Lopsided macroeconomic policy
A combination of OBR optimism and Bank pessimism on the outlook for the economy is screwing up macroeconomic policy
It’s the end of Productivity Week and we’ve had a cornucopia of analysis and ideas about how to fix the UK’s sclerotic economic growth from The Productivity Institute and others like the LSE. Next week is the grand finale of the Resolution Foundation’s epic Economy 2030 Enquiry which will present a comprehensive plan to break out of stagnation.
Fixing growth is the central economic policy challenge of the day. But what if how it’s forecasted is itself hampering growth and creating big problems for public debt? Specifically, are divergent official forecasts from the Bank of England and the Office for Budget Responsibility screwing up macroeconomic policy?
Standing back from the detail of last week’s Autumn Statement, one of the most striking things about the OBR’s accompanying forecast and the Bank’s November Monetary Policy Report is just how different the two institutions’ views are about the UK’s ability to grow.
Only one of them can be right (or more right). If the Bank is right then government borrowing must be unsustainably high after last week’s tax cuts. While if the OBR is right then presumably interest rates are higher than necessary to get inflation under control. What’s going on, why and what should we do about it?
The economic speed limit
‘Potential output growth’ is the underlying rate at which the economy can grow without causing inflation — the economic ‘speed limit’ as some people call it. This is the key determinant of whether and how quickly prosperity can grow, and its weakness since the financial crisis is why real pay has barely grown for 15 years. Potential output growth is the combination of productivity growth and the change in the number of hours of labour that are supplied. And over a five-year horizon, apparently small differences in judgements about what this unobservable speed limit is make a huge difference.
And a huge difference in views between the Bank of England and the OBR is exactly what we’ve got. The Bank’s Monetary Policy Report from earlier this month sees the economy’s potential growing by ¾%. The OBR’s Economic and Fiscal Outlook last week, on the other hand, sees it growing 1.6% a year between 2024 and 2028.
OBR optimism has its risks…
That gap is a very big deal for the public finances. Indeed, the OBR presents a scenario in which productivity growth — i.e. the bit of potential output growth that’s not labour supply — is cut to half of the 1% annual growth that underpins its central forecast. This would see productivity growth running at about the same rate we saw in the last decade, and would mean potential growth as a whole running at about 1.1%. Even this downside scenario is significantly more optimistic than the Bank’s 0.7%.
But such a forecast downgrade would, according to the OBR, have seen the chancellor missing his target to get debt falling by over £40.5bn in 2028–29. That would require an extraordinary £53.5bn per year of tax rises or spending cuts to regain the £13bn headroom the central forecast shows for 2028–29. On this outlook there was certainly no headroom for a £21bn tax cut. If anything the Chancellor should have been raising taxes by that amount last week.
How likely is this low-productivity outlook to be what happens? Over the years since the financial crisis the OBR has, like the rest of us, gradually been coming to terms with the new reality of sluggish productivity and associated wage growth.
But this chart — the Most Terrifying Chart in All of Economics — captures just how consistent the OBR’s optimism has been since 2010. While the latest productivity growth forecast (in light blue) is much more sober than we’ve had in the past, it’s still significantly above the post-2010 trend (light green) on which the OBR’s weak growth scenario is based.
This optimism bias is entirely understandable. There are multiple reasons why productivity growth might have been held back recently. But the financial crisis is firmly in the past and the worst of the Brexit adjustment is probably out of the way. If Covid bent the economy out of shape, patterns of life have now stabilised. So maybe this time the productivity pick-up will come through.
This is a judgement with big implications and the OBR doesn’t want to be responsible for demanding unnecessary austerity based on a judgement about which it can only ever have low confidence.
But it’s a very big hostage to fortune, and critically it means that fiscal policy is much looser, with the government piling on more debt, than it would be if the OBR was fully to adopt the more recent productivity trend. Incidentally, if I was a potential incoming chancellor I would look nervously at that productivity line and wonder whether the OBR will at some point soon throw in the towel and downgrade the productivity outlook, requiring some fairly nasty tax rises on top of all the other ones that will be needed after the election. Happy Friday!
…as does The Bank’s pessimism
At the other end of town, the Bank’s pessimism on potential output is part and parcel of its message that we should not expect interest rates to come down any time soon. Low potential output growth — if that’s what we have — means that demand can’t grow very quickly without causing inflation. That justifies the Bank keeping interest rates high and suppressing demand growth because, in their view, it isn’t consistent with inflation at target.
The Bank is a bit more pessimistic than the OBR on productivity growth (it averages 0.75% per year between 2023 and 2026) and a lot more pessimistic on labour supply growth. But if the Bank is wrong and potential supply growth is almost a percentage point higher over the next three years, that hawkish stance would choke off growth much more than necessary. All else equal the output gap (between the economy’s actual and potential output) would end up around three percentage points lower in 2026 than the Bank’s current projection of -1.5% in that year. That would presumably be way more than required to get inflation back down to target.
That also has implications for the public finances and wider prosperity. If the Bank is squeezing economic activity too much, that will reduce tax revenue in the short term and damage investment. The result could be a self-fulfilling prophesy of low growth.
As with the OBR’s optimism though, the Bank’s pessimism is understandable. Critics say it was late to act on surging inflation and it doesn’t want complacency or dovish speculation to weaken the already difficult task of getting wage growth back onto a path consistent with the 2% inflation target. Hence the tough talk about rates remaining high for a long time and matching gloomy forecasts of the economy’s speed limit.
Understandable though it is, that doesn’t make the stance correct. If the Bank took the OBR’s view, interest rates might have peaked earlier, and there would be even stronger grounds for expecting rate cuts before long. Near-term economic and wage growth would be stronger, tax revenues more buoyant, and chances of the government getting debt falling by the end of the decade would all be higher as a result.
A toxic combination
The understandable biases of the two official forecasters therefore risk us being in the worst of all worlds. A lopsided policy mix with excessively tight monetary and loose fiscal policy that is structurally over-reliant on fiscal support, pulling down growth and ramping up already-high public borrowing.
If the Bank and the OBR were to split the difference on potential output growth, the result would be tighter fiscal policy — probably to the extent that last week’s tax cuts wouldn’t have been affordable — and faster short-term growth, because interest rates would be expected to fall sooner.
At times of economic stability and quiescent inflation, divergent views from the two official forecasters are inevitably smaller and less significant. But at moments of economic volatility their institutional biases are likely to come to the fore. So this seems like a permanent structural problem that needs addressing.
To be clear, I am not arguing that the Bank is too pessimistic or the OBR too optimistic. There are good arguments in both directions. But they can’t both be right and that’s a problem. The obvious solution is to force closer alignment on the Bank and OBR’s views on the economic outlook. There is surely no justification for divergence to this extent when the implications are so significant.
