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UK Budget Hole of Up To £30 Billion May Threaten Reeves Plans

(Bloomberg Economics, OBR)

(Bloomberg) -- Chancellor of the Exchequer Rachel Reeves faces the prospect of a budgetary hole worth as much as £30 billion pounds ($39 billion) that would hinder the ability of the UK’s new government to fix the country’s ailing public services.

Office for Budget Responsibility forecasts for growth over the next two years are overly optimistic and any boost from the Labour Party’s policies to revive growth could be wiped out by downgrades, according to private sector economists. 

While the OBR, the fiscal watchdog whose projections underpin the government’s budget plans, has growth at 1.9% for 2025, the average of 56 economists surveyed by Bloomberg puts it at a more modest 1.3%. 

“It’s quite easy for forecast changes from the OBR to offset any boost to growth from government policies like housebuilding or the small changes to the EU trade relationship Labour seem to be planning,” Robert Wood, chief UK economist at Pantheon Macroeconomics, told Bloomberg. 

The warnings lay bare the fragility of the public finances at a time when the new Labour government is trying to spur growth to generate extra money to fund crumbling front line services. 

Labour will be hoping to build on what has been a bumper recovery from last year’s recession. New figures on Thursday showed the economy grew at twice the expected pace in May, putting the UK on course for another strong expansion in the second quarter.

While Prime Minister Keir Starmer has ruled out a return to austerity, his government will need to either borrow more, raise taxes or increase growth to mitigate spending cuts penciled in by the previous government if it wants to adhere to its own fiscal rules. 

Complicating matters further is the razor-thin fiscal headroom of just £9 billion that Former Tory Chancellor Jeremy Hunt left himself at his Budget in March, even with an OBR forecast that already had growth accelerating.

“Labour will have to do well on growth measures just to stop the already minimal headroom shrinking further,” Wood said.

In a bid to lower expectations of how much Labour can achieve straight away, Reeves has already said she’s inherited the worst set of public finances since World War II, while Starmer provided a flavor of the damage his government is seeking to fix when he said late Wednesday that the nation’s prisons were in a worse state than he’d anticipated, and that Labour would have to follow through on a Tory plan to release some inmates early. 

On Monday, Reeves said that the task of reviving the UK’s lackluster growth rates is the Labour government’s “national mission” after the poor economic performance since the financial crisis. The new administration is aiming to boost growth to the highest among the Group of Seven economies through higher investment and a blitz of supply side reforms, including overhauling the planning system.

City of London forecasters are concerned that the OBR is particularly optimistic on a return to stronger productivity growth, a prediction it made repeatedly in the 2010s that never came to pass.

Wood at Pantheon sees government borrowing £30 billion higher ($39 billion) in 2028/29 if productivity growth is weaker than expected and worker participation rates continue to deteriorate. However, he said he doesn’t expect such a large downgrade to the potential growth forecast from the OBR in the autumn given its optimism on productivity in the past. 

Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International, warned that pressures on the budget plans may emerge after 12 to 18 months.

“If growth comes in significantly below 2% and closer in line with consensus or the Bank of England’s forecast of around 1.25% in the next fiscal year (and beyond) that suddenly opens a budget hole of £20-30 billion which could cause a headache for policymakers,” Ahmed said.

Further out, the OBR predicts growth of 2% in 2026, compared to the 1.4% forecast by a smaller sampling of 21 economists. Some warned that the pressure on Reeves could arrive as soon as the autumn.

Estimates by Citigroup chief UK economist Ben Nabarro suggest there may be a £16 billion hit from moves on financial markets since the last projections and if the OBR downgrades its “optimistic” productivity forecast by 10-20 basis points in the autumn. This would wipe out gains in other areas, such as generating extra revenue from moving a year further on in the forecast.

“This would still constitute a near record low in terms of overall room to maneuver,” he said.

(Updates with May GDP data in sixth paragraph.)

©2024 Bloomberg L.P.

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