U.K. Fiscal Policy: Boom

Created
Fri, 23/09/2022 - 23:12
Updated
Fri, 23/09/2022 - 23:12

I normally stay away from commentary on budget statements, in that the analysis is mainly political in nature. In recent decades, the macro fiscal effects tended to be tepid and over-rated for political reasons. (The pandemic measures are the glaring exception, however, they were often enacted as stand alone measures and not part of the normal budgeting process. The same holds for the various fiscal measures enacted in 2008.) The recent “mini-budget” in the United Kingdom threw away that timidity. Since I have not been following the area closely, I will point you to Duncan Weldon’s piece, and offer a more theoretical response.

I am in the process of commenting on an article by neoclassicals that is doing inflation analysis solely based on Taylor rule parameters — which ignores minor details like fiscal policy. The ongoing rout in the British Pound and gilts (last quote I saw was +50 basis points at the 5-year point) underline that the fiscal stance matters.

The U.K. is currently having problems with inflation, exacerbated by the disruption in the energy markets. I have no opinion on the plan to cap energy costs within the mini-budget, but it is clear that muscular intervention of some sort (rationing) was needed to deal with energy prices. However, inflation is not just energy. A large tax cut is exactly not what is needed to deal with an inflation problem.

I am already seeing the predictable comments about bond vigilantes, and I guess the currency vigilante stories are spreading as well.

On the currency side, the economic policies of the Conservative government are best described as “omnishambles,” starting with Brexit, and now this budget document. Given the possibility of a hard landing, my amateur forex knowledge suggests that GBP is not particularly attractive. This will put political pressure on the government, given the long history of U.K. currency crises. The pound now floats, but why let facts get in the way of a good story? [Note: this text was mistakenly negated in the first draft - oops.]  Although this will likely speed up the government’s reaction (discussed below), I doubt that the Bank of England is going to start targeting levels of GBP (which is what “inflation vigilantism” would suggest).

As for rates, bond markets are just pricing in what the Bank of England is going to do: hike rates like crazy. They need to price the Bank’s reaction function, so it is not as if it requires a deliberate decision by masked fixed income strategists. The only way the bond markets would be acting truly independently is if the Bank of England had a mandate to keep the policy rate fixed — which it does not.

The Bank of England reaction is straightforward: hike 75/100 basis points per meeting until something breaks — or inflation miraculously rolls over. Given the stretched nature of the U.K. housing market, it does not take a whole lot of time to find the candidate for what will break.

The political reaction is also predictable. Once the crisis in the pound/interest rates hits some threshold, the government will announce cuts to social services (and possibly go forward with yet more privatisation in the National Health Service), pleading that the “markets forced us to do this.” This tactic has been used for decades by “free market” politicians, and yes, they will use it again. The only question is timing: will the housing market have crashed already? If so, the U.K. will get the implementation of austerity policies at the bottom of the cycle that is the trademark of conventional economic policies.


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(c) Brian Romanchuk 2022

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