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Weekly Economic Briefing


Breaking out of the straitjacket


Chancellor Hammond will be sharpening his pencils ahead of the Autumn Budget, published November 22. The new government provided a remarkably vague vision on fiscal policy in its manifesto. There was a promise to stick to the fiscal rules announced last year and to balance the budget by the middle of the next decade (see Chart 3). There were also commitments to cut corporation tax and increase personal tax free allowances, but the previous policy to not raise personal tax rates was dropped. On the spending side, there were promises to invest in transport, housing, R&D and vocational education, although it was not entirely clear to what extent these policies represented new money, or existing spending commitments. Overall, the manifesto provided some flexibility on individual policies, albeit with the onus still firmly on a gradual fiscal tightening.

Gradually balancing the books Underinvestment

Given the outcome of the general election, and Labour's success with a very different fiscal stance, will the Conservative government look to change policy direction later this year? In fact, we have already seen one or two small shifts from the government in the lead up to the Budget. The 1% cap on public sector pay rises has been scrapped, with the government agreeing to higher increases for prison and police officers. It has also come under pressure over its intentions to raise tuition fees by £250 a year, and ministers have promised a review. However, while we might see some further tinkering with policy at the margin, it seems unlikely that we will see a dramatic change in direction. Indeed, the Chancellor is expected to continue to pursue a gradual fiscal tightening, primarily through lower expenditure, to help bring the budget to a balance in the next parliament. Within this envelope there are likely to be a number of policy announcements aimed at addressing politically sensitive issues. The government will also likely continue to talk up its action on investment in infrastructure and skills, with its own manifesto noting that UK infrastructure is rated second bottom among G7 members (see Chart 4). However, we do not foresee measures of a scale sufficient to address the well documented shortcomings in these areas.

Action in this area has become even more urgent after the EU referendum. Private investment has been weak since the vote, as business defer capex plans, weighing on productivity growth. The shock to the supply side means that even the weaker growth thus far over 2017 looks to have been above the UK's potential, producing a tighter labour market. This is an adjustment that the Bank of England has warned it cannot offset through monetary stimulus, amid signals that it will probably start to raise rates later this year. The government can make a difference, with well-targeted investment in infrastructure and skills shortages a natural remedy. Part of its problem is self-inflicted, with the lack of flexibility in the government's fiscal rules providing limited room for unfunded investment spending. The Chancellor should take bold action in November; exempt capital spending from this straitjacket, and use this flexibility to invest in infrastructure projects with the highest return. A wide range of empirical evidence suggests that these tend to be smaller scale improvements to local infrastructure, rather than grand projects such as high speed rail. If action is not forthcoming then the UK economy will have to get used to a frustratingly low speed limit on growth.  

James McCann, Senior Global Economist