RBS Weekly economic update: The unavoidable budget

  • Unless you had your head buried in the sand last week, you will not have been able to avoid the UK budget. George Osborne’s first trip to Parliament with the famous red box in hand was covered exhaustively in the press, on television and on the radio. If you don’t want to know the result, look away now.
  • Last Tuesday George Osborne, the Chancellor of the Exchequer, announced the Coalition Government’s first Budget. He described it as “the unavoidable budget”, not from any advance sense of the press coverage it would receive, but because the task of reducing government borrowing and debt would affect every individual in the country. In his last budget as chancellor in March, Alistair Darling announced measures that would reduce the deficit by £73bn over the next four years. Tuesday's emergency budget aims to knock off a further £40bn, reducing the deficit from 10.1% of GDP this year to just 1.2% in 2015/16.
  • Spending cuts will deliver the bulk of this extra tightening, and higher taxes the balance. Much of the £32bn expenditure reduction will come through lower current spending, with only limited cuts in capital spending on top of those planned by the previous administration. The details of precisely where the axe will fall will be revealed on completion of the spending review in October, but most departments - excluding the protected NHS and international aid spending - can expect their budgets to be sheared by 25% in real terms. Pay freezes, cuts to benefits, and a change in the way annual increases in benefits are calculated all formed part of the sweeping measures announced.
  • Higher taxes will raise the remaining £8bn by 2014/15. The increase in the standard rate of VAT from 17.5% to 20% will net the government the most money and will also be the measure that most people notice. Prices will go up on 4th January next year, so expect the shops to be extra packed this Christmas as bargain hunters try to beat the taxman. Customer facing firms may feel the pinch from this measure, but on the whole businesses have a lot to be happy about. The main rate of corporation tax will come down from 28% this year to 24% in 2014, and the tax rate for small firms will fall even lower, to just 20%. But it wasn’t all one way traffic: the amount of investment spending firms can offset against their tax bill fell, and the rate of capital gains tax increased for higher earners.
  • Last week’s economic news wasn’t all about the budget; the Bank of England was also getting its share of the limelight. Minutes from the June meeting of the Bank’s Monetary Policy Committee showed dissension in the ranks. Andrew Sentence voted to increase the Bank Rate by 25bps, while the rest of the Committee opted to keep rates on hold. This highlights the dilemma facing monetary policy makers. On the one hand fiscal consolidation in the UK and abroad will weigh on domestic spending and prospects for UK exports, meaning spare capacity will persist and inflationary pressure will eventually subside. On the other hand, spare capacity may be lower than estimated, inflation has been persistently above target, inflation expectations are rising and this could feed through to high wage settlements.
  • Policymakers in the US walk a similarly fine line. At Wednesday’s meeting the Federal Reserve kept rates on hold and reiterated that rates are likely to remain “exceptionally low” for an “extended period” - but the dissenting voice of Kansas City Fed President Hoenig was heard once again. Hoenig remains concerned that continuing to signal that interest rates will remain low for an extended period could cause a build up of imbalances, increasing risks to financial stability and reducing the Committee’s flexibility to raise rates.
  • Activity in the US housing market is indicative of the headwinds facing the economy. New home sales fared much worse than expected in May plunging to 300,000 (annualised), the lowest level since records began in 1963. The expiration of the home buyer tax credit was marked by a collapse in sales of 33% from the previous month, demonstrating the reliance of the housing market on government support. Existing home sales also disappointed. Purchases of existing homes dropped 2.2% in May, led by an 18% decline in the Northeastern states. Lower sales and rising foreclosure rates have yet to impact home prices – at least thus far. Nationally, home prices rose in April and have been recouping previous losses since February. That said, prices are still 13% below their peak and on a par with where they were in November 2004.
  • Recent pressures in the Eurozone have done little to dampen business activity. Purchasing managers’ indicators – a good leading indicator for the economy, showed little change in June, slipping to 56.0 from 56.4. Fears that the clouds hanging over sovereign debt would reduce spending and activity have not yet been realised, through the recovery is fragile.

Paul W Turton
Business Development Director