MNI INTERVIEW: UK Budget Investment Spending To Curb Rate Cuts

MNI (LONDON) - A boost to investment spending permitted by changes to the government’s debt target is likely to push up inflation in the Bank of England's core model and slow the pace of rate cuts, Resolution Foundation research director and former senior BOE economist James Smith told MNI.

While there may be good reasons for the BOE’s Monetary Policy Committee to opt not to fully respond to any resulting higher inflation projection, the direction of the impact on policy of the change to debt rules expected in the Oct 30 budget is clear, Smith said.

"A big change in public investment would tend to slow the pace of Bank Rate cuts," he said in an interview.

Chancellor of the Exchequer Rachel Reeves is reportedly set on Thursday to signal a switch of the debt measure in the debt-to-GDP rule to one based on Public Sector Net Financial Liabilities, which fully accounts for student loans and other categories and would add an estimated GBP50 billion-plus in headroom against the current fiscal target. This will enable her to announce a significant boost to public investment, which had been seen falling from around 2.5% of GDP to about 1.5% under the plans of the previous Conservative government. (See MNI INTERVIEW: UK To Ease Debt Target, Avoid Net Worth Target)

BOOST TO INFLATION

"If you think they go as far as saying, we're not going to cut public investment, we're going to keep it about 2.5% of GDP. That's going to cost them something like 30 billion of public investment ... the peak effect on GDP is roughly 1% which is a pretty chunky effect," Smith said.

The "standard way of thinking about that would be that it maps straight into a smaller margin of spare capacity, so the output gap is 1% smaller and the effect on inflation, you tend to think of as half that, so then maybe it adds a point-five to inflation ... And then it's a question about what the Bank of England do in response to that," Smith added.

The MPC would be likely to regard that as a temporary effect, "but it will be having its maximum impact roughly around policy-relevant horizon, so the two-to-three-year mark, so there would be an argument to have a slower pace of cuts," he said.

"If you fully offset it, then it'd be something like one-percentage-point higher interest rates than they would have been otherwise," said Smith, with one possible response being to set rates a bit higher than otherwise in the next year or two and lower after that.

An alternative view is that enhanced investment spending boosts the supply side, offsetting some inflationary pressure, but Smith noted that recent work by the Office for Budget Responsibility pointed to only slight effects over the relevant monetary policy horizons, of 18 months and to the end of the three-year forecast. (See MNI INTERVIEW: UK Borrowing For Investment Risky - OBR's Miles)

TAX RISES

The Budget will also contain substantial tax rises, as Reeves aims to balance current revenue and spending five years ahead, so the growth boost will come only through the investment side. 

As the current Budget rule "will be binding, particularly on day-to-day spending, we're not expecting a big expansion of fiscal policy," Smith said.

"If you read the OBR's piece on the impact on the supply side effects are, A, very small and, B, take a long time to build. Over the horizons that monetary policy [impacts] .. those effects are going to be pretty negligible," he said.