The writer is an economist and the author of ‘Two Hundred Years of Muddling Through: The Surprising Story of Britain’s Economy from Boom to Bust and Back Again’
After 12 years of fiscal conservatism being the lodestar of British economic policy, the sudden switch to a tax-cutting, supposedly pro-growth agenda has clearly rattled investors.
To say that Friday’s “mini-Budget” went down badly with financial markets would be an understatement. UK government debt underwent its largest two day sell-off on record while sterling fell to a new low against the dollar. It is tough to find precedents for these sorts of market moves in British economic history.
Rarely has opinion on quite what the UK government’s abrupt shift means been so divided. On the one extreme, the unusual combination of a falling currency and rising interest rates has led some commentators to suggest that the UK is behaving like an emerging market. On the other, some of the government’s backers have welcomed sharp rises in interest rates as part of a deliberate shift to a combination of looser fiscal and tighter monetary policy.
Neither explanation rings entirely true. While the credibility of British policymakers with international investors has almost certainly sharply diminished, it has not vanished. For all the excitable talk of the public finances being on an unsustainable path, no one seriously expects a default.
The movement in gilt yields reflects changing market expectations of the path of monetary policy rather than worries over credit risks. But it is equally hard to take at face value those who claim this was “all part of the plan”. If the plan was to drive market expectations of future interest rates to a level that could potentially crater household income, trigger a fall in house prices and result in a deep recession, then the plan was clearly terrible.
The current macroeconomic tides look eerily familiar to 1972. Indeed, this was the largest tax-cutting budget since that year.
Back then Anthony Barber, the chancellor, faced a similar economic environment to the incumbent, Kwasi Kwarteng. Inflation was uncomfortably high even as growth slowed. Barber responded by cutting taxes in an infamous “dash for growth”. The resulting boom quickly turned to bust as the economy overheated, forcing a sharp adjustment. The market reaction was, if anything, even more brutal. Sterling lost about 10 per cent of its value over the course of 1972 and 1973 and the yield on government 10-year gilts rose from under 8.5 per cent to more than 14 per cent.
One major difference with the early 1970s is the existence of an independent, inflation-targeting Bank of England. In theory, as the government steps up the fiscal largesse, the BoE can move to offset the inflationary spill-over effects by tightening policy. But that theory is about to receive a difficult stress test.
Sterling stabilised, and even staged an impressive intra-day rally, on Monday on market expectations that interest rates will rise to 6 per cent by next summer. Such a level would have a heavy impact on UK households. According to Pantheon Macroeconomics, a research consultancy, that would imply homeowners coming off a two-year fixed rate mortgage with a 75 per cent loan to value ratio on the averagely priced house would see their monthly payments jump from £863 to £1,490.
The BoE is now caught between a rock and a hard place. It was already treading what the governor had termed a “narrow path” between a forecast recession and core inflation running at an annual rate of more than 6 per cent. That path has been made much more treacherous by the government’s switch to easier fiscal policy.
Either it will be prepared to raise rates to the kind of level markets have priced in, which would crush demand and lead to an even nastier recession, or it will not. In which case sterling will probably lose more value and imported inflation will rise further.
Neither option will be pleasant for Threadneedle Street but the latter is more likely. While the BoE will have little choice other than to step up the pace of tightening in the months ahead, it will almost certainly disappoint anyone anticipating a peak benchmark interest rate of 6 per cent for the UK. That implies more downside risk to sterling in the months ahead, adding to fears of higher-for-longer inflation.