The UK budget and the Bank of England: What to look for

It's a little under a month since Chancellor Rishi Sunak took over at the UK Treasury, but the circumstances surrounding his first budget this Wednesday have changed dramatically over that time.

Sterling soared in February on hopes of a sharp increase in stimulus – particularly related to public investment. But with the UK government warning of a wider coronavirus outbreak in the UK, the much greater focus now will be on any measures to mitigate the economic impact.

The challenge facing the Chancellor is well documented. The numbers are tight, assuming the Treasury honours a manifesto pledge to balance day-to-day spending within two-to-three years. Official forecasts back in March 2019 effectively gave the Chancellor £37 billion headroom – money that could be spent while still meeting the target.

But a combination of lower growth, some previous spending announcements and accounting tweaks mean that figure is now at best £10bn, probably less once the forthcoming Covid-19 growth shock is factored in.

A key focus will be on the slowdown in demand, increased rates of worker-isolation/illness, and what it all means for firms’ cashflow. The government is already planning to beef-up its “Time to Pay” system which allows struggling businesses to pay tax bills back in smaller instalments over time, and there are likely to be further measures announced this week.

One option might be to cut VAT temporarily as happened back in 2008, and the government could even allow firms to defer payment of their VAT bills. The former has been a fairly successful form of short-term stimulus in the past, although perhaps consumption-based measures will only go so far in this instance if shoppers are stuck at home.

Either way, with few fresh revenue-raising measures likely to be announced, we may well see some tweaks to the fiscal rules in order to facilitate the extra spending.

The most obvious move would be to allow a current budget deficit for longer - perhaps for the next five years, as opposed to balancing day-to-day spending by 2022/23. That might unlock a bit of extra cash (£5bn, according to the Resolution Foundation think tank), but will markets be fazed by the more relaxed approach to fiscal discipline?

Given the current demand for safe havens, our rates strategy team thinks the answer is probably “no”.

Away from the budget itself, markets are questioning whether the Bank of England could announce stimulus in coordination with the budget on Wednesday.

Incoming Bank of England Governor Andrew Bailey noted last week that there should be coordinated action, although a rate cut linked to a budget may inevitably raise some questions surrounding independence – even if the circumstances may warrant it.

Bailey also hinted that the Bank wanted “more evidence than we have at the moment” before making a decision. That helped explain why the BoE opted against joining the Federal Reserve in a coordinated rate cut, which probably also suggests the Bank would ideally wait until its meeting later in March before acting.

Realistically, there’s not much officials will be able to glean from the public dataflow before the 26 March meeting, but it would allow extra time to collect information from its network of agents.

BoE officials will also be acutely aware that a rate cut – lowering debt-service costs - is likely to be a less effective demand boost that it normally would, and is unlikely to mitigate the wider cashflow issues facing affected firms as effectively as some fiscal measures.