The risks to the UK recovery are fiscal not monetary

So this is how it is going to go. As the UK recovery proceeds, and rapid employment growth continues, at some point firms will begin to find it difficult to fill jobs. There are few signs (pdf, section 3) of that yet, but it is likely to happen sometime in 2015 or 2016. At that point, real wages will start to rise. Labour scarcity, and the recovery in investment that has already begun, will mean that at some point in the next year or two UK productivity growth will also recover to more normal levels.

What happens to interest rates will depend crucially on the relative timing of these two changes. If productivity increases when real wage growth resumes, wise heads on the MPC will note that cost pressures remain weak. If there are no other inflationary pressures, the case for raising interest rates also remains weak. However if real wages start rising before productivity growth picks up, such that unit labour costs rise, then the MPC will raise rates.

Which will happen is I think anyone’s guess, given the uncertainties associated with the UK productivity puzzle. It may come down to measurement errors in the data. However I also suspect it will not matter a great deal either way. This is because I take the MPC seriously when they say rate increases, when they come, will be small and gradual.

We can speculate about the impact of one or two quarter point increases in interest rates, but I think this would be ignoring the elephant in the room. That is fiscal policy, where its 2010 all over again. We have two austerity programmes: for simplicity call them Labour and Conservative. One is tough, the other is - well let’s just say very tough. Here is a picture.

Alternative Austerity Paths for cyclically adjusted net borrowing (excluding Royal Mail and APF transfers): source OBR and my estimates for Labour

We see the sharp fiscal contraction in 2010 and 2011. Thereafter it eases off. (If we look at the primary balance, which excludes interest payments, the easing off is even more noticeable - see here). Under the current government’s plans, fiscal tightening resumes again in earnest after the election. My guesses for what would happen under Labour are based on their (somewhat vague) statements so far.

In the past I have been a bit dismissive of these government plans, saying they represent a political gambit by Osborne to make Labour look relatively profligate. However that may have been politically naive. After all if the Conservatives win the 2015 election (or are part of a new governing coalition) this will have been achieved having followed a strategy of frontloading austerity. So why change a winning strategy? They might therefore keep to these plans, cut spending and welfare sharply in the first two or three years (more hits on the poor and disabled), and then again ease off, perhaps with tax cuts in the second half of the five year term.

Maybe the UK economy will be luckier than it was after 2010. Perhaps the recovery will be strong enough to shrug off this fiscal contraction, as the US economy has been able to. (Although many will correctly claim that the US recovery has been slower than it might have been as a result.) But the key similarity with 2010 is that UK interest rates will be at or close to their lower bound, so there is no insurance policy if things do go wrong. Just as in 2010, the government will be taking a huge gamble by embarking on a sharp fiscal contraction. The one difference from 2010 is that this time there is no pretext to take such a risk.