UK politics is stuck in a holding pattern. Ever since Liz Truss’s seven-week stint as prime minister, opinion polls have been consistent: the Conservatives are on course for a thumping defeat. Historical precedent suggests the race should get tighter as the election approaches but there is currently no evidence of that happening. In fact, Labour’s lead seems to be getting bigger.
What is worrying for the government is that its political plight seems to be getting worse even though the economic news has been getting modestly better.
The big development in recent months has been the sharp fall in inflation, which has had two significant knock-on effects: it has reduced interest payments on the national debt and led to mortgage lenders reducing home loan rates in anticipation of lower interest rates from the Bank of England. The first has provided Jeremy Hunt with some extra budget wriggle room; the second has already started to lead to a gentle revival in housing market activity.
Have voters noticed? If they have, there is scant evidence that they give the Conservatives any credit. As a result, the idea of an early election – which was being toyed with a couple of months back – has been ditched. The chancellor has not yet abandoned all hope of victory but wants the election delayed until the autumn, by which time the Bank should have started to cut interest rates and the effects of tax cuts will have be showing up in pay packets for several months. There is even talk of squeezing in another package of tax cuts in the autumn, which really would be a desperate last roll of the dice.
In reality, the Conservatives are now looking at damage limitation rather than victory – and even that will require not just tax cuts but also significant reductions in interest rates.
This Thursday the Bank will provide its quarterly assessment of the state of the economy and announce its latest decision on interest rates. It is a stone-cold certainty that official borrowing costs will be left at 5.25% but of more interest will be Threadneedle Street’s steer on what happens next.
In its November 2023 health check, the Bank stressed that interest rates were likely to remain high for an extended period and might need to rise if there was evidence of more persistent inflationary pressures. The best judgment of its nine-strong monetary policy committee was that inflation would not return to its 2% target until the end of 2025.
In the light of subsequent events, that now looks far too pessimistic. Analysts at the consultancy Capital Economics think tumbling energy prices will bring the annual inflation rate down from 4% now to 1.8% in April and to just 0.9% in September.
If the Capital Economics forecasts are anywhere near correct, the Bank will soon come under strong pressure to cut interest rates, pressure that it is likely to resist for only so long. There is sure to be a softening of its stance on Thursday, with talk of further rate rises dropped and perhaps an indication of cuts, provided the fall in inflation is sustained.
For now, the MPC is likely to take a cautious approach. It will point out that the labour market remains tight and that core inflation – which excludes food, energy, alcohol and tobacco – is still above 5%. The Bank will be monitoring pay settlements closely as the 2024 pay round gets under way.
It is also likely to warn that financial markets are getting carried away in expecting four quarter-point cuts this year and that there is a risk that the sort of rapid and aggressive easing of policy currently expected by the City might lead to inflation being above its 2% target in 2026. But rates have peaked at 5.25% and the next move will be down.
Threadneedle Street will be interested to see what Hunt decides to do in his budget on 6 March but you don’t need a crystal ball to work out what is going to happen. Frankly, it is not a question of whether or not the chancellor cuts personal taxes because that decision – as he made clear in comments made in Davos earlier this month – has already been taken. The real issue is by how much he cuts them, and the signs are that he might have about £20bn to play with.
That’s not to say cutting income tax and again freezing fuel duty for motorists is the best use of £20bn. As the Institute for Fiscal Studies pointed out last week, there is a high risk that any tax cuts now will be paid for by tax rises or spending cuts after the election.
It is certainly not hard to think of better uses for a £20bn windfall. Current Treasury plans involve a £20bn cut in public investment by 2028-29, which Hunt could reverse if he chose to do so. That would boost long-term growth potential rather than consumer spending.
Alternatively, he could spend the money on repairing the UK’s threadbare welfare safety net. In a report released last week, Donald Hirsch, an emeritus professor of social policy at Loughborough University, said the system was failing to meet the most basic needs, concluding: “Today, we do not have a safety net worth its name.”
That’s a disgrace but only someone not really paying attention would imagine that the last budget before an election is going to be devoted to making the social safety net fit for purpose. Governments facing a wipeout will always find a way to cut taxes even if the chances of them having a material impact on the election – as in this case – are vanishingly small.
