UK Budget: More Austerity not Less

There are two important events tomorrow in the UK in addition to the monthly jobs report. The first is the minutes from the recent BOE meeting. We already know the MPC did not resume their gilt purchases. However, the vote will be important for investors. Governor King, along with Miles and Fisher had favored resuming gilt purchases in January, but were outvoted. We expect that they did not change their minds, so once again the Governor was outvoted.
 
Moreover, we suspect the Governor votes last and knows full well that he was outvoted prior to casting his lot. Apparently this is to provide a signaling device. While stylistically this seems to be more collegial and democratic, the BOE has come under criticism recently for preventing MPC members from making comments that deviate from the BOE's "collective forecast".

In any event, if King, Miles and Fisher succeeded in convincing a colleague to switch votes, then the market may conclude that a resumption of gilt purchases would likely resume as early as April. The initial reaction would likely be to sell sterling--which has been the strongest major currency over the past five sessions, gaining 1.5% against the dollar and nearly 2.2% against the euro.


The other key event tomorrow is the UK budget. Despite calls from the junior coalition partner the Lib Dems, some businesses and the IMF, we expect Osborne and the Tory-led UK government to maintain the fiscal strategy of austerity. The austerity is counter-intuitively (for some), generating larger rather than smaller deficits and Osborne will have to postpone its deficit reduction targets again.

Osborne has reportedly warned the other ministers to prepare for an additional 1% cut in departmental budget for each of the next three fiscal years to pay for a 2.5 bln sterling increase in public investment projects that will be unveiled tomorrow. A few exemptions will be granted--health, education, overseas development offices as well as police and local governments. Apparently, some departments are under-spending their budgets by more than the historical average, according to the reports from the Prime Minister's office.

Some expect Osborne to announce a change in the BOE's remit that will allow its greater flexibility to tolerate higher inflation for longer. While we are aware of such discussions, we suspect that officials are not ready to say so formally. Unless there is to be a significant change, like giving the MPC a dual mandate or give it a different target, such as nominal GDP, for which there does not seem to be a consensus, Osborne may leave aside the issue.

After all, as today's inflation report shows, the BOE has already adopted "flexible inflation targeting" in practice. Consumer prices rose 2.8% from a year earlier, the fastest in three quarters and there is not even the slightest chance of a rate hike. The BOE has already made in clear in word and deed that it will look past above target inflation. For more than three years now (39 months), UK CPI has been above the BOE's target.

At the end of the day, the current policy trajectory of tighter fiscal policy and looser monetary policy is set to continue. That policy mix tends to be associated with underlying currency weakness. We note that sterling has also lost interest rate support. Since late February, the UK 2-year yield is at a discount to the US. A larger slide is seen in the 10-year differential where the 20 bp premium seen in late Feb now is a 6 bp discount and is approaching lows seen last year near a 16 bp discount last August (which was largest UK discount since late 2006).