The Uncertainty Principle

Executive Summary

After 18 months of providing unprecedented support to an economy ravaged by Covid-19, Rishi Sunak could be forgiven for thinking that the decisions at this coming Budget should be easy by comparison. But no such luck. He faces pressure for more spending on key manifesto pledges, including commitments to ‘level up’ the economy, and overdue policies to make the net zero transition a reality, as well as urgent calls on spending in order to repair the pandemic’s damage to public services. Set against that, he would also like to be the Chancellor of fiscal responsibility, repairing the damage to the public finances before the next election. To complicate these challenges further, this autumn looks set to be messy and unpredictable, with a fuel crisis, supply chain disruption and rapidly rising inflation threatening to derail the recovery.

So, this Budget and Spending Review will not only define this Government’s term in office, but also the type of Chancellor Rishi Sunak wants to be. In this report we preview the economic and fiscal outlook, and discuss the key decisions that he faces against this uncertain backdrop.

The good news for the Chancellor is that the starting point for the economy is much stronger than expected

The economic recovery has been much swifter than expected by the Office for Budget Responsibility (OBR) back in March. And the scale of the positive news is not small: the economy is around 4 per cent larger than expected. This leaves the OBR set to make the largest current-year upgrade to forecast GDP growth in nearly 40 years of fiscal projections, with the rate of growth in 2021 not seen in peace time in nearly a century. About a quarter of this improvement reflects changes to the size of the hit from Covid-19, with the rest reflecting both the better-than-expected performance of the economy while social distancing restrictions were in place, and a more rapid recovery when they were lifted.

But since the rapid bounce back as we came into the summer, slowing consumer spending and supply bottlenecks have weakened the recovery. Aggregate credit and debit card data on ‘social’ and ‘delayable’ spending have fallen since August, and were around 10 per cent below pre-pandemic levels at the start of October. All this has meant that GDP growth in July and August was just 0.3 per cent – hardly a booming recovery.

And signs that demand is losing momentum after its rapid recovery earlier in the year are being accompanied by disruption on the supply-side that is leading to sharp increases in inflation. Consumer Price Index (CPI) inflation increased to 3.2 per cent in August, having been just 0.4 per cent in February, almost all of which reflects an increase in goods prices, and the Bank of England’s most recent forecast is for inflation to hit 4 per cent by the turn of the year. A cost-push rise in goods prices driven by rising hydrocarbon costs is fundamentally temporary, but, with some goods markets struggling to adjust in the face of the recovery from the pandemic, and some wages rising in the face of labour shortages, there is a key uncertainty over how long-lasting such increases in inflation will prove.

But even such a temporary rise in inflation cannot be dismissed as benign. Higher inflation will weigh on real incomes, with the Bank’s forecast implying a fall in real incomes of around 2 per cent (or around £1,000 on annual average household income) by the end of next year, compared to the OBR’s March forecast. Together with a £13 billion raid on household incomes from increases in NICs, and sharp cuts to UC, there will be major headwinds to families’ spending power in the coming months. All this looks set to mean that aggregate real household income may fall slightly in the coming months and that the outlook for living standards is – at best – little changed since March despite the stronger economy. In addition, higher inflation could prompt policy makers at the Bank to raise rates, leading to higher borrowing costs for firms and households.

The extent of economic ‘scarring’ from the pandemic remains highly uncertain

The big judgement on the economy facing the OBR is over its estimate of economic ‘scarring’ from the pandemic. In March, the OBR assumed the economy would end up 3 per cent permanently smaller relative to its pre-pandemic path. This judgement was optimistic in an historical perspective, representing a lower degree of scarring than any recession since the 1960s. But the stronger economic outlook provides a clear rationale for the OBR to change its judgement, and similar changes have been made by a range of forecasters over the past six months, including the Bank of England (just two out of a dozen forecasters have increased the size of the expected medium-term hit to GDP since the start of the pandemic).

And there are specific reasons to suspect that the amount of scarring will be small. Unemployment is now expected to peak materially lower than was forecast in March, meaning less damage to human capital from long-term unemployment. There are also tentative signs that productivity and labour force growth will be stronger than expected. So our starting point is that the OBR may reduce its estimate of scarring to 2 per cent.

But the reality is that there remains huge uncertainty about the extent of any eventual scarring. This uncertainty should be factored into policy decisions in two ways. First, tightening aggressively in the near term should be avoided, as this runs the risk of increasing scarring. Second, policy for the middle of this decade should take this uncertainty into account: although the Chancellor may be hoping that improvements in the outlook will allow for lower taxes, he should plan for more difficult times.

