Truss began challenging “economic orthodoxy” with a package of energy subsidies, tax cuts and promises of supply-side reforms that would lift growth. But the plan was unfunded, and the pound and government bonds collapsed.
When bond prices fall, yields rise, making it more expensive to borrow from the government. Furthermore, the Office for Budget Responsibility (OBR), the UK’s fiscal watchdog, was not allowed to judge what the plan meant for the public finances, leaving the market to guess what the economic and fiscal impact of the plan might be. Volatility forced the Bank of England into temporary emergency intervention by buying government bonds.
Now, Sunak must act quickly to restore the government’s credibility by showing that its fiscal plan is sustainable, which poses political and economic challenges.
The government seems to have made some progress. Jeremy Hunt, the new Chancellor of the Exchequer, has effectively overturned Truss’ budget policies and reduced the government’s two-year cap on energy prices – intended to protect households against rising energy bills – to six months. This alone significantly reduces the risk that high gas prices will drive government spending unsustainably.
Further measures, likely to include higher taxes on corporate profits and slower growth in public spending, are likely to close the fiscal gap. Critically, the Office for Budget Responsibility will return to its mission of determining whether the government’s plans are fiscally sound and sustainable.
Does this mean that fiscal credibility in the eyes of the market is restored? The fall in government bond yields, even after the Bank of England ended its intervention, suggests that the bond market’s confidence in the government has partially recovered, important for many domestic and foreign investors who will continue to fund the UK. fiscal deficit These lower yields, in turn, mean lower interest rates for the government, which flows into lower interest rates for households and businesses.
But the government still has more to do to fully restore market confidence. Suna and Hunt will face a major challenge in finding additional revenue and cutting spending to ensure public finances are on a sustainable path, and even more difficult in shepherding these fiscal measures through parliament, with a shrinking and small Conservative parliamentary group. political capital in the bag.
In fact, political uncertainty will increase – and the markets see that. In practice, the government will have to tighten fiscal policy more than it otherwise would — meaning higher taxes or deeper cuts in benefits and spending — or risk much higher interest rates and debt.
This tax tightening will have real economic consequences. The UK economy is already on the brink of recession, with the main culprits being high energy prices and financial uncertainty for households and businesses. Consumer confidence is near all-time lows.
The Bank of England will continue to raise interest rates to address underlying inflationary pressures. Like the US, the UK is struggling with reduced labor supply and supply chain issues due to the pandemic. The impact of Brexit is still a concern for businesses.
The Bank of England has already raised interest rates to 2.25%, the highest since 2008. Although bond market volatility has fallen since then, interest rates for households and businesses are likely to rise, and the UK housing market is expected to worsen. sharp in winter With the economy weakened, the Bank of England may find itself returning to its dark rhetoric and reducing interest rate hikes.
It will be difficult to avoid a recession. It’s not strictly “domestic” – high energy costs caused by Russia’s cut in gas supplies to Europe, geopolitical uncertainty and rising global interest rates have all contributed to the UK’s economic woes – but it has certainly worsened economic policy. Under the truss
The experience underscores how important fiscal credibility is in a geopolitically charged world. It will take time for the UK to regain its hard-earned reputation for macroeconomic stability. There is hard work ahead for Sunak.