The Chancellor's Spring Statement, due on 23 March, was not supposed to be a major fiscal event. But rapidly rising inflation and the onset of the conflict in Ukraine might force the Chancellor to produce more than just a new set of economic and fiscal forecasts.
New IFS analysis, published ahead of the Spring Statement, lays bare the far-reaching economic challenges associated with this shifting outlook. Households and public services will be squeezed by higher inflation, the economy rocked by heightened uncertainty, and the public finances buffeted by the fallout from Ukraine.
Higher inflation will wipe out at least a quarter of the real terms increases to public service spending announced back in October.
If the government were to reflect that in higher public sector pay awards, it would come at an additional cost of around 10 billion, or around 1,750 per worker. Or, equivalently, if the changing outlook for inflation were not reflected in pay awards, the average public sector worker would see their gross salary reduced by around 1,750 in real terms. This would come on top of real pay cuts of between 5 and 10% for many public sector workers, including many teachers, over the last decade.
In terms of household budgets, just to provide the degree of protection against higher prices he intended back in February, Mr Sunak could need to find more than 12 billion on top of the 9 billion already committed;
So the Chancellor has to make at least three big calls:
- He will either have to spend and borrow billions more, or allow a hit to household incomes bigger than at any time since at least the financial crisis and quite possibly since the 1970s;
- He will either have to impose severe real pay cuts on teachers, nurses and other public sector workers, on top of big cuts over the last decade, or spend much less than intended on other aspects of public services, or add even more to public borrowing; and
- He will either have to leave defence spending as the only main element of government spending falling over the next three years, and falling much more than intended given current inflation, or again find more money from additional borrowing.
Paul Johnson, Director of the IFS, said:
At the Spring Statement Rishi Sunak has to make a huge judgement call. Will he do more to protect households from the effects of energy prices which have risen even further in the last two weeks? If he doesn't then many on moderate incomes will face the biggest hit to their living standards since at least the financial crisis. If he does, then there will be another big hit to the public finances. While he had little choice over big state action through the pandemic, his response to this crisis will tell us more about how he sees the limits of government in protecting citizens from buffeting by external forces.
He should also provide guidance on how he expects public sector pay settlements to respond to inflation that's far higher than expected when he set out his spending plans back in October. If pay rises for nurses, teachers and other public sector workers even just match inflation there will be billions less than intended for other aspects of public spending. If they do not match inflation then the real pay of millions of public sector workers will fall yet again, after a decade not just of falling behind the private sector but of significant real cuts in pay.
A top up to the budget for defence spending in the coming year - given rising energy costs and Russia's invasion of Ukraine - seems inevitable. More broadly, the era where Chancellors could use defence spending cuts to enable NHS spending to rise without an overall increase in the size of the state seems well and truly over.
For households:
Even before the war in Ukraine, consumer price inflation was expected to reach 7.3% in April. For the poorest households, who spend a much bigger fraction of their budgets on energy and fuel, the inflation rate was expected to be more than 9%. Richer households will be less affected by rising energy prices, and thus will face a lower rate of inflation (of more like 6%), but will be much harder-hit by the increase in National Insurance and the freeze to income tax thresholds. Now, in the wake of developments in Ukraine, multiple forecasters - including NIESR and Citi - expect consumer price inflation to peak at more than 8%, and expect inflation in 202223 to be between 3.6 (NIESR) and 4.7 (Citi) percentage points higher than the 3.7% forecast by the OBR last October.
The Chancellor's February package of support measures will only partially cushion the blow for the majority of households. Ofgem's February announcement implied that the hit to households from rising energy prices in the coming year would be 18 billion. The Chancellor's package of measures announced last month implied an outlay of 9 billion on measures to support households with these rising bills in the coming year, offsetting around half of the expected overall cost increase. But rises in energy prices since the Russian invasion of Ukraine could increase the hit to households to around 43 billion, meaning that the Chancellor's 9 billion package would now offset only about one fifth of the rise in household energy bills.
