Britain's wafer-thin margin to meet its deficit-reduction goals is under pressure not just from weaker growth and the euro zone debt crisis, but also from any change to the amount of slack in the economy, the country's fiscal watchdog said on Tuesday.
Chancellor George Osborne presented the Office for Budget Responsibility's new forecasts in his autumn budget statement on Tuesday. These showed he would not meet his budget surplus goal until 2016/17, the end of the five-year horizon he had committed to, and two years later than forecast before.
OBR head Robert Chote, explaining the forecasts at a news conference, said the number one risk to the government's goals was uncertainty surrounding the amount of spare capacity in the economy or the pace of potential growth.
These questions determine how much growth the economy can sustain in the medium term -- and therefore how much the government can rely on the recovery to reduce borrowing automatically, without the need for additional policy measures, Chote said.
Osborne's main goal is to reach a surplus on the government's current budget, which excludes investment spending, on a cyclically adjusted basis.
The problem for Osborne is that spare capacity is notoriously hard to measure, and Chote said it was perfectly possible the OBR might revise it down again -- particularly given uncertainty about British productivity growth.
Explaining why productivity growth has been so weak is not easy, he said. It no longer seems central to assume that growth in potential output will snap straight back to its pre-crisis average rate. We now assume that it will do so gradually over the next two years, he added.
The OBR said a combination of this, and its decision to reduce its estimate of the current output gap, meant that potential output by 2016 would be 3.5 percent less than it assumed at the time of the government's budget in March.
That longer-term downward revision -- and not the short-term weakening in the economy caused by headwinds from the euro zone debt crisis -- was the main reason why Osborne was having to make an extra 15 billion pounds of cuts by 2016-17, Chote added.
Some economists are concerned that overestimates of economic potential are developing into a worrying pattern in Britain's official economic forecasts.
Like the Bank of England, the OBR has been perpetually too optimistic about growth potential, causing it to forecast strong growth in the medium term, and the government has planned its spending accordingly, said Nomura's Philip Rush.
We believe the OBR is still too optimistic about the economy's growth potential. If this is once again proven to be the case, the government may need to announce new measures as soon as next year, or break its fiscal mandate, he added.
Chote rejected the idea that the OBR was being too upbeat in forecasting real growth of 3.0 percent for 2015 and 2016. The 0.2 percentage point upward revision to the 2015 figure was a statistical effect linked to a change in the measure of inflation used by the government, he said, and had little effect on government finances, which were determined more by nominal growth.
And it was legitimate to forecast growth in business investment of at least 8 percent a year for the next five years because investment as a share of GDP was far below its long-run average, he added.
However, in March the OBR forecast business investment would rise by just under 7 percent -- which on Tuesday it revised down to forecast a fall of around 1 percent.
The OBR is also assuming the Bank of England will use looser monetary policy to counteract the drag on growth created by extra fiscal tightening at the end of the forecast horizon -- which hinges on underlying inflation staying firmly in check.
The OBR estimates that there is roughly a 60 percent chance of the government meeting its fiscal mandate in 2016-17, compared to a less than 50 percent chance had ministers taken no action in their autumn statement, the OBR said.
However, a disorderly end to the euro zone debt crisis would pose a significant downside risk to its central forecast, the OBR added.
But (it is) one that cannot be quantified in a meaningful way given the numerous ways in which it might unfold, the watchdog said.
(Additional reporting by Peter Griffiths and Matt Falloon; Editing by Susan Fenton)