The improved economic outlook boosts the fiscal position

The improved economic outlook will be matched by positive revisions to the fiscal forecasts. The good news about the economy this year has materially improved the short-term fiscal position, with borrowing this year set to be £20-30 billion lower than expected in March. The data for this fiscal year already suggests an improvement of around £30 billion, so our view is that there will little or no further improvement in the second half of the year. This is partly because rising inflation means additional debt-servicing costs; and also because the unexpected ‘underspend’ in Covid-19 support schemes, such as the Coronavirus Job Retention Scheme (JRS), will not continue once those schemes have ended.

But more important for the Chancellor and the public finances is the outlook for the later years of the forecast. If the OBR does assume a smaller amount of scarring, then the forecasts of borrowing in the medium-term could fall by around £10 billion a year. But it is entirely possible that the OBR will stick to its previous 3 per cent judgement; if so, then there would be little, if any, improvement in borrowing after 2021-22.

The Government is expected to announce a new set of fiscal rules to guide policy making from now until the next election. Those rules are likely to commit the Government to not borrow to fund day-to-day spending (i.e. to achieve a current budget balance), and to put debt on a downward trajectory. Our central case is that the Government will meet these rules by 2024-25 under current plans. However, the ‘headroom’ between the fiscal forecasts and the rules would be the smaller than any set of fiscal rules at the point of introduction since 2015, so even a small downgrade to the economic forecast would knock the Government plans off-track (and such changes must be more likely than usual given the huge economic uncertainty this year and beyond).

But the huge uncertainty means rushing to raise taxes is risky

Fiscal policy has been the main tool of macroeconomic support during this crisis, making up around two-thirds of the boost to the economy provided by policy, substantially higher than during the financial crisis, when about a quarter of support was from fiscal policy. This was partly because the Bank of England was constrained by the lower bound on interest rates, and so unable to provide anything like the support it provided during the financial crisis, and partly that fiscal policy can be more targeted, which was important, given the highly uneven impact of the pandemic on households and firms.

Given this, it is very surprising how much of the current debate is about when monetary policy might tighten: the key policy discussion should instead be about fiscal policy, which has already started tightening very rapidly on all metrics. The fall in borrowing of 14.1 per cent of GDP in the five years of the OBR’s March forecast is more than twice as large as the fastest recorded fall in any five-year period (borrowing fell by 6.7 per cent of GDP in a five-year period following the 1990s recession, but a significant contribution to that was the cut in interest rates of nearly 10 percentage points, reducing debt interest payments).

In particular, the high levels of economic uncertainty at this time should make policy makers more cautious in withdrawing support. Slowing growth and rising inflation both represent real macroeconomic risks but imply different policy responses: more support for slowing growth; tighter policy to control inflation. Reasonable people can disagree how to manage such a trade-off. But our view is that these risks are not symmetric: were the economic recovery to speed up and inflation rise further, the Bank of England could quickly tighten policy if necessary; but if the economy turns out weaker, monetary policy is already at its limit, so cannot provide more support, and fiscal policy is typically slow to change course, which would risk entrenching a weak recovery. Sensible management of these risks, then, demands that the policy makers are cautious in withdrawing support. If the Chancellor is too aggressive in tightening policy, that risks derailing the recovery. If the Bank of England also rush for the exit, there is risk of something worse.

The Spending Review will define government policy at least until the next election

Budget day will also involve the Chancellor setting out the details of the first multi-year Spending Review since 2015. This will provide settlements for individual departments for 2022-23 to 2024-25 on day-to-day and capital spending, and will clarify policy in three main areas.

First, the Spending Review will set out how the Chancellor plans to fund Covid-19 related spending in 2022-23 and beyond. Having previously used a Covid-19 reserve to allocate pandemic-related funding, the Chancellor has signalled that, from next year, pandemic-related costs – such as school catch-ups, court backlogs and transport subsidies – will be funded from additional spending only in “exceptional” circumstances. Instead, most departments will be expected to fund continuing day-to-day Covid-19 related costs from existing budgets; we will find out on 27 October whether any departments will receive extra funding for this.

The second task is to continue the move beyond austerity that Philip Hammond began in 2019. After three Spending Reviews since 2010 that featured real-terms falls in day-to-day spending (2010, 2013 and 2015) this will be the third, after 2019 and 2020, in which real terms day-to-day departmental spending will increase. Although most of this increase comes in the final year of the three-year period, this continues the better news for unprotected departments after a decade of austerity which has involved very large cuts for some: the Department for Transport budget, for example, fell by half in real terms between 2009-10 and 2019-20.

