Osborne Walks Tight Rope

The Bank of England's Monetary Policy Committee meets Thursday.   There is an overwhelming consensus in the market that there will be no action taken--no rate cut or resumption of the gilt purchase program (QE) that was completed last month.

More importantly, tomorrow the Chancellor of the Exchequer Osborne will make his Autumn Statement to parliament.  He will have to tread a narrow line.  Circumstances will force him to acknowledge that it is taking longer to recover from the financial crisis than the government had anticipated.  

Therefore it will take longer to eliminate the structural deficit.  While sticking to the general austerity program, Osborne needs to acknowledge that too much austerity will itself pose an obstacle to recovery.  What this balancing act means is that the government will have to extend its time frame.  Austerity may have to run several more years, with some suggesting as much as half dozen years.  

Osborne will present the government's plan as a mid-course correction to get the deficit reduction effort back on track.  The social contract the government appears to be offering is spending cuts on social welfare and tax increases on the wealthy. 

One proposal already hinted at is to break the link between inflation and social benefits.  This is a more subtle,  though no less real, than an outright cut in spending per se.  On the other hand, the junior coalition partner, the Lib Dems proposal for a "mansion tax" was rejected by the Tories.  The Lib Dems are engaged in a rearguard action to block or minimize the deepest cuts in social spending.  

There is a strain in the governing coalition, but it does not seem likely to breakdown over the 2013 budget.  Nevertheless, the greater commitment to austerity over growth alienates the rank and file Lib Dems and has seen support for UK's third party decline precipitously.  The danger is that to share power, the Lib Dems have sold their collective soul.  Polls suggest that if an election were held today, the Lib Dems would see their representation in parliament dwindle.  

There seems to a race of sorts over which G10 country is the next to experience a downgrade.   The UK is definitely in contention.  Unlike the US, the UK has a fiscal consolidation plan.  However, it is not working.  In fact, the government sector as been more of a drag on US quarterly GDP figures (excluding Q3) than it was in the UK.   Moody's and Fitch already have a negative outlook for the UK.  

With the policy paralysis in the US and looming fiscal cliff, one cannot count the US out in this ugly contest.  Meanwhile, Abe in Japan appears to be tempting the rating agencies as well, suggesting a substantial fiscal stimulus program and may be not implementing the controversial retail sales tax in 2014.  Moreover, Abe wants to get the BOJ to buy more government bonds.  

With UK interest rates substantially above UK growth, the debt/GDP ratio is difficult to stabilize.  This is met by the government with new austere efforts, which in turn, diminishes aggregate demand.  Perhaps the appropriate image is not walking a tight rope, but a dog chasing its tail.  

Turning to sterling, it is benefiting from the weaker US dollar environment.  With today's modest gains, it has completed a 61.8% retracement of the decline from the year's high near $1.631 on Sept 21 to the mid-Nov low near $1.5830.  The next upside target comes in near $1.6200, but a retest of the year's high is looking increasingly likely.  Sterling continues to lag behind the euro, however.  The  euro's Oct high near GBP0.8165 is the next immediate target, but there is near-term technical potential toward GBP0.8200.  

Osborne Walks Tight Rope Osborne Walks Tight Rope Reviewed by Marc Chandler on December 04, 2012 Rating: 5
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