Chancellor Phillip Hammond should have good news for savers in next week’s Budget, if policy-makers keep to their word.
Earlier this month, Theresa May told the Conservative party conference that austerity “is over”. Ending austerity does not mean raising taxes to pay for more government spending. Higher taxes do not end austerity; they merely shift it onto other people. Instead, ending austerity means ending fiscal tightness.
And this requires a significant policy loosening. One measure of the fiscal stance is cyclically adjusted net borrowing. The OBR foresees this falling from 1.9 per cent of GDP this year to 0.9 per cent by 2022-23. That’s a tightening of one percentage point of GDP. If austerity is to end, so too must this tightening. Fiscal policy must therefore be loosened by a percentage point of GDP – just over £20bn – over the next four years.
Which is where savers get good news. Looser fiscal policy should mean higher interest rates. The reason for this is straightforward. Looser fiscal policy, other things bring equal, means higher aggregate demand. The Bank of England, however, believes that inflation tends to rise “when demand for goods and services exceeds supply”. It thinks we are already at this point. In August bank governor Mark Carney said there was “very limited spare capacity” in the economy; that inflation pressures were “building”: and “the prospect of excess demand emerging”. Looser fiscal policy will add to these pressures and so require higher interest rates if the Bank is to keep inflation to its 2 per cent target.
How much higher? If we assume the fiscal multiplier is around one, then a removal of next year’s planned tightening would add 0.3 per cent to aggregate demand. To offset this requires a rise in Bank rate of around half a point: Bank economists estimate that a percentage point rise in Bank rate cuts activity by 0.6 per cent. If chancellor Hammond really does abandon austerity, further half-point rises will be needed in 2020 and 2021.
These rises should come on top of those that were likely on the old fiscal plans; in September, economists expected Bank rate to rise half a point in 2019. We should therefore expect Bank rate of around 1.75 per cent by the end of next year, if Mr Hammond delivers on Ms May’s promise.
Of course, there are many 'ifs' here. If Ms May had in mind merely both higher government spending and higher taxes, then there’s no need for extra rate rises: higher (income) taxes would hold down inflation. Personally, I’m sceptical of the Bank’s view that inflation is determined simply by the output gap. And if the economy falters because of a no-deal Brexit, rate rises would be off the table.
Nevertheless, it is possible that our era of tight fiscal and loose monetary policy is coming to an end. While good news for cash savers, the impact of this on equities might well be more mixed.
