By David Milliken
LONDON (Reuters) - Britain looks set to become the first big economy to undergo a two-pronged withdrawal of COVID-19 stimulus as finance minister Rishi Sunak sets out tighter budget plans next week and the Bank of England prepares to raise interest rates.
The British economy has rebounded more quickly than expected this year after suffering a nearly 10% crash in 2020.
But many analysts think the recovery is too fragile for the kind of squeeze intended by Sunak, who has promised to tackle debt levels of nearly 100% of gross domestic product.
Some economists say he also appears to be trying to create room for tax cuts before the next election.
Across town, BoE Governor Andrew Bailey has said the central bank is preparing to act as inflation pressures mount, prompting investors to price in rate rises for November and December.
"We definitely seem to be in the vanguard of tightening, which is surprising given the size of our overall hit," said James Smith, research director at the Resolution Foundation think tank.
On the face of it, Sunak will have more to celebrate on Oct. 20 than at his last budget in March, when Britain was only beginning to ease COVID-19 lockdown rules.
The rebound in the world's fifth-biggest economy means borrowing this financial year is likely to be around 40 billion pounds ($55 billion) below official forecasts.
After hitting its highest since World War Two, at 15% of gross domestic product in the year to March, the budget deficit looks set to fall to 8.4% of economic output in 2021/22 and 3.7% in 2022/23, according to HSBC.
But only a fraction of this windfall is likely to be used to fund extra spending on Britain's stretched public services and welfare programmes - probably around 3 billion pounds, HSBC reckons.
The government will instead flesh out future investments to support Prime Minister Boris Johnson's promises of "levelling up" poorer regions and to shore up Britain's climate change plans before it hosts the COP26 summit later this month.
Sunak has said government borrowing to fund investment would be sensible under new fiscal rules that he is likely to announce next week, unlike borrowing for day-to-day spending. He said last month a three-year review would limit annual rises in day-to-day spending to about 3% on top of inflation.
That probably means more real-terms cuts for higher education, courts and local government because health spending looks set to remain high after the pandemic while spending on schools, defence and overseas aid is protected.
Sunak also faces a double-edged sword from rapidly rising inflation, which will boost some tax revenues but also erode the value of increased government spending and push up the cost of servicing inflation-linked government debt.
Sunak and the BoE will have to tread carefully. The economy's post-lockdown surge has lost steam, hit by staff absences due to a summer wave of COVID-19 and then by the kind of supply-chain bottlenecks and staff shortages facing many countries but which have been aggravated in Britain by Brexit.
Sunak has ordered a 12 billion pound tax hike for workers from April to pay for higher health and social care spending - initially to tackle a backlog in routine medical care that built up during the pandemic. Many households have just lost a 1,000-pound-a-year welfare top-up. And unemployment could rise after the end of Sunak's job subsidies programme.
He bristles at suggestions that Britain faces a new round of austerity, saying the huge levels of public spending during the pandemic have to be dialled back.
But the squeeze comes as surging energy prices and broader inflation pressures are likely to weaken consumer demand. Bailey at the BoE has warned of the "hard yards" ahead.
"Just standing back, it does seem very odd that one of the economies with the least advanced economic recoveries is turning off fiscal and monetary policy support pretty rapidly over the next six months," said Samuel Tombs, chief UK economist at Pantheon Macroeconomics.
Tombs and Smith think that with a national election likely in mid-2024, or maybe earlier, Sunak wants to get difficult budget choices out of the way early.
"He will preserve any scope to ease off tax rises for much closer to the next general election," Tombs said.
But as happened after the global financial crisis, premature budget tightening, especially alongside BoE rate rises, could stop Britain from ever recouping the growth it lost during the pandemic.
"Trying to tighten quickly to loosen further out risks being self-defeating," Smith said.
($1 = 0.7243 pounds)
(Reporting by David Milliken, Editing by William Schomberg and Catherine Evans)