James Bevan: The outlook for rates and fiscal policy

In the past few months markets have more or less priced out the possibility of a BoE rate increase this year and have also continued the trend – that dominated much of last year – of steadily reducing the expected terminal rate. Both of those assumptions could be challenged this year.

On the timing of the first rate hike, if the UK economy enjoys solid growth, rising pay growth and falling unemployment, then the market looks extremely mispriced for the first rate increase.Secondly, the MPC’s current forward guidance states that the Committee expects rates to rise only gradually.

This reflects not only judgments on the outlook for inflation-related variables, but also the constraint on the ability of the MPC to normalise policy imposed by the high leverage of the household sector and its sensitivity to short-term interest rates. But there’s the issue as to what happens if rates are hiked late, and the BoE will be wary of getting behind the curve as this might then require more tightening than would be the case if tightening occurs ‘on time’. Thus, with an eye on the possible hit to household spending from significant hikes in rates, and the need to avoid getting too behind in tightening policy, the BoE may decide that to ensure that rates only rise gradually, it needs to start policy normalisation sooner rather than later, perhaps starting to raise rates in Q3, possibly July or August.

If the onset of policy tightening comes sooner than expected, this may also lead markets to reconsider the terminal rate. The MPC’s current forward guidance states that the Committee expects the terminal rate to be below the average rate that prevailed before the financial crisis, and MPC members have signalled that the terminal rate in any tightening cycle could be 2-3%. At present markets are expecting a terminal rate of 1.52%.

A key reason the MPC gave for expecting a lower terminal rate was the wide spread between lending and deposit rates from banks and the Bank Rate relative to the pre-crisis years. That remains the case, but spreads have been narrowing, and the more they narrow, the more they represent de facto monetary loosening that could need to be offset by tighter policy.

One factor that could lead to delayed tightening of monetary policy would be any significant shift to tighter fiscal policy, possibly announced after the May general election. At present the UK suffers from both significant fiscal and external deficits, with the public sector deficit now more or less the same size as the current account deficit, at roughly 6% of UK GDP. These imbalances have persisted for some time without unfortunate market or economic consequences and can continue to do so, but there is a risk that a change in market sentiment precipitates a disorderly and abrupt correction in one or both.

One of the unknowns is how much of the fiscal deficit is structural or cyclical. On most estimates, the UK’s output gap is now relatively small, and this suggests that the deficit is largely structural, and indeed, the Office for Budget Responsibility (OBR) estimates that the structural deficit is slightly more than 4%. The risk is that it is larger than that, implying the need for significant further fiscal consolidation if the next government is to reduce the deficit to levels that would allow the public sector debt ratio to fall. That looks to be a significant challenge given that since the end of the financial crisis, the UK economy has only experienced two years of fiscal tightening: 2010 and 2011, and since then there has been no further fiscal squeeze, and this may be one reason why the recovery has been so vigorous.

Looking ahead, a new phase of fiscal consolidation would likely dampen demand growth, and if it were on a scale seen in 2010-11, when the tightening was worth around 1.5% of GDP per annum, it would certainly negate the need for monetary policy to slow the economy down to a pace of growth consistent with stable unemployment.

By way of context, the current government’s fiscal plans imply an enormous fiscal squeeze in the next few years, with tightening in 2016-17 on a par with, or even more exacting than, that seen in 2010-11, with that tightening largely in the form of spending cuts, rather than higher tax.

On the practicalities of fiscal consolidation, it can’t be clear whether the general election in May will leave a government with a clear mandate to undertake the scale of fiscal tightening required to deliver a smaller, or non-existent, budget deficit.

At present, spending is historically high while tax revenues are more or less in line with their historical average and although high public spending looks anomalous, the scale of the spending restraint undertaken in the past few years has already reduced spending (in real terms) in areas other than pensions and health, by around 8%. Any realistic plan to reduce public spending towards historical norms would have to involve spending cuts to those areas and politically, that seems challenging for any government.

The alternative, to bring tax revenues up as a share of GDP (to historically high levels), may seem more plausible. But that would involve broad-based increases in taxes that may also prove deeply politically unpalatable. For example, to achieve an increase in tax revenues worth 2% of GDP would require either increasing the income tax rate by 6.4%, or increasing the VAT rate by 6.3%.

So although there may be much discussion about the need to tighten fiscal policy after the election, such tightening will be challenging to implement. If it is implemented, then the case for monetary tightening would be equivalently reduced.But if it is not, then markets may start to become concerned about the persistence of a large fiscal deficit and rising public debt.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla