Tomorrow, Philip Hammond, will present not only his first fiscal statement to Parliament, but the Office for Budget Responsibility’s first post-referendum forecast.
Rather than just second guess how the OBR’s forecasts might change, what follows dissects how our Nation Institute of Economic and Social Research (NIESR) forecasts for the public finances have evolved between May and November of this year.
That we have revised up our forecasts for government borrowing might not come as a surprise, but what might surprise is that we have revised up by only a cumulative £50bn (or £10bn per annum).
So what's going on?
Offsets play a significant role.
There is the direct effect on the public finances from recent monetary policy decisions, but there is also a large unknown in the form of future contributions to the EU’s budget.
Changes to the economic outlook are behind higher borrowing forecasts
We have lowered our economic growth forecasts over for the next few years, with the slowdown concentrated in 2017.
This temporary slowing is largely due to a drop in domestic demand; elevated uncertainty weighs on investment decisions, while the purchasing power of many households will be eroded by the pass through into consumer prices from the recent depreciation of sterling.
Weaker growth maps into weaker tax revenues and higher spending on out of work benefits.
In May we expected cumulative public sector net borrowing of £137bn over the period 2016/17 to 2020/21.
Our more recent subdued economic projections increase our borrowing projections over this same period by around an additional £81bn.
This is, however, only part of the story.
Our forecasts for borrowing have actually been revised up by only £50bn.
So why do we increase our borrowing projections by £50bn instead of £81bn?
This comes from two important offsetting factors: monetary policy and EU budget contributions.
Looser monetary policy is a direct offset
That monetary policy always has implications for the public finances is well known.
After all, changes in interest rates affect the borrowing costs of the government, just as they do households and firms.
The loosening of monetary policy announced in August directly improves the public finances substantially.
The Bank of England is on course to hold £435bn of government bonds.
At the same time, the Bank receives coupon payments on its stock of gilt holdings.
Since 2012 it has returned this cash to the Exchequer, less a fee charged at Bank Rate.
The reduction in Bank Rate in August means more cash now flows back to the government.
Finally, the additional purchase of bonds by the Bank pushes up the price of government bonds.
With prices further above par, fewer bonds need issuing to meet the government’s cash requirement.
Our estimates suggest the direct effect of recent monetary policy changes will improve the public finances by a cumulative £15bn.
Future contributions to the EU Budget key, but highly uncertain
Upon exit in 2019 we have assumed that the UK will no longer contribute to the EU budget, improving the position of the public finances by almost £8bn per annum in each of 2019/20 and 2020/21.
This is an admittedly heroic assumption.
The new relationship with the EU may involve a contribution to the EU budget.
Indeed, this is the case for EEA members and Switzerland.
This could be one of the key surprises in the OBR’s forecast.
Their remit is to produce a forecast based on government policy, but given that we do not yet know what Brexit actually means how they will approach assumptions about future EU budget contributions is a large unknown.
The size of borrowing still expected to shrink each year
What does this mean for trajectory of borrowing?
Despite the multiples of billions in additional borrowing just discussed, it does not change the overall profile too much.
Borrowing, both as a percentage of GDP and in money terms, is still expected to shrink, just at a slower pace.
The key to this continued reduction in borrowing is one crucial fact that has not changed: there is still a significant amount of fiscal consolidation planned for this Parliamentary term.
At around 6 per cent of GDP (£120bn in 2016 money), the consolidation planned for this Parliament, is of a similar magnitude to that undertaken by the coalition government over their term in office.
Finally, what might this all mean for the OBR’s borrowing projections?
And finally how do these figures compare to OBR’s March forecast?
NIESR’s pre-referendum projection for the public finances was more conservative than the OBR’s - meaning we already expected the Government to borrow more.
The difference between our current borrowing forecasts and those of the OBR's from March is now £92bn (including the monetary policy and EU budget assumptions).
Whether the change in the OBR’s forecast hits £100bn or not will depend on assumptions they make about EU contributions and how generous the Chancellor chooses to be this side of Christmas.
Simon Kirby is Head of Macroeconomic Modelling and Forecasting at the National Institute of Economic and Social Research.
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