Will the fiscal stimulus deliver much bang for its buck? - Capital Economics
UK Economics

Will the fiscal stimulus deliver much bang for its buck?

UK Economics Focus
Written by Andrew Wishart

We think that the coming fiscal stimulus will raise annual GDP growth by about 0.6ppts this year and 0.25ppts in 2021. This is part of the reason why we expect GDP growth to beat the consensus forecast by rising to 1.8% in 2021 and helps to explain our view that the Monetary Policy Committee won’t cut rates this year, and will raise them from 0.75% to 1.00% in 2021.

  • We think that the coming fiscal stimulus will raise annual GDP growth by about 0.6ppts this year and 0.25ppts in 2021. This is part of the reason why we expect GDP growth to beat the consensus forecast by rising to 1.8% in 2021 and helps to explain our view that the Monetary Policy Committee (MPC) won’t cut rates this year, and will raise them from 0.75% to 1.00% in 2021.
  • The new Prime Minister and government have a very different attitude to fiscal policy from the last austerity is out and spending is in. Admittedly, the new fiscal rules don’t give the government a blank cheque. After factoring in the economic slowdown in 2019 and the £13.4bn (0.5% of GDP) increase in funding for public services starting in 2020/21 announced in September’s Spending Round, the Chancellor will probably only have about £14bn (0.5% of GDP) to play with in the Budget on 11th March. Nonetheless, we expect him to use most of it to raise public investment. If we are right, the total loosening of fiscal policy in 2020/21 would amount to about 1% of GDP. This is a step change in fiscal policy, switching it from a sustained headwind to a tailwind.
  • As the fiscal stimulus would be tilted towards investment, it has the potential to be particularly effective at boosting GDP growth. Spending on investment typically boosts demand by more than tax cuts, at least in the short term. In other words, the government gets a bigger bang for its buck, or in economist speak, the package has a larger multiplier.
  • At this late stage of the cycle, however, it is questionable how effective any form of fiscal stimulus would be at boosting growth. In theory, when there is no slack in the economy looser fiscal policy pushes up prices rather than output. In practice, it is less clear. The US stimulus in 2018 is a good recent example. Despite there being very little slack in the US economy, the stimulus provided a decent boost to US growth but hardly raised inflation at all.
  • There are, of course, differences between the US economy in 2018 and the UK economy now. The UK labour market is probably a bit tighter. But there is evidence of more slack than there was in the US in other parts of the economy. Capacity utilisation, investment and sentiment are all lower in the UK.
  • The upshot is that we think the UK stimulus will provide a substantial boost GDP growth, and is the main reason why we think the economic slowdown in 2019 will be reversed later this year. We suspect the stimulus will add 0.6ppts to annual GDP growth this year and 0.25ppts in 2021. This is part of the reason why we think GDP growth will rise from 1.0% this year to an above-consensus 1.8% in 2021.
  • But the repercussions for inflation will probably be limited. While inflation might firm up as stronger demand gives firms the confidence to pass on some of the recent rise in labour costs, an appreciation in sterling and structural headwinds will prevent inflation from taking off. Our forecast is for inflation to return to the 2% target by end-2021, but not exceed it.
  • So while we think the market will be caught out by the MPC not cutting interest rates this year and raising them in 2021, we don’t think that rates will have to rise very far or fast to keep inflation in check.

Will the coming fiscal stimulus deliver much bang for its buck?

This Focus is an adapted version of a presentation given at the Capital Economics UK Forecast Forum held in London on 21st January 2020.

Back in July 2019 we highlighted that the next big theme for the economy would be a major loosening of fiscal policy. (See our UK Economics Focus “Political risks and three big economic trends”, 11th July 2019.) This Focus looks at how big the impending fiscal stimulus will be, whether looser fiscal policy will boost GDP growth, and whether it will lead to higher inflation.

Austerity is out and spending is in

The new Prime Minister and government have a very different attitude to fiscal policy from the last. Under the watch of George Osborne and then Phillip Hammond, the government budget deficit shrank from over 10% of GDP to 2% of GDP. Hammond had planned to continue to reduce the deficit, aiming to keep it below 2% of GDP in 2020/21 and eliminate it entirely and permanently by the mid-2020s.

But the new government wants to spend. And it has changed the fiscal rules to allow it to do so. Collectively, the new fiscal rules of the Chancellor, Sajid Javid, allow the deficit to rise to 3% of GDP. (See Chart 1.)

Chart 1: PSNB (Exc. Public Sector Banks, % GDP)

Sources: Refinitiv, HMT

A 3% of GDP budget deficit limit might sound familiar. Ironically, it’s also the budget deficit target laid down in the Maastricht Treaty, chosen to keep EU members’ debt-to-GDP ratios stable. And the irony doesn’t stop there. European Commission documents around the time of Maastricht refer to a “golden rule of public finance”, namely that current expenditure should be covered by current revenue and that only capital expenditure can be financed by borrowing.

