EY ITEM Club comments: Autumn Statement, Thursday 17 November 2022

• As expected, the Chancellor tightened fiscal policy in today’s Autumn Statement off the back of a particularly gloomy OBR economic forecast. The scale of tax rises and planned restraint on public spending, peaking at £55bn per year, was broadly in line with expectations and will be divided roughly equally between spending cuts and higher taxes.
  
  
• However, the bulk of the fiscal squeeze has been delayed until the second half of the decade. As a result, the EY ITEM Club thinks there’s a considerable chance some of the longer-term plans for tax rises and spending restraint could eventually be cancelled.
  
  
• The EY ITEM Club thinks inflation will decline next year more quickly than the OBR expects, and that interest rates will peak lower than markets and the OBR assume. The UK also enjoys some economic positives, including strong demand for workers and significant ‘excess’ savings held by households. As such, the EY ITEM Club does not think the economy will perform as poorly as the OBR predicts.
  
  
• However, austerity rhetoric itself risks having an immediate negative effect on consumer and business sentiment. Meanwhile, reducing the generosity of the energy price guarantee will result in even higher bills next year. Freezing public investment in cash terms from 2025 could prove particularly challenging to longer-term growth, as will tax rises on work, production, and saving. Furthermore, the fact that both monetary and fiscal policy are now in tightening mode as the economy heads into a likely recession seems highly likely to intensify the downturn.

Martin Beck, chief economic advisor to the EY ITEM Club, says: “The run-up to today’s Autumn Statement had seen probably more policy kites flown than in any fiscal event in living memory. In the end, today’s statement was a package of tax rises, mainly on energy producers, high earners and unearned incomes, and public spending restraint, peaking at £55bn per year, or just over 2% of GDP, in 2027-28. The size of the package was broadly in line with expectations. What also met predictions was that most of the planned fiscal tightening will not kick in until the second half of the decade, when, in the EY ITEM Club’s view, the economic situation may give a future Chancellor the option to change course.

“Granted, that’s not a prediction which would be supported by the OBR’s latest economic forecast, which appeared gloomy on most fronts. The OBR expects GDP to shrink 1.3% next year, well below the latest consensus expectation of a -0.8% contraction, and for growth to average only 0.8% over the next three years. The economy is expected to be more than 3ppts smaller by 2027 than expected in March, reflecting the persistent effect of the energy price pressures and weaker growth in the workforce.

“With the OBR delivering a poor prognosis for the economy’s prospects, the fiscal position is expected to face challenges accordingly, with substantial upward revisions to public borrowing over the next five years. But the EY ITEM Club thinks the OBR’s forecast is potentially too downbeat. The OBR’s numbers are conditioned on interest rates rising to 5%, a level which the official forecaster predicts would contribute to inflation falling below zero in 2025. A lower rate assumption, and one consistent with the Bank of England’s 2% inflation target, would mean a better growth outlook. Inflation is expected to decline only slowly, despite the substantial disinflationary forces which are now building, while the OBR also forecasts the unemployment rate to rise to close to 5%, which seems high given continued evidence of an excess demand for workers. Moreover, households could make more use of the £200bn-plus of ‘excess’ savings accumulated during the COVID-19 pandemic than the OBR expects. A different assumption around households’ appetite to dissave would make for a less downbeat forecast for consumer spending.

“That said, a recession looks a near-given in the short-term. And today’s announcements mean that both fiscal and monetary policy settings will be getting more restrictive just as the economy heads into a downturn – a move which appears to run counter to conventional macroeconomic advice and risks intensifying an already difficult situation.

“The fact that a cash freeze in public investment from 2025 is included in today’s package adds to the downsides, given the large multiplier effect of infrastructure spending. A new fiscal rule, to limit total public borrowing to no more than 3% of GDP, leaves investment spending more vulnerable to future cuts. Furthermore, Bank of England intervention has allowed pension funds to de-lever and means the gilt market’s vulnerability has declined. Tightening fiscal policy as a result of concerns that September’s market fragilities remain in place – and will remain a permanent source of potential volatility – could arguably be addressing a problem that’s no longer there.

“However, the threat to the economy from tighter fiscal policy isn’t as great as it could have been. Much of the new fiscal tightening will be backloaded to the second half of the 2020s. In particular, there will be no cuts to public spending over the next two years, relative to current plans, although annual real rises in spending will be limited to 1% from 2025 to 2028 – a considerable fall from previous plans for average increases of 3.7%. And the Government’s second new fiscal rule requires that the debt to GDP ratio is falling in five years’ time, rather than three years, as was previously the case.

“Back-loading tightening will likely reduce the negative economic impact which would have arisen from bigger near-term tax rises and spending restraint. And it makes sense on other grounds. A later debt target should also be more achievable since the debt to GDP ratio will likely be higher in five years than three. The arithmetic of debt sustainability means that, for a given rate of GDP growth and interest on government debt, a higher debt ratio would likely enable the Government to actually run a bigger deficit while still seeing the debt to GDP ratio fall.

“Moreover, rational investors should appreciate both the economic challenges that would result from doing too much fiscal tightening too soon, and that economic and fiscal forecasts at present are even more uncertain than normal. So, a debt rule that doesn’t have to be met until the second half of the decade would not be expected to cause too much market concern.

“The experience of the 2010s suggests austerity can be self-defeating, by weakening the economy and so making it harder to reach deficit or debt-reduction goals. The Government has committed to a significant, if delayed, fiscal squeeze to appease the markets, but one, which if implemented in full, risks weakening the economy and the structural fiscal position. But in the EY ITEM Club’s view, there’s a significant chance that at least some of the fiscal tightening announced today may not ultimately happen, reducing the potential downsides.”