After a period of elevated volatility in Sterling and British financing costs, a sigh of relief engulfed the markets, mainly triggered by changes in the government’s fiscal approach. While now-former Chancellor Kwasi Kwarteng came out with numerous promises, including cutting taxes and safeguarding consumers against an energy crunch, things took a 180-degree turn during the past week.
While the new PM Liz Truss intended to gain more popularity in an already-divided party, her approach turned out to be disastrous, further complicating the delicate situation the country is facing. Rampant inflation, a war in Ukraine, persistently high energy costs, and a diminishing standard of living, are factors that can weigh on a government’s credibility.
Runaway deficits – no longer a good idea
In an environment where commodity prices are high, spending more to shield the private sector does not pose the best results. Compared to last year, central banks are no longer in the market, buying bonds to prevent a sharp rise in borrowing costs. Instead they focus on tightening financing conditions, so inflation doesn’t become persistent in the longer run.
Deficit spending means the government is introducing new purchasing power to the economy, leading to greater price pressures. With the slump in the Pound’s exchange rate and drop in Gilts, markets are adjusting to what might happen in the near-term, as a result of the mini-budget.
Jeremy Hunt and the fiscal U-turn
Sacking the former Chancellor and bringing Jeremy Hunt in his place turned out to be a good choice, at least for now. Lower taxes for companies and people with higher incomes, alongside a bottom tax rate lowered to 19%, are measures that have been taken off the table. Also, the energy support package, designed to protect consumers from high prices, will only last until April 2023 in its current form.
According to experts working for easymarkets, this is one of the reasons why the Pound managed to recover against its peers, and financing costs did not reach new highs for the year. Initial estimates of the government point out a 32 billion GBP reduction in deficit spending by April 2027, meaning fewer new bonds will have to be issued by then.
Implications for the economy
The fiscal U-turn means the private sector has to take in more of the negative consequences generated by the energy crunch and looming recession. The BoE already predicted that the UK economy would enter a recession during Q4 of this year, so with no extra help from the government, GDP prints should be negative for a few consecutive quarters.
However, less fiscal spending means inflation might peak earlier than anticipated, not forcing the central bank to hike more aggressively. Price stability could pay higher dividends in the longer run, even if that implies some pain in the short-term. After a decade of low interest rates, adapting to a world where that’s no longer the case is quite a challenge, not just for private companies, but for the government as well.