BOE: Forecasts Won't Reflect Fiscal Realities

14:15 10Nov09 BOE WATCH: Forecasts Won't Reflect Fiscal Realities
DJ BOE WATCH: Forecasts Won't Reflect Fiscal Realities


LONDON--Forecasts to be published by the Bank of England
Wednesday are likely to predict stronger economic growth and a tighter monetary policy than is probable.

That's because the BOE has a self-imposed rule that requires it to base its projections on the announced fiscal plans of the government. Right now, those plans envisage a halving in the budget deficit by 2014, from 12.4% in the fiscal year to the end of March 2010.

But with international credit rating agencies pressuring the government to cut its debt more rapidly, the self-imposed rule means a key factor in the BOE's forecasts is likely to be flawed.

The ratings agencies are key players in the setting of fiscal policy over the coming decade because they have threatened to remove the U.K.'s cherished AAA rating if the government that emerges from elections due by mid-2010 doesn't move more aggressively to cut spending, raise taxes, or pursue a combination of both.

Standard & Poor's in May lowered its outlook on the AAA rating to negative from stable, saying it would make a decision after the election.

On Tuesday, Fitch Ratings also warned that the U.K. may lose its position as one of the world's safest borrowers if it didn't take firmer action to cut its debt.

David Riley, Fitch's co-head of global sovereign ratings, said that among the major economies, the U.K. was "potentially most at risk" of a downgrade "given that if faced the largest budget adjustment."

But he added that the U.K.'s current stable rating outlook "reflected our expectation that the U.K. government will articulate a stronger fiscal
consolidation program next year."

Neither the ruling Labour Party nor the opposition Conservative Party can afford to ignore those warnings, because a strong rating is essential for attracting buyer interest to a country's bonds. Without it, many market players are unable to invest.

If the U.K. were to lose its AAA rating, some investors would be forced to sell their existing holdings. That would push up the U.K.'s cost of borrowing, and make it even tougher to cut borrowing without even bigger tax hikes or spending cuts.

"We all need to sit up and listen to this latest warning from an
international credit rating agency," said George Osborne, the Conservative's spokesman on economic policy. "Britain is singled out for concern over the size of our debt crisis, and the message could not be clearer: if we don't start dealing with those debts we will face a downgrade."

The Conservative Party has had a consistently large lead over the Labour Party in recent opinion polls.

So the BOE will therefore present its Inflation Report Wednesday knowing that the fiscal tightening will be much more severe than already announced, but unable to incorporate that understanding into its forecasts.

A larger, more rapid squeeze on public spending and higher taxes should reduce economic growth over the next few years, so the BOE's forecast will therefore be higher than it ought to be.

And since it uses that growth forecast to estimate future inflation and the level of interest rates needed to hit its 2% inflation target, the implicit signal given by the central bank on its future policy will likely also be unrealistic.

"(Inflation Report) projections need to be read in this light: that the
central projections for growth and inflation may be too high if they are not allowing for a considered 'more realistic' fiscal tightening," said David Page, U.K. economist at Investec Securities.

Economists say that U.K. monetary policy will have to stay loose for a long time to compensate for the large cuts in spending that whichever party forms the next government will need to pursue. A general election is due by June 2010.

The BOE has kept U.K. interest rates at a record low of 0.5% since March, and is pumping GBP200 billion into the economy through its quantitative easing policy of buying bonds with freshly created central bank money.