liz Truss became prime minister and promised to shake things up and she certainly did. In less than a month, the new government has pushed interest rates up, crashed the pound, torpedoed the property market, made a recession inevitable and set its party on course for an epic defeat at the next election. Not bad for starters. The encore will have to be good to match the debut.
As economist Mohamed El-Erian has pointed out, the chaos since Kwasi Kwarteng’s mini-budget has been more typical of what is happening in developing countries than in rich, developed countries.
A full-blown crisis in emerging markets still seems a long way off, as unlike a troubled emerging market, the UK has its own currency and can print pounds in the last resort to cover its loans.
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 reject any criticism of her plans as much as she likes, but the fact remains that last week’s events have made the UK a much riskier place for those investors, who are now demanding higher interest rates to put a stop to the UK. .
So while some stability had returned to currency markets by the end of last week, with the pound back around the level it was before Kwarteng announced its tax changes, it has come at a price. Bond yields – in fact the interest that the government pays on its new loans – have risen sharply. “In fact, the UK now needs to offer much higher returns to global investors to maintain the same currency value that prevailed before the announcement, with much lower rates,” said Krishna Guha of investment banking consultancy Evercore.
The government has tried to argue that the UK is not alone in facing higher interest rates or weak currencies. This is true, but does not explain why the pound briefly hit a record low against the US dollar last week. Nor is it a reason why the Bank of England was forced into an emergency bond-buying program to prevent a run on UK pension funds. These were the results of blunders by Truss and Kwarteng.
Sure, global interest rates have risen throughout the year, but this should have made the Prime Minister and Chancellor more cautious announcing a package of unfunded and unsupervised tax cuts without first settling the markets. It wasn’t as if Truss and Kwarteng hadn’t been warned; they just chose to ignore the advice they had been given by officials and outside experts alike. The decision to proceed without any sort of scrutiny by the Office for Budget Responsibility was particularly reckless.
As a result, the mini-budget will have the exact opposite result of the intended results. Truss lashed out at Treasury orthodoxy and abacus economics, but now both are back with a vengeance. Whitehall departments have been told to cut efficiencies and the Treasury Department has made it clear it has no intention of reopening last year’s spending round, although the agreed settlements are now buying less amid higher-than-expected inflation. It seems very likely that state benefits will not increase with inflation.
And if Truss thought of exerting more control over the Bank of England after it failed to prevent inflation from hitting its 40-year high, those plans have now been abandoned after the pension fund bailed out. Threadneedle Street last week. “The government has managed to make the Bank of England look good, which is an achievement,” said a leading economist.
The pressure on government spending is one of the reasons Truss can say goodbye to hopes that her mix of tax cuts and supply-side reforms will boost growth in the coming months. A more important factor will be a higher interest rate.
On the day before the Kwarteng mini-budget, the Bank raised interest rates by half a percentage point to 2.25%. She waived a bigger raise because she thought the UK was in recession. Coincidentally, an upward revision to growth in the second quarter means the economy isn’t really in recession, but the calm is sure to 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 currently expect official borrowing costs to continue rising to 6. %.
Make no mistake, if the Bank pushes rates anywhere near 6%, it better be prepared for a colossal recession. Last week there were already signs of trouble in the mortgage market, as more than a thousand home loan products were attracted by lenders watching what happened to bond yields and the expected course of official Bank of England rates.
Many homebuyers have taken out mortgages at high multiples of their income in the belief that a permanently low interest rate will make them affordable. That assumption is now in tatters, and holders of floating-rate mortgages and those whose fixed-rate term expires face huge increases in their monthly payments. The supply of new buyers will dry up quickly. House prices will fall.
The irony is that the first budget of a supposedly pro-growth government has not made a recession less likely. The government may implement supply-side reforms in the coming months, but if interest rates remain high to appease nervous investors, the trend rate of growth will be lower, not higher. Britain’s economic history is littered with budgets that have quickly unraveled: Kwarteng’s is in a league of its own.