the OBR went out at 13:51. After this, a video outlining the main messages was made available at 13:52 alongside other summary tweets of the OBR’s interpretation of the Budget. And the press conference began around 14:30.

Up until the OBR began spinning the Budget, gilt prices were well-behaved—drifting higher in price and therefore lower in yield.

Only once the OBR’s assessment of the Budget as expansionary was released—with with implications for inflation, the output gap and Bank Rate—did asset prices begin to move.

Gilt prices fell sharply from around 2pm and fell further still at the start of the OBR press conference.

household saving and sector balances

To be sure, it might be argued that a Budget is expansionary if the “multiplier” on a change in expenditure is larger than any revenue equivalent.

In the latest projections, revenues are expected to increase faster than expenditures—withdrawing spending power from the private sector, recycled by government into current and capital spending which would otherwise contract relative to GDP.

If the private sector is willing to resist the loss of purchasing power from rising taxes by borrowing or running down assets, then the Budget might still be expansionary. Than again, if the Budget measures are permanent it would make sense to adjust to them.

In any case, what do recent trends in UK household saving and sector balances suggest about the private sector’s potential willingness to continue spending at this time?

Well, the saving puzzle previously noted by Huw Pill remains—household saving is higher-than-normal since the pandemic while unemployment remains low. Typically, higher household saving is associated with increasing unemployment—gun to the head, it looks like saving typically leads unemployment higher.

In fact, household saving has continued to increase in the period since Pill made these observations on this recent puzzle.

Why would this be the case? Well, higher mortgage rates might be encouraging saving pre-reset by home-owners. Or households may be pocketing more income as a precaution post-pandemic. Or, perhaps growing inequality is channeling more income to richer households for whom opportunities to consume are limited.

Whatever the reason, households are indeed saving more than before the pandemic—and at a rate consistent with the post-GFC deleveraging, the last time austerity was tried.

This might suggest households have scope to offset the oncoming fiscal contraction. But unless we understand why household saving remains elevated it hard to rely on it to offset for austerity. The OBR did so in 2010, but it didn’t work out too well.

Seen in terms of net financial flows, non-financial corporates (NFCs) are found to be in small deficit, alongside the larger government deficit, as the counterpart to net saving by households and financial corporates.

As NFCs have to navigate the forthcoming combined increase in the national living wage and employer national income contribution, they could do so by running an even larger deficit, similar to the mid-2010s, to offset the compression in the government’s deficit. But again, as with the high household saving rate, without understanding the motivations of NFCs at this time and their likely reaction to a growing cost base, we could equally assume they will cut back on investment, reduce workforce, and raise prices to resist greater net indebtedness—passing the adjustment problem onto households.

For completeness, the OBR’s projection assumes household net lending declines gently over their forecast horizon as the counterpart to fiscal adjustment—though the immediate negative fiscal impulse is met by an increase in corporate sector net indebtedness.

Absent such adjustment, the Reeves’ Budget will indeed prove to be an austerity one.

the BOE‘s interpretation

Fortunately, the UK has an independent central bank able to challenge the OBR. But did they? No. the Bank of England largely endorsed the OBR’s analysis in the November MPR, though with a few nuances.

The BOE factored in higher nominal growth of government expenditures (see Table 1.B) but did not reflect on overall negative fiscal impulse due to higher revenues and drain on private sector spending power. They did not suggest the output gap would be positive as a result, only less negative.

But the Bank lifted the inflation impact and overall tone almost from the OBR:

• “The combined effects of the measures announced in Autumn Budget 2024 are provisionally expected to boost the level of GDP by around ¾% at their peak in a year’s time, relative to the August projections. The Budget is provisionally expected to boost CPI inflation by just under ½ of a percentage point at the peak, reflecting both the indirect effects of the smaller margin of excess supply and direct impacts from the Budget measures.”

It was only at the December monetary policy meeting, about 6 weeks later, that this interpretation began to be challenged (bolded emphasis added):

• “Most indicators of UK near-term activity have declined. Bank staff expect GDP growth to have been weaker at the end of the year than projected in the November Monetary Policy Report.”

• “The Committee discussed the extent to which recent developments in output could reflect the weakness of both demand and supply, such that there might be fewer implications for the margin of spare capacity in the economy and thus domestic inflationary pressures. There was also uncertainty around how the measures that had been announced in the Autumn Budget were affecting growth. This included the extent to which companies would, over time, take account of the indirect spillovers to private demand from higher public spending, as well as the direct consequences of the increase in employer National Insurance contributions (NICs) that would take effect from April.”

In the meantime, the shift higher in the front end of the gilt curve that accompanied the OBR’s interpretation on Budget Day has gone unchallenged—the Bank continues to refuse to offer clear guidance on the interest rate path (with the joyous exception of Alan Taylor) despite Bernanke and his well-publicised review.

conclusion: what a mess!

It is certainly often the case that the macroeconomy needs protection from politicians. The Truss-Kwartang imbroglio is the most recent reminder of that.

But when macro institutions themselves contribute through flawed analysis and an inadequate policy response—when they become the problem rather than a stabilising influence—then we may also need protecting from the technocrats.

Consider the chain of failings by UK macroeconomic institutions over the past 12 months.

• HM Treasury failed to inform the OBR of known spending commitments, which were therefore omitted from their March baseline;

• OBR incorrectly interpreted a multi-year austerity Budget as expansionary, arguing that tighter monetary policy was needed in response—despite this not being their mandate;

• BOE failed to correct this flawed analysis, de facto endorsing the OBR’s assessment of fiscal policy as expansionary;

• The Bank have not meaningfully challenged market pricing on the front end of the yield curve disturbed by specious OBR analysis ;

• Meanwhile, the ONS is scrambling to measure unemployment correctly—a crucial measure of the economy’s pulse.

This stuff really matters.

It contributes to higher interest rates for mortgage holders, higher yields on government debt, lower real incomes and weaker investment—exacerbating inequality, proliferating poverty.

What does all this say about the state of macro in the UK? It’s painful to watch.

The content in this piece is partly based on proprietary analysis that Exante Data does for institutional clients as part of its full macro strategy and flow analytics services. The content offered here differs significantly from Exante Data’s full service and is less technical as it aims to provide a more medium-term policy relevant perspective. The opinions and analytics expressed in this piece are those of the author alone and may not be those of Exante Data Inc. or Exante Advisors LLC. The content of this piece and the opinions expressed herein are independent of any work Exante Data Inc. or Exante Advisors LLC does and communicates to its clients.

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