Welcome to day 1 of our preview of Scotland’s Budget Report!

As part of the run-up to the full publication of our report on the 15th December, we will be releasing a number of blogs previewing some of the analysis we are conduction at the FAI. Today’s blog sets the scene in terms of the economic outlook for the Scottish and UK economies.

Look out for more analysis in the coming days, as touch on other areas such as spending pressures, tax policy and options and more.

The economic outlook

In this section, we will go through the main economic developments at Scottish and UK level in recent quarters, and how those are likely to be reflected in the SFC’s forecasts next week.

Scotland’s economy has bucked recession this year, but the SFC is unlikely to be very optimistic going forward

As with GDP for the UK as a whole, the level of Scottish GDP has been revised up throughout 2021 and 2022 in line with the Office for National Statistics’ (ONS) Blue Book  2023 revisions. This means that the economy recovered more quickly than anticipated from the pandemic, which is welcome news. It is now estimated that the Scottish economy is 0.9% larger than it was prior to the outbreak of the pandemic.

Chart 1: Scotland’s real GDP: outturn and successive SFC forecasts

Source: Scottish Government, SFC, FAI calculations

However, despite the higher level of GDP, growth has not been particularly great – particularly in quarter 2 of 2022, in which the Scottish economy contracted by 0.3%, even if it has bounced back with 0.4% growth in quarter 3. Scotland’s better performance than the UK as a whole in quarter 3 can in large part be explained by being unaffected by large-scale strikes in the health sector.

But market participants now expect Bank Rate to both peak and stabilise at a higher level than a few months ago. Partly this is just a reflection of the fact that the BoE has increased interest rates further than expected – but the persistence of the higher level is also reflective of more persistent inflation, which will take longer to remove from the system.

Chart 2: Bank Rate and market expectations used in different forecasts

Source: OBR, BoE

The higher level of interest rates is likely to cool demand substantially, and is one of the main reasons for the OBR downgrading real GDP growth forecasts at UK level. It is also part of the reason why we downgraded prospects for the Scottish economy in our 2023 Q3 Economic Commentary.

Of course, it will be the SFC’s forecasts on the 19^th December which will be used for the official assessment of the Scottish Government’s finances, but it seems unlikely they will diverge significantly – especially as much of the better performance of Scotland in quarter 3 relative to the UK as a whole is explained by one-off factors such as strike action in England rather than underlying strength.

Inflation has revealed itself to be more permanent than anticipated, and has spread economy-wide

CPI-measured inflation peaked in the UK at 10.7% in quarter 4 of 2022, and has been falling since then – though nowhere near as fast as in other countries, and at a slower pace than the OBR had previously anticipated. Whereas in March it expected CPI inflation to fall below target by early 2024, the OBR now sees it remaining above 2% until mid-2025.

Chart 3: CPI inflation at successive OBR forecasts

Source: OBR
Note: Dashed lines are forecasts

This an additional year of prices rising more quickly than targeted by the Bank, and it puts further on the Monetary Policy Committee to hold interest rates at a higher level for longer. And it also means pain for consumers, who have seen prices rising at a much faster rate than they have been accustomed to.

It is worth remembering that falling inflation is not the same as falling prices, just that they are rising less quickly. While that is welcome, it still means that there has been a permanent increase in the level of consumer prices – which are now 15% than they would have been in the absence of the pandemic recovery’s supply constraints and the Russian invasion of Ukraine. This will not change – rather, with inflation remaining above target, this permanent effect will yet grow a further 18 months.

Why has inflation become so embedded? Energy prices are much lower than they were at the beginning of the year, which is good news, but this has been outweighed by strong pay growth, which remains above 7% year-on-year.

The generalised effect of inflation on the economy is illustrated by movements in the GDP deflator, which is a broader measure of inflation – taking into account the increase in prices used in domestic production, and excluding import prices. As chart 4 shows, CPI inflation started increasing steeply towards the end of 2021, as overseas shocks fed through to consumer prices immediately. But the GDP deflator increase lagged it considerably, tracking the sustained increase in average earnings instead, indicating the widespread nature of the inflation in the UK economy.*

Chart 4: Inflation and average earnings, outturn and OBR November 2023 forecasts

Source: OBR
Note: Dashed lines are forecasts

Living standards may not be forecast to fall as far as previously thought, but the OBR is still forecasting the two worst consecutive years on record

Living standards are usually measured using real household disposable income (RHDI) per person – a comprehensive measure which accounts for inflation, income flows to households, changes in taxes and benefits, and population growth.

The OBR is forecasting UK RHDI per person to fall for three years in a row – from 2022-23 to 2024-25 – in what would be the first time it has happened since record began in 1955. This would be a total fall of 3.4%, and reflects two main factors.

The first is the sheer level of the inflationary shock, which has caused a large increase in the price level which has not been met in full by increases in both labour and non-labour income.

But the other main source of this fall is caused by policy, and it is one that is share across both Scotland and the rest of the UK. The freeze in thresholds for taxes on labour income – enacted separately by the Scottish Government for Scottish Income Tax and by the UK Government for Income Tax in the rest of the UK and NICs – has the effect of reducing disposable income significantly throughout the OBR’s forecast. This is true even with the cuts in the NICs rates, which only partly offsets the fiscal drag of the threshold freeze.

Chart 5: UK real household disposable income per person

Source: OBR
Note: Dashed lines are forecasts

The economic outlook is challenging – there might be no recession, but growth is hardly happening

The story of the Scottish Economy in the last 24 months has been one of essentially flat-lining. There have not been two quarters of consecutive contraction, and so a technical recession (which many had predicted, including us) has been avoided. But the economy is still the same size as in the first quarter of 2022, which qualifies as poor performance by any standard.

Of course, the Scottish and wider UK economies have been buffeted by a number of shocks, and have in fact been more resilient than the general consensus at the time. But the after-effects of these shocks and the Bank of England’s expected path for interest rates in its fight to bring down inflation weigh down growth prospects.

In many ways, fiscal authorities are in a bind. Any fiscal stimulus is likely to lead to aggregate demand rising further above the supply potential of the economy, and would probably lead the Bank to take a more aggressive approach to offset it.

The supply potential of the economy is hard to change in the short-run – the Treasury has tried to incentivise more people into the workforce, but even the OBR’s relatively optimistic assumptions about their effectiveness do not shift the dial in any meaningful way.

With monetary policy determined at UK level and little in the way of manoeuvre on its own fiscal stance, the DFM’s decisions will need to deliver a budget that takes all these constraints into account, and some large parts of her funding are already determined – especially as it pertains to the Block Grant. But the monetary dominance in the current UK situation is a reminder that fiscal policy’s ability to influence macroeconomic outcomes can be a mirage.

 

* Average earnings growth was higher than normal in 2021 due to the widespread use of the furlough scheme in 2020, which only replaced at 80% of normal earnings (and slightly less in some months). Average year-on-year growth in earnings between quarter 2 of 2019 and quarter 2 of 2021 was 2.4%, broadly in line with growth pre-pandemic.