Fiscal consolidation is now occurring in many countries, as governments attempt to bring down budget deficits that have risen sharply over the past couple of years.
- New U.K. government announces significant deficit reduction
- Sterling strengthens further
Fiscal consolidation is now occurring in many countries, as governments attempt to bring down budget deficits that have risen sharply over the past couple of years. In the case of some countries, for example Greece, Spain and Portugal, this austerity has been forced upon them by the markets. In the case of others, like the UK and Germany, governments have voluntarily decided to reduce deficits, albeit the process will not begin in the latter until 2011. Interestingly, the US government argues that securing a sustainable economic recovery is the priority and so will complete its existing ‘stimulus’ programme before turning its attention to deficit reduction, according to Bank of Ireland’s latest Bulletin which was published today, 2 July 2010.
The new UK government plans an aggressive fiscal consolidation over the medium-term, with the budget deficit projected to fall from 11% of GDP in the fiscal year 2009/10 to just over 1% in 2015/16. Though the economy is still in the very early stages of recovery, the government intends to cut the deficit by 3.5% of GDP by the end of the fiscal year 2011/12. This is likely to have some dampening effect on economic activity over this period, and indeed the newly created Office for Budget Responsibility (OBR) has revised down its forecast for GDP growth in 2010 (marginally, to 1.2% from 1.3%) and 2011 (to 2.3% from 2.6%) after incorporating the measures announced in the budget.
According to Michael Crowley, Senior Economist, Bank of Ireland: “Fiscal consolidation will add to the Bank of England’s monetary policy dilemma. Notwithstanding the depth of the recent downturn, inflation remains well above the target of 2%. The resilience of inflation has already prompted one member of the MPC (Monetary Policy Committee) to vote for an increase in interest rates. The planned increase in VAT from January next year means, everything else equal, that inflation will be slower to return to target than the MPC had previously thought. If this causes expectations of inflation over the medium-term term to rise, the MPC has indicated it might have to respond by raising interest rates. However, it is likely that the MPC will have to revise down its forecasts for GDP growth in light of the planned fiscal consolidation. It has also indicated that a significantly weaker outlook for economic growth on account of deficit reduction might have to be met by an easing of monetary policy, presumably through an extension of its asset purchases programme (QE), given that interest rates are already close to zero.
“The most likely outcome, in our view, is that monetary policy remains on hold, with interest rates staying at 0.5% until well into 2011 and no extension of QE. What of the implications for sterling of the planned fiscal consolidation? The combination of very low interest rates and a significant tightening of fiscal policy might be expected to weaken a currency. However, sterling has strengthened against both the euro and the dollar post the budget. The market obviously views the proposed deficit reduction as credible. It also seems to believe it secures the UK’s top sovereign rating. Further gains probably lie ahead for the currency, with a move to 80p and perhaps below against the euro now likely”, concluded Michael Crowley.
2 July 2010
Bank of Ireland Global Markets
Tel: 01 609 3341
Bank of Ireland
Tel: 076 623 4772
Download the July Bulletin (PDF, 131kb)