It is a sign of how badly confidence in Britain’s economy has been shaken that on the day Italy seemed set to have its first far right-led government since the war, investors were more preoccupied by the new UK government’s radical shift in policy. Sterling had already hit a 37-year low after chancellor Kwasi Kwarteng on Friday announced the biggest tax cuts since 1972. Early on Monday, the pound briefly touched its lowest ever against the dollar; two-year gilt yields soared to their highest since the financial crisis. The market instability is further confirmation of the recklessness of the Truss government’s strategy of funding historic tax cuts and energy subsidies through debt, backed only by a promise of improved growth.
Investors do not believe Kwarteng’s plans are credible. The prospect of higher interest rates would otherwise lure many investors into sterling; the fact the opposite is happening reflects tumbling faith in the fiscal and economic outlook. Rising gilt yields are being driven by expectations that the Bank of England will have to tighten monetary policy even more to curb inflation, with rates of nearly 6 per cent next year now being priced in — more than double their current level. With Britain’s elevated debt now set on an unsustainable path by Kwarteng’s plans, investors may increasingly demand higher returns to hold it. There is a risk that credit rating agencies might downgrade UK debt, moving borrowing costs to another level.
The market moves have major implications. Britain’s record current account deficit means it depends significantly on investors to lend to it and buy UK assets. The rise in gilt yields raises government borrowing costs even further, and risks becoming self-reinforcing. The pound’s weakness, moreover, raises the cost of imports, including energy, which reinforces inflation. Further rate increases would sharply push up borrowing and mortgage costs, potentially eviscerating the benefits of the government’s energy support package — and of Kwarteng’s tax cuts.
The government needs to act quickly to calm markets. Ideally, it should reverse some tax cuts, even though this would be politically unsustainable. The Truss government should at least stop pledging more cuts to come, as Kwarteng did at the weekend. It needs to provide a more convincing explanation of the rationale for its policies, and of how it intends to stabilise public finances — even before it presents its fiscal plan and forecasts from the Office for Budget Responsibility, now set for November 23. It should make clear that, if things do not go to plan, it is prepared to do whatever is necessary to balance the books — even if that means cutting spending, however undesirable that may be.
Although it is in an unenviable position, the Bank of England should be more explicit about its plans to control the increased inflationary pressures. In the coming weeks it should build on its statement on Monday and indicate that a record rate hike could be on the table at its November meeting. This ought to help stem inflation expectations, and ease pressure on the pound. The Monetary Policy Committee should also closely monitor risks in gilt markets, particularly in light of its programme of quantitative tightening.
Friday’s “mini-budget” highlighted the Truss administration’s dogmatic belief in the power of slashing taxes and regulation to boost private enterprise and growth. Staking so much on this unproven approach working, when the British economy is so fragile, threatens serious costs for households and for companies. The reaction of the pound and gilts has shown once again that credibility is more important than blind conviction.