The Chancellor has set himself exactly these constraints. In 2022/23, he aims to balance the current budget (day-to-day receipts and spending) but will allow the government to borrow up to 3% of GDP for investment. So just as we leave the EU, giving us the freedom to set our own rules, it turns out we quite like some of the EU’s ones!

The Office for Budget Responsibility’s (OBR) last full forecast, produced in March 2019, projected that the budget deficit would fall to 0.6% of GDP in 2022/23, well below the Chancellor’s new 3% target.

As the Budget was cancelled in November because of the election, the OBR didn’t get the chance to publish a new forecast. However, in December it “restated” its March 2019 forecast to account for various methodological changes, principally the change to student loans accounting. These changes pushed up the deficit quite a bit.

In the new figures, government borrowing only falls to about 1.5% of GDP in the 2022/23 target year. Accordingly, the government can probably only increase spending by 1.5% of GDP if it wants to meet its 3% of GDP deficit target. (See Chart 2.)

Chart 2: PSNB (Exc. Public Sector Banks, % GDP)

Sources: Refinitiv, OBR, HMT

However, the new figures aren’t a full OBR forecast. As a result they don’t account for two things that make the outlook for borrowing even less rosy. First, the recent economic slowdown means nominal GDP growth will be lower than the OBR forecast back in March. That will push up the deficit by 0.5% of GDP in 2022/23. Second, the government announced an increase in spending of £13.4bn a year in September’s Spending Round. This adds another 0.5% of GDP to the deficit.

If the Chancellor was aiming to loosen the purse strings a lot, the end result is underwhelming. The Chancellor’s fiscal space has been reduced to only 0.5% of GDP. (See Chart 3.) So government spending isn’t about to shoot off to the races.

But we do think that the Government will use this fiscal space in the Budget on 11th March for new investment. If that’s the case, the deficit will rise to about 3% of GDP.

Chart 3: PSNB (Exc. Public Sector Banks, % GDP)

Sources: Refinitiv, OBR, HMT

This increase in spending and borrowing mean that the government is accepting permanently higher debt. Rather than falling to 70% of GDP as was projected under Hammond’s plans, Javid looks set to preside over a stable debt-to-GDP ratio of about 80%. (See Chart 4.) The debt would still be sustainable. After all, very low bond yields mean the government’s debt servicing costs are very low at about 2% of GDP, down from around 4% between 1950-90.

Chart 4: Public Sector Net Debt (% GDP)

Sources: Refinitiv, OBR, Capital Economics

So we expect a loosening in fiscal policy totalling over £20bn, or about 1% of GDP, made up of the increase in day-to-day spending announced in the Spending Round and an increase in government investment that we expect will be announced in the Budget. This is a step change in fiscal policy, switching it from a sustained headwind to a tailwind. (See Chart 5.)

Chart 5: Fiscal Impulse (Change in Cyclically-Adjusted Deficit, % GDP)

Sources: Refinitiv, OBR, Capital Economics

At the moment we are assuming the fiscal loosening all comes through in 2020/21. But it’s possible that the investment spending will be phased in more gradually, in which case the fiscal boost would be more spread out. Either way, we know that much of the stimulus, the part announced at the Spending Round last year, will come in 2020/21.

The economic impact of looser fiscal policy

This loosening of fiscal policy is happening at an unusual time. In the four previous occasions there has been a large fiscal stimulus in the past 40 years, three have happened when the economy is slowing sharply or there is lots of slack and the unemployment rate has been high or rising. The only exception to this is the early 2000s when the Blair administration pushed up spending on public services. (See Chart 6.)

Chart 6: Unemployment Rate & Fiscal Policy Stimulus

Sources: Refinitiv, Capital Economics

The impending loosening of fiscal policy is another exception as the unemployment rate is very low. Economic theory tells us that when there is no slack in the economy, higher demand will push up prices rather than output. And there could also be financial crowding out, where the financing of government consumption and investment replaces private sector activity that would have otherwise taken place.

We suspect that the UK fiscal stimulus will only be two-thirds of the size of the one in the US relative to the size of the economy. But it could be just as, if not more, effective because we think the stimulus in the UK will be weighted towards investment rather than tax cuts. Spending on investment typically boosts demand by more than tax cuts, at least in the short term. In other words, the government gets a bigger bang for its buck or in economist speak, the package has a larger multiplier. (See Chart 7.)

Chart 7: Size & Effect of Fiscal Stimulus with OBR Multipliers (% GDP)

Sources: Refinitiv, Capital Economics

That’s all well and good, but at this stage of the cycle it is questionable how much effect fiscal stimulus will have, regardless of the specifics of the package. Fortunately, the Trump stimulus in 2018 provides a recent example of the impact of a fiscal stimulus on GDP growth and inflation when there doesn’t appear to be much slack in the economy.

US GDP growth rose from 2.0% in 2017 to 2.9% in 2018. It’s true an acceleration in US and global growth was already in train ahead of the stimulus being implemented. But this was supported in part by anticipation of looser fiscal policy following the election of Donald Trump. (See Chart 8.) Meanwhile, core inflation edged up from 1.8% in 2017 to 2.2% in 2018. But if you take out the dip in inflation in 2017, which was due to a one-off fall in the price of mobile phone contracts, then inflation hardly rose at all.

