The Chancellor said the aim of his Budget was to provide some "breathing space" in the face of rising prices, but its main effect may be to provide breathing space for the government. While markets reacted calmly to a package that was small by recent standards and almost exactly as billed, attention will now turn to a long list of pressures and decisions deferred until next year's Spending Review.
Much of the public debate ahead of the Budget focused on the government's fiscal "headroom". In the event, it came in at £15 billion, lower than before. Although this was expected, the importance of fiscal headroom to markets tends to be overstated, in our view, and it makes much more sense to focus on the near-term path for the deficit and gilt issuance.
The government's plans for what it intends to do by 2029-30 (the year in which the fiscal rules are assessed) are unlikely to carry much weight with markets, not least because it may be an election year. Whether headroom is a few billion pounds higher or lower is also dwarfed by the much greater uncertainty over the state of the economy and public finances several years from now.
The Office for Budget Responsibility (OBR) now expects the deficit to fall from 4.2% of GDP this year to 3.4% next year, and around 2% in three years.
£15bn
Government fiscal headroom reported in the Autumn Budget
3.4%
OBR expected UK deficit percentage of GDP for next year
3.75%
Current Bank of England policy interest rate
Deficit trajectory and fiscal credibility
On paper, the UK's deficit-reduction plan remains one of the most aggressive in the developed world. But this Budget once again saw the plan slip to the right, with borrowing revised higher across the forecast and progress in reducing the deficit from a year earlier almost grinding to a halt in the current fiscal year. As with last year's Budget, the Chancellor chose to loosen policy in the early years through higher spending, offset by the prospect of higher taxes in later years, although on a smaller scale than in previous Budgets.
We assign little credibility to the precise long-term deficit plans beyond next year. However, if the government can reduce the deficit to around 3.5% next year as planned, that would be a meaningful achievement and help restore fiscal credibility. But there are still some reasons for caution.
Fiscal uncertainty will persist into next year and, if the past few years are any guide, further fiscal slippage is likely. Spending pressures are growing ahead of next year's Spending Review, including on defence. We also note that the fuel duty freeze and the extension of the VAT cut on domestic energy are both pencilled in to expire in July. Given that few observers expect either to expire in practice, today's Budget was clearly not the last word.
Gilt yields, markets, and the monetary outlook
While precise borrowing needs for next year remain uncertain, the direction still matters. If the deficit falls to "three-point-something", we expect bond markets to become less sensitive to fiscal and political headlines over time. That is not far from the level needed to stabilise the debt-to-GDP ratio. The rest of Europe provides a useful comparison. Markets remain on high alert for fiscal and political developments in France, where the deficit is above 5%, but are much less concerned about next month's election in Spain, where the deficit is 2%-3%.
Gilts continue to price in a small fiscal risk premium, with the curve slightly steeper than in most other developed countries. Removing that remaining premium will require continued evidence that the deficit is falling. But the main reason gilt yields are high is monetary rather than fiscal. The Bank of England's policy rate is high at 3.75% and markets have priced in four to five further rate hikes. The Budget did little to change those expectations. The government announced some modest disinflationary measures, but these are small in the context of the broader uncertainty surrounding inflation and energy prices.
With the Budget now out of the way, attention will shift back to inflation, growth, and the BoE outlook. Growth has surprised to the upside, the labour market appears to be stabilising, and there are tentative signs of firmer core inflation. But we see few signs of overheating, and think the degree of tightening priced by markets is unlikely to materialise. Against this backdrop, we continue to find gilts attractive as part of a diversified global fixed income portfolio.
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