Will the £22bn black hole suck the UK back into recession?

It’s been a bad week for Labour’s new Chancellor as she prepares for her first Budget on 31 October.  The decision to means test pensioners’ winter fuel allowance has attracted widespread criticism, the latest figures on consumer confidence fell, ending a steady string of increases, and figures for the budget deficit overshot even the pessimistic expectations.

The BoE’s decision not to follow the 50 bps cut in US interest rates will cost the Treasury an extra £440mn by the time of their next meeting in November, as a result of the ill-judged Quantitative Tightening programme (The BoE: double punched from QE & carry trade unwinds). And there’s worse to come. Household energy bills will rise by 10% on 1 October. 4 million customers on pay-as-you-go meters will see the effect immediately. Inflation will also rise. Economic data, which had been coming in much stronger than expected are now slowing and have turned negative on some measures. Many commentators say the Chancellor herself is partly to blame with her talk of a ‘tough’ Budget.

We think the pessimism is overdone. Yes, the changes to winter fuel allowance will reduce demand for those affected but overall real incomes are growing strongly as the wage/price spiral operates in reverse, and workers benefit from the cuts in National Insurance Contributions from the outgoing Conservative government – which Labour have promised to keep. The saving ratio is close to a record high. Moreover, although the BoE decided not to cut rates last week, the market sees this as a prudent delay and expect hefty cuts to come. 2 and 5-year swap rates have tumbled as a result so mortgage rates are falling, in some cases below 4%. Housing activity is increasing, which will help to release wealth and create further economic activity. Lower mortgage rates have also reduced the ‘refinancing shock’ to those who took out cheaper deals in the past. We also think the next OFGEM price cap will see lower energy prices next year following recent declines in natural gas prices.

We do expect the Budget to raise taxes and take a prudent approach to government spending. But fears that it will lead to significantly weaker aggregate demand are misplaced. Tax increases will be focused on the wealthy with limited immediate impact on spending. Consumer confidence is likely to bounce back after the Budget. Yes, the latest figures for the closely watched purchasing managers’ index, which have just been released, showed a fall but they remain in expansionary territory. Forecasts for UK growth this year have been steadily revised up but this reflects better actual data for the first half of the year, growth forecasts for next year remain deeply depressed at just 0.4%. We think the number will be much higher.

There is no denying that there are problems for the government. Much of the £22bn ‘black hole’ is of their own making, courtesy of the generous public sector pay awards. Suggestions that the minimum wage will rise by 5.8% next April, rather than the 3.9% that seemed likely a few weeks ago, will raise overall wage inflation. This may further delay BoE rate cuts. But I am confident that the UK economy will exceed the deeply pessimistic forecasts in 2025, just as it has this year.