The fiscal tightening implemented by the new coalition should not choke off the recovery, but it will slow UK economic growth over the next two years, according to the forecast.
The Chancellor’s five-year plan to cut the deficit while keeping the pace of the economic recovery is very ambitious. But ITEM Club believes that in the long term it will lead to more sustainable high-quality growth from 2013 because it will be led by business investment and exports, rather than public spending.
Peter Spencer, chief economic adviser to the Ernst & Young ITEM Club, commented, “The new coalition’s plans to cut the deficit are certainly ambitious. But the bulk of the additional tightening is set to come in the second half of the parliamentary term, when we believe that the recovery will be firmly entrenched and the economy should be able to deal with the headwinds from the Budget.”
Spencer added,” On the assumption that the government is able to implement the overall reduction of £40 billion set out in the budget, we expect that UK growth will struggle to reach 1% this year but will gradually speed up in the following years to give the UK a high-quality recovery based on trade and investment.”
Spencer said that the VAT rise will help to plug the fiscal black hole over the following 12 months. But he cautioneed that after that the medium-term forecast for the UK economy is fraught with uncertainty.
He believes that to prevent CPI inflation moving below 1% it will be necessary keep the bank base rate low at 0.5% for much longer than the OBR and the markets have anticipated. The ITEM forecast suggests that the base rate will remain on hold until the end of 2013, although this is dependent on the assumption that the impending spending cuts actually come through. “A base rate of 0.5% will begin to look like the new normal,” Spencer remarked.
