Osborne wins—for now

The Chancellor looks set to hold a good hand of cards ahead of the next election, according to our latest economic predictions.

We have revised up our forecasts of economic growth in 2014 and 2015 to 3.1 per cent and 2.2 per cent respectively. This compares with February forecasts of 2.8 per cent and 2 per cent and reflects a continued improvement in forward-looking indicators for the UK economy. In addition to record high business confidence on some measures, we have seen consumer confidence rising again in recent months after plateauing towards the end of 2013 (according to the YouGov/Cebr Consumer Confidence Index). Critically, our research with YouGov on consumer confidence shows that while last year’s rise in confidence was largely due to improvement in the housing market, this year confidence is being driven by more households reporting an improvement in their living standards.

This rebalancing of consumer confidence is unsurprising given what the data show. Earnings growth is picking up, inflation has fallen back and unemployment has declined much more rapidly than almost anyone expected. Our forecasts show that 2014 will be the first year since the financial crisis in which gross earnings growth overtakes inflation.  Taking into account tax changes and declining unemployment too, households are likely to see their real disposable incomes rising, supporting consumer spending. Measures such as the Asda Income Tracker show that the amount of money households have to spend on discretionary items is rising again.

In addition to an improving consumer situation, business investment is expected to grow strongly in 2014 and 2015, making a notable contribution to economic expansion and helping reduce the extent to which growth is dependent on consumer spending. While household consumption accounted for 81 per cent of the economic growth seen in 2013, this is expected to decline to 46 per cent this year as the economic recovery becomes more balanced.

Overall, the Chancellor looks set to see a strong set of economic indicators in the run up to the next general election, which should leave him well-placed to offer some giveaways next year.  Because the Chancellor and the Coalition government have high credibility with the financial markets and because Labour’s two key economics spokesmen—Ed Miliband and Ed Balls—have little, there is some scope for tax cuts in the March 2015 Budget. Judging how far he might safely go in cutting taxes is more an art than a science but we predict that he could get away with up to £7bn of additional cuts as well as those already announced.

Challenges remain beyond 2015, however, and we suspect that much of what we’re seeing at the moment is a political business cycle, with growth being driven up ahead of the next election and a difficult decisions being postponed until the next parliament. Economic growth is likely to peak this year and fall back in 2015 and 2016 as some of the factors driving economic expansion at present—such as households dipping into savings—wear off.

Economic growth at the moment in part reflects the fact that the government has effectively given up on cutting public spending for the remainder of this parliament. Deep cuts will need to be implemented after the next election if the Chancellor is to even come close to meeting his deficit reduction targets beyond this fiscal year. Between 2015 and 2020, we expect real government spending to decline by 2.1 per cent as these cuts kick in.

In addition, the UK still faces a huge challenge in improving its trade position. We believe that the balance of payments is the Achilles Heel of the UK economy and its weakness could constrain growth. The current account deficit has almost doubled from £40bn when the Coalition government was formed in 2010 to an estimated £79bn this year. At some point the burgeoning deficit will constrain fiscal policy, cause the currency to weaken or force a rise in interest rates or some combination of all three. However, the timing is difficult to predict. George Osborne will be hoping that these problems are for the next parliament rather than the current one.