The UK Economy - there are no good options from here, just less bad ones

Jeremy Lawson, chief economist, abrdn Research Institute.

26 September 2022 – 2pm

Last week the new Chancellor of the Exchequer – Kwasi Kwarteng – unveiled a new mini-budget intended to usher in a period of stronger and more dynamic growth. This capped a furious few weeks of policy announcements since Liz Truss became Prime Minister at the start of September.

The scale of policy changes is breath-taking. The most important from a macroeconomic perspective have been:

• Capping household energy bills at £2500 per year until 2024 to soften the cost of living crisis, with a similar, shorter-lived scheme put in place for businesses.
• Significantly cutting taxes for individuals and businesses, headlined by reversing the 1.25% national insurance increase; suspending the planned corporate tax increase; dropping VAT on tourist spending; eliminating the 45p tax rate on earnings over £150k; and lowering the basic rate of income tax.

Together with a raft of deregulatory actions, the mini-budget was part of a plan to drive long-term growth up to 2.5%, well above the average rates that have been achieved since the global financial crisis.

But while we agree that growth-enhancing structural reforms are much needed, there are few reasons to think that this particular combination of measures announced will have anything close to their intended effect. At the same time, the tax cuts that will largely benefit already wealthy households, will worsen inequality, a measure the UK already performs poorly on.

There is also little doubt that the country’s public debt is set to soar further over the next few years, especially if the recent shift higher in government borrowing rates is maintained or rises further. And over the long run, we are concerned that the permanent dent in the government’s finances will increase concerns about the sustainability of the debt burden in the context of structurally increasing demand for government spending.

In the meantime, the ill-timed and inappropriately sized fiscal loosening will push up aggregate demand into an economy already overheating, forcing the Bank of England to tighten monetary policy more aggressively. That in turn ultimately makes a recession more rather than less likely.

The market reaction to the debt-financed tax cuts has been vicious. At one point on Monday morning, Sterling had fallen over 10% in the past two weeks. 5-year gilt yields spiked by the largest amount on record on Friday. And equity prices have fallen, a reversal of the usual effect of the currency on the FTSE..

Forecasting currency moves is difficult at the best of times. But the UK already runs one of the largest current account deficits in the world. It has large and growing public financing needs as well as extensive foreign liabilities. Uncertainty about future inflation and the course of negotiations over the Northern Ireland Protocol is high.

And the Fed’s own actions to stamp out inflation are putting upward pressure on the dollar. It therefore seems more likely than not that the pound will depreciate further, both against the dollar, and on a trade-weighted basis.

All of this puts the Bank of England in a huge bind. The onus was already going to be on the Bank to act more forcefully than its tame 50bp increase in Bank rate last week. Recent market moves do not yet reflect a judgement that the UK is heading towards a balance of payments or debt crisis. But confidence in 'UK Inc' is falling and further large falls in Sterling will make the inflation picture work. An inter-meeting verbal intervention from the BoE is becoming more likely, especially if disorderly market moves continue.

If that does the short-term trick, the Bank’s November meeting will need to deliver a much larger increase in the policy rate. The market is pricing in close to 200bp of cumulative rate increases by the end of the year, well above what was being priced when the MPC met on Thursday. And if that is not enough, an interim meeting might be required, though that would risk escalating tensions with the new government. Any signs that the Bank is shirking from its task, will only make matters worse.

Either way, there are no good options from here, just less bad ones, with the UK’s already struggling household and businesses left to pick up the pieces.