We already know that the Chancellor will be prioritising health spending in this Spending Review, as was the case throughout the 2010s, with health budgets set to grow by 3.8 per cent over the three years to 2024-25 in real terms, compared to an overall real growth rate for day-to-day spending of 2.3 per cent. A large part of this increase in health spending was announced by the Government on 7 September 2021 as part of a new plan for health and social care.

After a reduction in spending plans during the pandemic of a similar amount (around £15 billion a year), this (tax-rise-funded) health and social care funding uplift has returned overall day-to-day spending to the levels planned pre-pandemic. As such, overall day-to-day spending is now more concentrated on health, with other departments facing tighter settlements than if plans had not changed over the past 18 months.

As well as on health spending, the Government has already made commitments on schools, defence and Official Development Assistance (ODA) spending, together totalling over 60 per cent of day-to-day spending, and so we can estimate how much will remain for unprotected departments in each year. This suggests that, although 2022-23 will be tight for unprotected departments, with budgets falling slightly, on average, in cash terms, the latter years of the Spending Review will involve more generous settlements for much of Whitehall. However, it is likely that unprotected departmental spending will still be 20 per cent below its 2009-10 level in 2024-25, measured in real per-capita terms, with only one-third of the cuts that took place in the 2010s reversed by the middle of the 2020s.

The third task of this Spending Review will be to provide funding for new priorities, from levelling up to net zero. This is likely to be funded through the large capital spending envelope set aside in the March 2020 Budget. Despite a renewed emphasis on investment since the election, less than half of the new capital spending envelope has been allocated. So, we expect to hear more about how this will be spent. On levelling up, the Government has indicated a key area will be transport, particularly improving connectivity beyond London. This is understandable: per capita capital spending on transport was nearly double that in any other region or country of the UK. On net zero, hosting COP26 should provide a catalyst for long-awaited policies to drive the transition to net zero. On investment the priorities should be: measures to accelerate the decarbonisation of domestic heating, retrofit public buildings, and improve the infrastructure for low-carbon transportation (with some policy details expected after the time of completing this report but before the Budget). The problem for the Government is how to balance delivering on these big new priorities for capital spending without neglecting other more long-standing areas needing more spending, including social housing and supporting science and research and development spending.

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The Chancellor has his work cut out in a Budget that will define this Government’s term in office

After an exceptional year and a half as Chancellor, with at least eight major sets of policy announcements, you might forgive Rishi Sunak for thinking that things should be getting a lot easier. During that time, he has shown nimbleness and pragmatism in rightly taking decisions that led to unprecedented levels of spending to boost the economy as it faced the largest economic downturn in a century. The centrepiece of the £340 billion in support provided was the £70 billion furlough scheme that has played a key role in shielding the labour market from the ravages of the pandemic.

But the upcoming Budget and Spending Review will be far from straightforward. Now that a vaccine-driven recovery from Covid-19 has seemingly taken hold over the summer, the Budget and Spending Review are set to return to the Government’s policy agenda, after some of the big decisions were pushed back by the pandemic. There is no shortage of competing priorities, including: to deliver on promises to ‘level up’ and reduce regional inequality; measures to meet ambitious targets for delivering net zero; and helping government departments, most obviously the NHS, recover from the ravages of the pandemic. But Rishi Sunak also wants to be the Chancellor of sound public finances, repairing the damage from the pandemic quickly, in the hope of bringing down the (record high) tax burden by the time of the next election.

So, this Budget will both make the Chancellor’s own priorities clear and define the sort of Chancellor he wants to be.

Unfortunately, Rishi Sunak faces a messy and unpredictable outlook with clear risks on the horizon

The economic context for this key fiscal event remains clouded in uncertainty. Supply chain disruptions, sharply rising inflation and a fuel crisis have materialised, and threaten look set to derail the recovery. And with the Covid-19 caseload rising as we move into the autumn, it is clear that the pandemic is far from over.

In this report we preview the difficult decisions for the Chancellor against this uncertain backdrop. To this end, the rest of this report is structured as follows:

• Section 2 discusses the economic outlook, focussing on how economic developments have changed since the Office for Budget Responsibility’s (OBR) previous forecast in March 2021.
• Section 3 considers what that means for the public finances, and for the overall stance of fiscal policy.
• Finally, in Section 4, we preview the Spending Review, which will set departmental budgets for both day-to-day and capital spending out to 2024-25; we discuss the implications of spending priorities that the Government has already set out for unprotected departmental spending.

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The strength of the economic recovery over the summer has been much swifter than expected by the OBR back in March 2021, with the economy in August now measured to be around 4 per cent larger than expected. This good news means the OBR is likely to make the largest upgrade to the forecast of current-year GDP growth in nearly 40 years. And the rapid bounce back means that growth in 2021 looks set to be the fastest in peacetime for nearly a century.

