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The UK’s Chancellor of the Exchequer presented
his Autumn Statement last Tuesday. His independent Office for Budget
Responsibility (OBR) downgraded economic growth prospects, partly due to
higher than expected energy prices and their effect on the GDP deflator. He
made much play about why his sensible approach ensured interest rates
remained low, unlike those in most European countries.
Interest rates are a wild-card, and in this respect
the Chancellor is surely tempting providence. For the fact is that interest
rates are only as low as they are because the Bank of England is funding the
Government’s borrowing more cheaply than the free market would on its
own, given the size of the borrowing requirement. That is the difference
between Italy and Britain, not as the Treasury tells us. But then the
Treasury has a long history of not understanding markets, as those of us who
were around in the 1970s will remember.
In that socialist era the government of the day
frequently maxed-out its credit with the markets. This would encourage sharp
slides in sterling which would disrupt the sales of gilts. The result was
that money supply, without the sterilisation of bond sales, would take off,
driving sterling yet lower and making it harder for the government to borrow.
The Bank of England, which in those days was under direct Treasury control,
would respond with interest rate rises, which were always too little too
late. Eventually, the Treasury would give in and sanction a rise in interest
rates high enough to satisfy the most bearish expectations. That is how we
ended up with 12%, 13½% and 15¼% coupons on twenty year gilts
and a poorly performing economy which staggered from crisis to crisis.
The solution was only resolved by gilt yields
rocketing to sufficiently high real rates adjusted for inflation. How
different it is today! The market turns a blind eye to negative real yields
for gilts against a background of record debt issuance, but this will not
continue for ever. The budget deficit is forecast to be 8.4% of GDP in the
current year, and outstanding government debt will be at 67.5% and rising.
Compared with European states and with a reasonable debt maturity profile it
perhaps doesn’t look so bad. But as Italy found out, the fact that
there are countries in a worse position does not guarantee you will escape
the market’s attention for long.
Tucked away in the Statement was an extraordinary
bit of wishful thinking, which perhaps explains the Treasury’s optimism
about interest rates: the rate of CPI-measured inflation is forecast to fall
from 4.6% in the current fiscal year to 2.4% next, and 2% thereafter. These
estimates are central to everything, but so far the forecasting record for price
inflation has been very poor. If inflation turns out higher than forecast,
the GDP deflator will again be higher than expected, to the detriment of real
GDP. And if real GDP undershoots, the budget deficit will not fall as
forecast.
The set-up for a repeat of the funding crises of
thirty years ago is in place, and it is only a matter of time before markets
understand this. The OBR’s inflation forecasts are exposed to +further
rises in energy and food prices, and sterling weakness. All we need is for Europe
to slip out of the headlines, which it eventually will, for the focus to
swing to Britain.
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