Kwasi Kwarteng has been handed independent forecasts on the state of the UK finances that are expected to show a hole of more than £60bn left by his sweeping tax cuts and a sharply slowing growth outlook.
At the end of a turbulent week for Liz Truss’s government, the chancellor was on Friday handed the initial predictions for the economy and public finances by the Office for Budget Responsibility (OBR) which are likely to paint a gloomy picture.
Sir Charlie Bean, a ex-member of the independent watchdog and a former Bank of England deputy governor, said the document would probably show a large shortfall for the exchequer.
“It will be in the order of £60bn to £70bn relative to its previous forecasts,” he said, adding that Kwarteng would face three options: further U-turns on his tax-cutting plans, deep cuts to public spending, or risking the ire of already rattled financial markets by substantially adding to the national debt.
“What he’ll be confronted with, and I don’t think to be honest most observers and MPs have really woken up to this yet, is the extent to which the public finances has deteriorated since the spring,” Bean said.
“It will be interesting to see what the chancellor comes up with, what rabbits he can pull out of the hat. They could U-turn on the tax cuts they announced a fortnight ago, but that of course I’d say would be politically terminal for the Truss government.”
The Treasury was on Friday closely guarding the details of the OBR forecast, despite pressure from rebellious backbench Conservative MPs demanding an early release of the estimates for economic growth and the public finances.
The job of the Bank of England, which since 1997 has had the statutory task of hitting the inflation target set by the government – currently 2%.
The Treasury is responsible for fiscal policy, which involves taxation, public spending and the relationship between the two. 'Fiscal easing' is when plans for tax cuts not are not matched by planned spending cuts.
The gap between what the government spends and its tax revenues
The sum of annual budget deficits – and the less frequent surpluses – over time.
In the UK these are known as gilts, and are a way the state borrows to finance its spending. The fact that governments guarantee to pay investors back means they are traditionally seen as low risk. Bonds mature over different timescales, including one year, five years, 10 years and 30 years.
Bond yields and prices
Most bonds are issued at a fixed interest rate and the yield is the return on the capital invested. When the Bank of England cuts interest rates, the fixed return on gilts becomes more attractive and prices rise. However, when interest rates rise gilts become less attractive and prices fall. Therefore when bond prices fall, bond yields rise, and vice versa.
Short- and long-term interest rates
Short-term interest rates are set by the Bank of England’s MPC, which meets eight times a year. Long-term interest rates move up and down with fluctuations in gilt yields, with the most important the yield on 10-year gilts. Long-term interest rates affect the cost of fixed-rate mortgages, overdrafts and credit card borrowing.
Quantitative easing and quantitative tightening
When the Bank of England buys bonds it is called quantitative easing (QE), because the Bank pays for the bonds it is purchasing by creating electronic money, which it hopes will find its way into the financial system and the wider economy. Quantitative tightening (QT) has the opposite effect. It reduces the money supply through sales of assets.
Pension funds and the bond markets
Pension funds tend to be big holders of bonds because they provide a relatively risk-free way of guaranteeing payouts to retirees over many decades. Movements in bond prices tend to be relatively gradual, but pension funds still take out insurance – hedging policies – as protection to limit their exposure. A rapid drop in gilt prices can threaten to make these hedges ineffective.
Buying on margin is where an investor or institution buys an asset through a downpayment and borrows money to cover the rest of the cost. The upside of margin trading is that it allows big bets and higher returns when times are good. But investors have to provide collateral to cover losses when times are bad. In times of stress they are subject to margin calls, where they have to find additional collateral, often very quickly.
This is where a financial crisis starts to feed on itself, because institutions are forced into a fire sale of their assets to meet margin calls. If pension funds are selling gilts into a falling market, the result is lower gilt prices, higher gilt yields, bigger losses and further margin calls.
This is where the Bank of England is prevented from taking the action it thinks is necessary to combat inflation because of the size of the budget deficit being run by the Treasury. Fiscal dominance could take two forms: the Bank might keep interest rates lower than they would otherwise be, in order to reduce the government’s interest payments on its borrowing, or it might involve covering government borrowing by buying more gilts.
Larry Elliott Economics editor
After the Treasury watchdog was sidelined by the chancellor for his mini-budget – among the several moves credited with spooking financial markets – the forecasts are thought to take into account the £43bn of unfunded tax promises announced by Kwarteng late last month.
The chancellor is understood to be working on plans to cover some of the shortfall in the public finances, due to be announced in a fiscal statement alongside the release of the OBR forecasts. Although pencilled in for 23 November, the chancellor is expected to announce to parliament next week that the event will be pulled forward, to before the end of October.
After receiving the initial forecasts on Friday, Kwarteng will update the OBR on his plans over the coming weeks. The watchdog will then produce a final forecast taking them into account to be published alongside the fiscal statement.
In an effort to close the gap, analysts at Deutsche Bank said they expected Kwarteng to use spending cuts worth between £25bn and £30bn over the next three financial years. However, such a move would be politically sensitive after a decade of austerity and growing demands on public services.
It said this would also still leave the government’s budget deficit – the shortfall between public spending and revenue – close to £185bn this year, compared with a March estimate made by the OBR for a £99bn shortfall. It said the deficit could fall to £155bn next year, but would still be more than £100bn above previous forecasts.
In the spring, the OBR estimated the government would have headroom of about £30bn within a target to get the UK’s national debt falling as a percentage of GDP. However, Bean said dramatically higher levels of inflation had pushed up government borrowing costs since then and led to a material slowdown in the economy.
The former OBR member, who vetted the tax and spending plans of three consecutive chancellors before stepping down in December last year, said this meant £30bn of headroom was probably now at least a £30bn shortfall. He said Kwarteng’s tax cuts could be added to this figure for the overall size of the hole in the UK’s finances.
Kwarteng has argued cutting taxes could help to drive economic growth, which could in turn benefit the public finances, and has set a growth target of 2.5% a year.
However, Bean said this was a “fairytale” that the OBR would also disagree with. It could though publish scenarios showing how faster growth rates could benefit the government finances.
It comes as the Bank of England awaits details of the chancellor’s mini-budget before setting interest rates early next month. Dave Ramsden, one of the Bank’s four deputy governors, said the mini-budget had prompted a “material” economic impact that it would be forced to take into account when setting borrowing costs.
Suggesting that the Bank would be forced to take tougher action to control inflation, he said there had been four successive “shocks” for the British economy: the mini-budget, the turbulence in financial markets seen in its wake, high energy costs, and shortages of workers.
“The picture you get is of successive upwards revisions to inflation and successive downwards revisions to growth, with the energy price shock the principal driver of both,” he said.