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For months, the UK Treasury has lived in fear of the Office for Budget Responsibility and its darkening view of Britain’s economic prospects.

On Wednesday, those fears were realised, as the independent fiscal watchdog smeared its economic forecasts in red ink.

The OBR said this year’s growth rate would be 1.5 per cent, down significantly from the 2 per cent it predicted as recently as March.

More worryingly, however, the OBR also dramatically downgraded its growth forecasts for the medium term, saying the UK economy would grow by just 1.4 per cent next year, 1.3 per cent in 2019 and 2020, and 1.5 per cent in 2021.

The fiscal watchdog has now wiped 40 per cent off its estimate of UK potential growth since the July 2015 Budget, when it thought Britain’s economy could expand every year by 2.5 per cent. Just over two years later, that estimate has been cut to 1.5 per cent.

If the forecasts prove correct, Britain will be poorer than policymakers had hoped, real wages will barely grow over the next five years, the public finances will become even more stretched, and the worst decade for UK real incomes for over a century will continue at least for another five years.

The 0.5 percentage point drop in this year’s growth projection was particularly surprising, given the OBR predicted 2 per cent growth just eight months ago.

Robert Chote, chairman of the OBR, said the discrepancy is explained largely by a downward revision to the official growth figures for last year. As a result, the economy started 2017 smaller than originally thought in March.

Mr Chote added that the OBR had expected the economy to weaken in the summer, and “the resulting slowdown in growth came one quarter earlier than we expected in March”.

Independent forecasters have made similar changes to their growth forecasts for this year.

The OBR stressed on Wednesday that it had not changed its “broad-brush” view on Brexit, and still assumes that the UK will leave the EU in March 2019.

The fiscal watchdog also assumes that Brexit will slow import and export growth due to new frictions in trade between the UK and EU, and that the UK will adopt tighter immigration controls while still failing to meet the government’s “tens of thousands” target for net migration.

Instead, the OBR’s gloomy medium-term forecasts were informed by the watchdog’s judgments about how much scope there is for the population to grow, for more people to get jobs, for people to work longer hours and for people to produce more for every hour they work.

Potential productivity growth — the additional amount the OBR assumes an average worker can increase his or her output for each hour worked — is by far the most important building block of the forecast. The watchdog slashed its estimates for productivity growth for each year of the forecast on Wednesday. Productivity growth is now expected to fall from 1.8 per cent to 1 per cent in 2020.

UK economists have traditionally thought that productivity growth would vary from year to year, averaging at around an annual increase of just over 2 per cent.

But productivity has stalled since the financial crisis in 2008, with output per hour rising just 0.2 per cent a year in the last decade, compared to an average of 2.1 per cent a year over the preceding 35 years, according to Mr Chote.

For many years, the slowdown was thought to be a temporary hangover from the financial crisis. But the OBR now thinks it can no longer simply assume a recovery is coming, having been wrong so many times in the past.

“It seems sensible to place more weight on weak performance of the recent period as a guide to the outlook for the next few years, but without abandoning hope of a recovery altogether,” Mr Chote said.

The OBR now predicts UK productivity growth is likely to rise towards a medium-term average of 1.2 per cent a year, giving no credit to the chancellor’s package of measures designed to boost it further, such as increasing the national productivity investment fund by £8bn.

Economic growth can only come from more people working, or existing employees working more hours. The OBR assumes there will be more people in Britain every year over the next five years, and this will contribute about 0.5 per cent a year to the growth rate.

But with the Office for National Statistics projecting a gradual fall in net inward migration to 165,000 a year by 2023, and the population ageing with more people retiring, the OBR assumes the employment rate will begin dropping in the 2020s.

The OBR’s latest assumptions about employment and hours are more optimistic than they were in March, but do little to offset the productivity growth downgrade and leave the watchdog’s assessment of long-term economic growth at only 1.5 per cent.

The watchdog’s economic growth figure is in line with the Bank of England’s assessment, and slightly better than the European Commission’s estimate. But it is much more pessimistic than most independent economic forecasters, who are sticking at around a 2 per cent annual rate in the medium-term.

Jonathan Loynes of Capital Economics said the OBR was now “too gloomy about productivity”, while Alan Clarke of Scotiabank said the watchdog was “probably too bleak”.

Howard Archer of the EY Item Club said the OBR’s forecast “may now be over-cautious”.

However, if the OBR is right, the consequences for the UK economy and British living standards are troublingly clear. Low productivity growth means companies will not have the money to raise wages. As a result, the OBR now expects real earnings growth to be only 0.6 per cent a year over the next five years, while real household disposable income is predicted to grow by just 0.3 per cent a year. Traditionally these figures rose around 2 per cent annually.

The Resolution Foundation think-tank calculated that average real incomes are now expected to be £540 lower by 2023 than originally forecast in March, with annual projected pay down £1,000.

“Pay is not set to return to pre-crisis levels until the middle of the next decade,” said Torsten Bell, the think-tank’s director.

With its productivity downgrade, the OBR also challenged UK chancellor Philip Hammond’s messaging in his Budget.

While the chancellor talked about cash to help companies invest, the OBR revised down its forecasts for business investment. And despite Mr Hammond’s £44bn housing package, the OBR revised down its estimate of residential investment growth as a result of its forecasts for weaker incomes and house prices.

“This is not a reflection of the housing measures announce in the Budget, but it does represent a challenging baseline for the government’s housebuilding target,” Mr Chote said.

Most of the OBR’s forecast contained nasty surprises for the chancellor. But there is one piece of good news for Mr Hammond: now that the watchdog has taken drastic action, future Budgets are unlikely to be so bleak.

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