So the US stimulus provided a decent enough boost to GDP growth, but not much of a rise in inflation.

Chart 8: US GDP & Core Inflation

Source: Refinitiv

There are, of course, differences between the US economy in 2018 and the UK economy now. In both cases the central bank thought that the unemployment rate was below its natural rate. But the UK labour market may be a bit tighter.

At the time of the stimulus, the US prime-age employment rate was still some way below its pre-crisis level. In contrast, in the UK it is well above its pre-crisis level, suggesting there is very little unused labour supply. (See Chart 9.) Concerns about the effectiveness of late-cycle fiscal stimulus might, therefore, be more valid in the UK than they were in the US.

Chart 9: Prime-Age Employment Rate (Ages 25-54, %)

Source: Refinitiv

But in other areas of the economy there is evidence of more slack than there was in the US. While the employment rate is high, capacity utilisation is lower. So firms think they could produce more if demand was stronger. A boost to demand is more likely to arrest the recent fall in UK capacity utilisation than cause firms to struggle to meet demand. (See Chart 10.)

Chart 10: Capacity Utilisation (Balances)

Source: Refinitiv

And stronger demand induced by the government could have outsize effects if it helps revive animal spirits dampened by the past three-and-a-half years of politicians wrangling over Brexit. Business sentiment in the UK is much lower than it was in the US. (See Chart 11.)

Chart 11: Economic Sentiment (Balances)

Source: Refinitiv

Finally, tightening financial conditions and the trade war have caused US business investment growth to slow over the past year. But Brexit uncertainty has caused business investment in the UK to fare far worse, in fact it has fallen outright. (See Chart 12.) The upshot is that the risk of higher government investment crowding out private sector activity is limited. Indeed, the UK civil engineering activity PMI fell to its lowest level since March 2009 in December, so there is no doubt the construction sector has capacity to spare.

The received wisdom is that Brexit has led firms to boost employment at the expense of productivity-boosting investment. It would be no bad thing if that balance was redressed.

Chart 12: Business Investment (% y/y)

Source: Refinitiv

Bringing this together, we expect the 1% of GDP increase in government spending on investment and government services to raise GDP by 0.9%, spread over the next two years.

We think GDP growth will be roughly 0.6 percentage points (ppts) higher in 2020 and 0.25ppts higher in 2021 than in the absence of fiscal support. The fiscal boost is the main reason why we think economic growth will start to reverse the 2019 slowdown in 2020. Thereafter, other components of demand start to strengthen. (See Chart 13.)

Chart 13: Contribution to GDP Growth (y/y, ppts)

Sources: Refinitiv, Capital Economics

Will looser fiscal policy stoke inflation?

It’s possible that the UK will have a slightly more inflationary experience of fiscal stimulus than the US. After all, the tighter UK labour market is already generating more wage inflation than the US labour market was just before the Trump stimulus was implemented. (See Chart 14.) And the UK stimulus should cause demand for labour to increase, or at least stabilise, following recent signs that it is waning.

Chart 14: Wage & Price Inflation (% y/y)

Source: Refinitiv

So far, inflation has not reacted to rising labour costs. It might firm up in 2021 as strengthening demand gives firms the confidence to pass on at least some of the recent rise in labour costs.

That said, inflation is unlikely to take off for two reasons. For one thing, any rise in inflation driven by the past rise in labour costs is likely to be offset by a strengthening in sterling triggered by any improvement in the economy, which would dampen core goods inflation. Second, the structural factors that held down inflation in the US, such as low inflation expectations, demographics, technological progress, and weak labour bargaining power, are all also present in the UK. Our forecast is for inflation to return to the 2% target by end-2021, but not exceed it.

Finally, while the support to aggregate demand we expect fiscal policy to provide is one reason why we think the next move in interest rates will be up rather than down, the Monetary Policy Committee will be wary of overreacting. After all, the Fed had to reverse some of the policy tightening it undertook after fiscal policy was loosened in the US. (See here.) Our forecast is that the next move in interest rates will be a hike from 0.75% to 1.00% in 2021 but we aren’t expecting them to rise very far or fast thereafter.

Conclusion

Overall, we think that the government will make use of its new fiscal rules to announce a rise in government investment in the Budget on 11th March. Together with the Spending Round, that means a fiscal loosening worth about 1% of GDP is on the way.

While the labour market is tight, evidence of slack elsewhere in the economy suggests that this stimulus will be effective in lifting growth.

We expect it to contribute to a recovery in GDP growth from 1.0% this year to an above-consensus 1.8% in 2021. (See here.) Inflation might nudge higher. But it is unlikely to rise much above the Bank of England’s 2% target. So while we suspect the market will be caught out by the next move in interest rates being up rather than down, we doubt they will rise very far after that.


Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com