UK fiscal tightening implemented by the new coalition government should not choke off the recovery, but it will slow UK economic growth over the next two years, according to the latest Ernst & Young ITEM Club forecast report, out today.

The report says the chancellor’s five-year plan to cut the deficit while keeping the pace of the economic recovery is very ambitious. But the ITEM Club believes that in the long term it will lead to more sustainable high-quality growth from 2013 because it will be led by business investment and exports, rather than public spending.

Peter Spencer, chief economic advisor to the Ernst & Young ITEM Club comments, “The new coalition’s plans to cut the deficit are certainly ambitious. But the bulk of the additional tightening is set to come in the second half of the parliamentary term, when we believe that the recovery will be firmly entrenched and the economy should be able to deal with the headwinds from the Budget.” Spencer adds, "On the assumption that the government is able to implement the overall reduction of £40 billion set out in the budget, we expect that UK growth will struggle to reach 1% this year but will gradually speed up in the following years to give the UK a high-quality recovery based on trade and investment."

Two weeks ago, the Chartered Institute of Personnel and Development (CIPD) said in a report that the UK faces a five year jobs deficit if economic growth slightly undershoots official forecasts. The CIPD chief economic adviser John Philpott has warned that given that the Office of Budget Responsibility’s (OBR) forecast of net total employment growth of 1.3 million to 2015 accounts for a net fall in public sector employment of 600,000, the forecast implies that the private sector will create 1.9 million jobs during the forecast period. This amounts to an average increase in private sector employment of 1.6% (roughly 380,000 jobs) per year. He says the effective private sector job creation requirement could be greater still. Unverified Treasury estimates leaked to the Guardian newspaper (30 June 2010) suggest that the coalition government’s deficit reduction measures will result in 600,000 to 700,000 job losses in private sector businesses dependent on public sector contracts. If so, the private sector as a whole will need to create at least 2.5 million jobs by 2015 if the OBR forecast is to prove correct.

Official  figures published last Friday show that  the UK economy grew almost twice as strongly as expected in the second quarter of this year.

The performance was lifted by a sharp pick-up in services output and the fastest rise in construction output in almost 50 years.

The Office for National Statistics said GDP (gross domestic product jumped) 1.1% compared with the first quarter, the fastest rise in four years. The annual growth rate of 1.6% was the highest in two years.

Tax increases v spending cuts: The Ernst & Young ITEM Club report says as suggested by the coalition a combination of tax increases and spending cuts is necessary to cut the deficit. Past evidence suggests that fiscal corrections that are focused on spending cuts are more likely to lead to successful debt reduction with limited impact on growth. However, with the deficit being so large, it says the the government had no choice but to raise taxes, the centrepiece being the increase in the standard rate of VAT to 20% on 4 January 2011. Spencer says that the VAT rise will help to plug the fiscal black hole over the following 12 months. But he cautions that after that the medium-term forecast for the UK economy is fraught with uncertainty. “The medium-term outlook for growth, inflation and interest rates is critically dependent upon the coalition’s ability to cut back spending,” he says.

Interest rates pinned to the floor until 2014: High energy prices and the increases in VAT will keep CPI inflation above target over the next 18 months, but ITEM believes that it will then move well below 2% as these effects wear off and spare capacity bears down on pricing decisions and wage bargaining.

To prevent CPI inflation moving below 1% it will be necessary keep the Bank base rate low at 0.5% for much longer than the OBR and the markets have anticipated. The ITEM forecast suggests that the base rate will remain on hold until the end of 2013, although this is dependent on the assumption that the impending spending cuts actually come through. “A base rate of 0.5% will begin to look like the new normal,” Spencer remarks.

European crisis: The report says one of the bigger areas of concern for the UK economy is the escalating European crisis which could damage the recovery. Retrenchment in the Eurozone, the UK’s biggest trading partner, could drag the area back into recession, undermining the value of the euro, eroding demand for UK exports and weakening UK competitiveness. As the prospect for exports is not as good as it has been in previous ITEM forecasts it is essential for UK companies to take the lead role in the recovery.

Time for business to bounce back: Despite the recent revival in the economy, the prospects for UK business spending and investment remain uncertain. “Company managers have been shell-shocked over the last two years, but they are starting to find their feet as uncertainty around the fiscal outlook begins to dissipate,” says Spencer. Larger companies in particular are generally in a strong financial position, certainly for this stage in the cycle, with plenty of profitable opportunities for expansion.

Yet with the pace of economic growth set to slow over the next two years business spending is still being held back, with company treasurers more likely to pay down debt than loosen the purse strings for investment opportunities.

However, the Budget should go some way to encouraging more investment, with a remarkably business-friendly tax package including reliefs for small business and projections for cuts in mainstream corporation tax.

Spencer explains, “It is time for businesses to take advantage of the tax incentives presented in the Budget. This time the consumer is in no position to pull us out of recession, indeed the outlook for households continues to be bleak - -  what with pressures from the labour market, pay pauses and higher taxes there will be a major strain on real disposable incomes in the short-term. The impetus for the economy has to come from business spending, private sector employment and entrepreneurial initiative. Without that response, it will certainly be very hard for the government to pull off the trick of retrenchment and recovery.”

Challenging times ahead: Spencer concludes, “The coming years will inevitably be difficult for the UK economy. However, the emphasis on spending cuts rather than tax increases over the medium term reduces damage to incentives and increases the chances of success, as does the business-friendly nature of the tax changes. A reduction in the uncertainty around the fiscal and monetary policy outlook should also support investment and employment. However, this forecast - -  not to say the success of the coalition’s fiscal strategy - -  hangs critically upon a positive response from UK plc and the financial markets.”