The tricky part is that the OBR’s forecasts, which feed directly into the central bank’s models, are for a five-year horizon, while the BOE’s horizon is two years shorter. The government is currently trying to balance the books within three years, although Hunt will almost certainly extend that. Any spending cuts or tax increases that Hunt proposes three years from now are essentially irrelevant to the BOE because it can’t model the impact on growth or inflation. So to affect the BOE’s forecasts, fiscal tightening needs to be in place over the next two years and be big enough – tens of billions of pounds – to count.
But what makes sense economically and for market credibility may be at odds with political reality, especially if tax increases upset an already fractious Tory party. This is where realpolitik comes in for both Hunt and Prime Minister Rishi Sunak: the judicious choice of their poison will determine not only the future of this Conservative government, but also how the Tory party will be perceived heading into the next election in two years’ time.
The final test will be how Thursday’s package affects sterling and gilt yields. On his way to the G-20 meetings in Bali, Sunak told reporters earlier this week that putting public finances on a sustainable trajectory was essential to “meet the expectations of international markets.” The government is well aware that it cannot afford to cause the kind of gold market crash that brought down Lizzie Rabbit after just 44 days.
Hunt will no doubt use some trickery to reduce spending as far as is plausible in the OBR’s five-year term. Fiscal resistance—not keeping spending growth in line with inflation and not changing tax thresholds so that real incomes fall—is the most insidious path. Such opaque measures are far from a fair solution; but the promise to be frugal will not last beyond the next election.
Therefore, it is necessary to raise enough short-term revenue from a higher tax rate, combined with sufficient spending restraints, to keep the market calm. The BOE must feel confident that a tight grip on public finances will complement its efforts to contain double-digit inflation. Only then can it begin to ease the pace of interest rate hikes.
With the current cap on energy prices set to expire in April, consumer price forecasts will also need to take into account the reduced but still significant cost of the taper replacement, which targets the most deprived residents, to be announced on Thursday. As Ana Andrade and Dan Hanson of Bloomberg Economics put it this week, “Hunt has more say over 2023 inflation than the BOE.”
But Hunt will also want the chance to offer some respite from the relentless austerity drumbeat ahead of the election. It will take some ingenuity not to be too “eye-popping” with this week’s fiscal tightening, as Hunt has repeatedly warned. He has certainly set the stage for everyone to pay more taxes, and in many ways.
The gilt market will closely monitor the government’s borrowing needs for the rest of this fiscal year. There may be a slight reduction in the net cash requirement, allowing fewer gilts to be sold through April. However, Hunt may choose not to facilitate debt sales, knowing that next year’s needs will be much greater. A Bloomberg study of five gilt traders showed that average issuance is expected to be £250 billion in the next financial year; in addition, the BOE is expected to sell around £50 billion of its QE holdings, with a similar amount not reinvested at maturity. The OBR’s forecasts will set the tone in the longer term for how bond markets will cope with increased supply.
The more Hunt can do now to strengthen the fiscal stance, the less the BOE will have to do on the monetary side. Unfortunately, too much fiscal pain will send the economy into an even deeper recession than it might already be, weakening the pound and deepening the hole from which the government is trying to escape. Closing the fiscal gap without harming near-term growth while curbing rampant inflation will not be easy. But a good place to start would be to consider the government and the central bank, under the close supervision of the independent watchdog OBR.
More from Bloomberg’s opinion:
• Will Sunak test the love of Britain’s top 1%?: Teresa Raphael
• Cost of living crisis is a slow burn for UK consumers: Andrea Felsted
• British families hit by secret taxes: Stuart Trow
This column does not necessarily reflect the views of the editorial board or of Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He was previously chief market strategist at Haitong Securities in London.
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