- A median earner (earning 27,500) would still have been almost 500 worse off next year in real terms before the recent spike in gas and oil prices. They are now likely to be 800 worse off, based on Citi's latest forecasts.
- Someone in the 75th percentile (earning 41,600) would have been almost 900 worse off and now looks likely to be 1,300 worse off.
Living standards will suffer across the board. If Rishi Sunak does decide that a further round of support is warranted, he will need to decide whether to continue with his broad-based approach, giving flat-rate payments to a large number of households, or whether to target additional support at those least able to weather the storm. The former looks increasingly expensive. To achieve the level of protection he was aiming for in February he would need to spend something like another 12 billion on top of the 9 billion outlay already committed.
For public services:
The 3-year spending settlements agreed in October's Spending Review were based on inflation forecasts at that time and, importantly, were set in cash terms. Higher prices mean that departments can buy less with the same cash budget. We estimate that even on pre-invasion forecasts, higher-than-expected inflation could wipe out one quarter of the planned real-terms increases for departments. If (pre-invasion) changes in forecasts for CPI fully feed through into the GDP deflator (the relevant measure of inflation for public spending), then the 3.3% average growth per year planned between 202122 and 202425 could drop to 2.4%. And increases in the outlook for inflation since could eat into this further.
Departments with larger physical footprints will be especially exposed to rising energy prices. The Ministry of Defence (MoD) spends around 600 million per year on energy and fuel, and rising prices will wipe out the modest real budget increase planned between this year and next. In the medium term, if Germany succeeds in meeting its new pledge to spend 2% of GDP on defence, and the UK wishes to retain its position as the country with the second biggest defence budget in NATO (in absolute terms, after the United States), the defence budget would need to grow by around a quarter, to approximately 2% of GDP. That would ultimately mean lower spending elsewhere or higher taxes.
For public sector pay:
The public sector employs around 5.7 million people at a total cost of roughly 240 billion. CPI inflation next year is now expected to be approximately 4 percentage points higher than forecast back in October. If the government were to reflect that in higher public sector pay awards, it would come at an additional cost of around 10 billion, or around 1,750 per worker. Or, equivalently, if the changing outlook for inflation were not reflected in pay awards, the average public sector worker would see their gross salary reduced by around 1,750 in real terms.
Final decisions on public sector pay will not be taken until later in the year, but the Chancellor should give an indication of overall pay policy in the Spring Statement. Most public sector workers had their pay frozen this year, after a decade in which many had already experienced substantial pay cuts. Given the inflation outlook, and the budget increases planned for departments, cash increases seem a certainty. But below-inflation pay awards seem highly likely. A 5% nominal pay award for NHS workers would cost roughly 4 billion, eat up more than one-quarter of the planned cash increase in the NHS budget next year, and still imply a real-terms pay cut for doctors, nurses and other health workers. For schools, a 5% nominal pay award would cost 1 billion, take-up almost half of the planned budget increase and again still imply a real wage cut for teachers and other support staff.
For the public finances:
The Chancellor will be confronted with a gloomy outlook for growth - even gloomier than what he was presented with in October. Under the Bank of England's February forecasts, the economy is expected to under-perform even the dismal rates of growth achieved over the 2010s. That will temper any improvement in tax revenues from higher inflation. And these forecasts don't yet incorporate any drag on growth from the Russian invasion of Ukraine.
One clear impact of the changing outlook will be on debt interest spending. Around a quarter of the government's debt is directly linked to RPI inflation; changes in the inflation outlook since October will add some 11 billion to the debt interest bill in 202122, and could easily add another 20 billion or more next year. Any interest rate hikes by the Bank of England in response to higher inflation would push the bill for debt still held as part of quantitative easing higher still, perhaps by another 11 billion based on recent market expectations. Debt interest spending remains manageable, and low by historic standards, but this will eat into the small headroom the Chancellor has against his fiscal targets and could further limit any room available for pre-election tax cuts.