Liz Truss became prime minister promising to shake things up and she certainly did. In less than a month, the new government has hiked interest rates, crashed the pound, torpedoed the housing market, made recession inevitable and left its party on course for an epic defeat in the next few months. elections. Not bad to start. The recall will have to be good to match the first performance.
As economist Mohamed El-Erian has noted, the chaos since the Kwasi Kwarteng mini-budget was more typical of what is happening in developing countries than in rich, developed ones.
A true emerging market-style crisis still seems a long way off because, unlike a struggling emerging market, the UK has its own currency and can as a last resort print books to cover its borrowing.
But the UK has both a huge trade deficit and a large (and growing) budget deficit, and relies on investors to fund them. Truss can dismiss criticism of her plans as much as she likes, but the fact remains that the events of the past week have made the UK a much riskier place for investors, who are now demanding rates higher interest rates to tackle the UK.
So while some stability returned to the currency markets at the end of last week, with the pound back to the levels it was at before Kwarteng announced its tax changes, it comes at a cost. Bond yields – effectively the interest rate the government pays on its new borrowings – have risen sharply. “Indeed, the UK now has to offer much higher yields to global investors to maintain the same currency value that prevailed, with much lower rates, before the announcement,” says Krishna Guha, of the consultancy in investment banking Evercore.
The government has tried to argue that the UK is not alone in facing higher interest rates or a weak currency. That’s true, but that doesn’t explain why, last week, the pound hit an all-time high against the US dollar. Nor can it be seen as a reason why the Bank of England was forced to launch an emergency bond-buying program to prevent a run on British pension funds. These are the results of the mistakes made by Truss and Kwarteng.
True, global interest rates have been rising all year, but that should have made the Prime Minister and Chancellor more cautious about announcing a package of unfunded and unaudited tax cuts without first face the markets. It wasn’t as if Truss and Kwarteng hadn’t been warned; they were but chose to ignore the advice they received from both officials and outside experts. The decision to move forward without any form of oversight from the Office of Budget Responsibility was particularly unwise.
The result is that the mini-budget will have exactly the opposite results to those expected. Truss took on treasury orthodoxy and abacus economics, but now the two are back with a vengeance. Departments in Whitehall have been told to make efficiency savings and the Treasury has made clear it has no plans to reopen last year’s spending cycle, even though agreed settlements now buy less due to higher than expected inflation. It seems very likely that state benefits will not be increased in line with inflation.
And while Truss was planning to exert more control over the Bank of England after its failure to prevent inflation from hitting a 40-year high, those plans have now been shelved following the bailout of the Threadneedle Street pension fund the last week. “The government has managed to make the Bank of England look good, which is quite an achievement,” said a prominent economist.
Squeezing government spending is one reason Truss can kiss goodbye to hopes that his mix of tax cuts and supply-side reforms will boost growth in the months ahead. A bigger factor will be higher interest rates.
The day before the Kwarteng mini-budget, the Bank raised interest rates by half a percentage point to 2.25% – deciding not to raise further as it believed the UK was in recession. In this case, an upward revision to growth in the second quarter means that the economy is not really in recession, but the respite will certainly be short-lived.
Huw Pill, the Bank’s chief economist, has warned that “significant” increases in interest rates can be expected at the next meeting of the monetary policy committee at its next meeting, and financial markets are getting angry. currently expect official borrowing costs to continue to rise at 6%.
Make no mistake, if the Bank pushes rates close to 6%, it had better prepare for a colossal recession. Already last week, there were signs of trouble in the mortgage market, where more than a thousand home loan products were pulled by lenders monitoring what happened to bond yields and the expected trajectory of official rates of the Bank of England.
Many homebuyers took out mortgages at high multiples of their income, thinking that permanently low interest rates would make them affordable. That assumption is now in tatters, and holders of variable-rate mortgages and those whose fixed-rate terms are coming due are facing huge increases in their monthly payments. The supply of new buyers will dry up quickly. House prices will go down.
The irony is that the first budget from a supposedly pro-growth government made recession more, not less, likely. The government may introduce supply-side reforms in the coming months, but if interest rates stay high to appease nervous investors, the trend rate of growth will be lower, not higher. Britain’s economic history is littered with rapidly collapsing budgets: Kwarteng’s is in a class of its own.