But it is too soon to declare the pandemic over. The pace of the recovery has slowed across a range of indicators, with GDP growth in July and August just 0.3 per cent – far from a booming recovery. Signs that demand is faltering after its swift bounce back have been exacerbated by disruption on the supply side and some wages rising in the face of labour shortages leading to sharp increases in inflation: CPI inflation reached 3.2 per cent in August, having been just 0.4 per cent in February, and the Bank of England has forecast that it will rise above 4 per cent by the turn of the year. While the causes of this higher inflation are inherently temporary, it is unclear how persistent it will prove. Temporary or not, higher inflation is a problem because it will reduce real incomes by as much as 2 per cent (or around £1,000 on average annual household income) by the end of next year, relative to the previous forecast made by the OBR in March. It could also prompt higher interest rates from the Bank of England. Together with a £13 billion headwind from increases in employer NICs, and sharp cuts to UC, there will be major headwinds to families’ spending power in the coming months.

The big judgement facing the OBR is whether to reduce its estimate of economic ‘scarring’ from the pandemic. This is important because such a change would reduce the OBR’s borrowing forecast, creating more room for the Chancellor. In March, the OBR thought that, in the medium-term, the economy would be 3 per cent smaller than it had predicted pre-pandemic. This level of ‘scarring’ would be lower than any UK recession since the 1960s. While it remains unclear how much of the pre-pandemic trend the economy will recover, there have been tentative signs of improvement in data relating to the longer-term supply-side of the economy since March. Unemployment is expected to peak materially lower, meaning that long-term unemployment will do less damage to the economy. There are also tentative signs that productivity and labour force growth will be stronger than expected. These factors are reflected by the fact that only two out of 12 official and private sectors forecasters have reduced their estimate of the size of the economy in the medium-term in the past six months. But the level of scarring remains hugely uncertain – not least because a key determinant of the extent of eventual scarring will be how successful fiscal policy is in driving a rapid recovery – and the OBR’s judgement will have significant impacts on this and future fiscal forecasts.

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The faster-than-expected recovery in economic activity has materially improved the short-term fiscal position, with borrowing likely to be £20-30 billion lower in 2021-22. But, more important for the Chancellor and the economy is the outlook for the later years of the forecast. Here, again, the main message is one of heightened uncertainty. If the OBR reduces its estimate of ‘scarring’ from this pandemic to 2 per cent of GDP medium-term borrowing could be around £10 billion per year lower. But that is far from certain, and the OBR’s medium-term fiscal forecast could easily end up being little changed since March 2021.

Fiscal policy has out of necessity been the main tool of macroeconomic stabilisation during this crisis. This is partly because the Bank of England was unable to reduce interest rates by as much as in the financial crisis. But it is also because the hugely uneven impact of the pandemic on households and firms required targeted fiscal support. Recent debate about the overall stance of macroeconomic policy has failed to recognise this reality and so focused too much on the stance of monetary policy; increases in interest rates will only play a small role in the overall tightening of policy. Instead, fiscal policy is much more important. In this context, the Chancellor must take the huge uncertainty into account. Given that it would be hard to provide more stimulus in a timely manner if growth stalls, policy should avoid withdrawing fiscal support too quickly, as this risks an unnecessarily protracted recovery. Looking further ahead, Rishi Sunak would like to be in a position to reduce taxes in the coming years. But the uncertainty about the longer-term economic impact of Covid-19 means that he must also prepare for a weaker outlook that could require higher taxes.

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This Spending Review is a big moment for the Chancellor, the Government and the country. It is the first time since 2015 that a multi-year spending trajectory will be set out, and comes at a crucial period, as the recovery from the pandemic appears to be taking hold.

This recovery means reduced Covid-related spending pressures, but one key task for the Chancellor at this Spending Review is to decide (or at least signal) which departments will receive how much funding to deal with the costs of the pandemic in the years ahead.

The Chancellor will also continue the work of his immediate predecessors in unwinding austerity. We know already that the Chancellor is set to continue with the trend of the last decade in prioritising health spending over other areas; this, coupled with a tight overall spending envelope, implies spending cuts for unprotected departments in 2022-23. By 2024-25, unprotected departments are set to still have budgets that are, on average, one-fifth lower than in 2009-10 when measured in real terms per capita.

Finally, coming after a Cabinet reshuffle which prioritised ‘levelling up’ and just before the crucial COP26 summit at which net zero will take centre stage, this Spending Review will be the Chancellor’s key moment to set out how the Government plans to meet new priorities for the decade ahead.

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