The economic and market implications of the UK "mini budget"

Commentary September 27, 2022

The UK cabinet led by the newly-appointed Conservative leader Liz Truss surprised markets when it shared the details of the so-called "mini-budget" last week. Chancellor Kwasi Kwarteng outlined a series of measures aimed at capping energy prices for individuals and businesses and, more importantly, slashing income and corporate taxes across the board.

Breaking it down, the provisions to put a ceiling on energy prices are both popular and necessary from a social perspective. Still, they will come at an astounding cost, currently estimated to be around £60bn over the next six months. The final bill, however, will depend on the wholesale gas and electricity prices and there is no ceiling on the government's liability. Russia continues to apply pressure on Europe by further restricting the gas supply and a colder than expected winter could see prices rising from the already elevated levels.

The starker parts of the budget were the large tax cuts to income taxes, National Insurance contributions, Stamp Duty and the reversal of the planned increase in Corporation Tax from April 2023. While many have criticized the government for the unequal distribution of gains, perhaps more noteworthy are the implications of the sizable demand-side boost at a time when inflation is at a 40-year high. While the policy is projected to boost near-term incomes, the following squeeze from higher interest rates may leave both individuals and the economy worse off over a longer time horizon.

At the centre of the new plan is a bet that the fiscal expansion will boost long-term growth which in turn will ensure debt sustainability.

Another worrying fact was the lack of assessment by the Office of Budget Responsibility (OBR) which provides an independent analysis of the UK's public finances. Absent were comments from the chancellor about future spending who focused instead on the increased projected growth as a result of the new budget. The next set of five-year forecasts by the OBR will be critical for markets and the chancellor may be forced to clarify his intentions and commitments to fiscal stabilization in order to avoid disruptions in asset markets.

What was the market reaction and how does it change the outlook for the UK economy?

The UK government bonds sold off aggressively on the day of the announcement, pushing the yield on 10-year bonds up by more than 0.3%. This was followed by another sharp move on Monday which pushed yields to 4.2%, the highest level since 2008. The realization that the Treasury will have to sell more gilts than previously planned scared investors who also had to reassess the long-term outlook for inflation. At the same time, the pound slid more than 5% and reached $1.07, bringing the year-to-date decline versus the dollar to more than 20%.

At the centre of the new plan is a bet that the fiscal expansion will boost long-term growth which in turn will ensure debt sustainability. The government aims to raise trend growth to 2.5% but there is weak evidence that these types of measures can meaningfully raise growth rates in the long run. Furthermore, the government's actions will leave the Bank of England (BoE) little choice but to respond by raising short-term rates, a lot of which has already been priced by the market. Indeed, the BoE made an emergency statement on Monday to reiterate its commitment to long-term price stability but this did little to reassure investors.

In more basic terms, while the energy price cap is expected to ease headline inflation (inclusive of food and energy) in the short term, the tax package, by supporting income and demand, is expected to put higher and broader pressure on long-term inflation. And since inflation is one of the main determinants of bond yields, gilts have to re-price lower and the government will need to finance the newly-issued debt at higher rates. The lack of domestic savings makes the British economy dependent on foreign capital inflows, and the debt-financed tax cuts and spending are posed to widen the current account deficit. The question of how the budget holes will be plugged in the future remains unanswered and foreign investors are demanding a higher return to lend to the UK to compensate for the risk.

The sharp market reaction made the prospect of a UK balance of payment crisis a distinct possibility, albeit a remote one at this time. The observed economic growth in the next several quarters will be crucial to assess the feasibility of the new government doctrine in the face of opposing actions from the Bank of England that will do everything in its power to maintain credibility. In all likelihood, the pressure on the pound and gilts will continue in the absence of policies that can soothe investors' fears. In the backdrop of a complicated global outlook, the path for the UK economy and interest rates remains uncertain.