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Receptive market conditions, changing political ideologies, and the coronavirus shock all mean that this week’s UK budget is likely to see Rishi Sunak open the fiscal taps and allow the UK deficit to increase. 

Central bank rates are rapidly approaching their lower bound globally, and fiscal policy is increasingly being looked to by politicians and markets as a means of mitigating the incoming global growth shock.

Due to a confluence of political, economic and financial market factors the UK is likely to be at the forefront of this transition, beginning with this week’s budget, which has the potential to be the most significant in decades:

  • Boris Johnson’s motives for ousting Sajid Javid became clear when the UK’s negotiating mandate with the EU was published. In taking a hard line insisting on no dynamic alignment with EU rules, Johnson knew that he would once again raise no-deal risk and create another uncertainty shock for the economy of the sort that slowed growth in Q4. It looks like Javid was ousted to make way for a chancellor that was willing to open the spending taps to mitigate this uncertainty shock, even if it meant abandoning ambitions for a balanced budget over the medium term.
  • In previous years and decades, fears of increasing government bond yields or currency depreciation were often cited as a reason to avoid debt-funded fiscal stimulus. In the UK this took the form of various fiscal rules committing the Government to a balanced budget within a certain timeframe, most recently a pledge to reach a balanced budget over a 3 year horizon. We believe Rishi Sunak is highly likely to significantly revise these commitments to enable a spending boost, representing a sea change in the political consensus on fiscal policy.
  • Financial markets are not so much receptive to the prospect of fiscal spending as they are raising their hands to a parched sky and praying for it. When Javid’s resignation was announced, sterling jumped, in our view due to the increased likelihood of a spending boost. 10-year gilt yields reached fresh lows last week along with many global equivalents, including US treasuries. This is a market that is likely to reward, instead of punish, fiscal stimulus.

 

Given the fall in the UK’s growth prospects over recent months, as well as the additional coronavirus shock the OBR’s updated growth forecasts are likely to leave little headroom for fiscal spending without breaking the commitment to a balanced budget.

As such, this commitment will likely be abandoned. In terms of the actual stimulus, high profile manifesto pledges such as changes to the National Insurance contribution threshold, social care and NHS funding are highly likely to feature.

Suggested revenue increases are highly likely to be shelved or scaled down; meaning the next fiscal effect of the budget is highly likely to be increased deficit forecasts at some point over the next three years.

Graph: UK Budget balance set to fall further into negative territory

 

The size and timing will depend on the chancellor’s choices, but given the fact that the virus shock will be front loaded this would seem to suggest an expansion in the near term deficit from current levels, to beyond 2% of GDP.