In the United Kingdom, the debate over the draft measures to revive the British economy, which is close to recession and has recorded almost 10% annual inflation, is endless. On Monday 3 October, the Minister of Finance (equivalent to the Minister of Finance), Kwasi Kwarteng, announced that the government had finally withdrawn the most controversial provision from its “tax event”: the abolition of the 45% tax rate for the richest households.
The executive is thus reversing its mini-fiscal shock programme, which was presented on 23 September and strongly condemned by the opposition since then. In particular, the revelation of this plan led to a historic fall in the pound sterling in the markets three days later, as investors feared an explosion in the British debt. On Sunday 2 October, Prime Minister Liz Truss, in office for a month but already at record levels of unpopularity, had acknowledged “failures” in communication but insisted the policy of cutting taxes was a “good decision”.
But contrary to the original scenario desired by Liz Truss and Kwasi Kwarteng, there is no empirical evidence that cutting taxes for the wealthiest is beneficial to economic activity.
A policy mix that lacks coherence
Above all, the combination of monetary and budgetary policies in the United Kingdom, the so-called policy mix, does not seem coherent. In fact, like most central banks, the Bank of England (BoE) is currently in a cycle of raising its key interest rates to try to combat inflation and bring it back to the 2% target. On September 21, two days before the announcement of the fiscal measures, the BoE’s monetary policy committee notably decided to raise its key interest rate (Bank rate) by 0.5 percentage points to 2.25%.
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On the other hand, the central bank had simultaneously decided to gradually reduce the holdings of government bonds it had bought over the next 12 months, which is also contributing to the tightening of financial conditions. However, recent academic literature converges on the negative macroeconomic consequences of such austerity, greatly increasing the risk of falling into an economic recession.
On the balance sheet:
the inflation that the Bank of England is trying to fight will be driven by a tax cut that the government decides;
the government’s objective of increased economic growth will be thwarted by the tightening of financial conditions triggered by the central bank.
Moreover, this recovery plan is not self-financed, but will be fed by public debt. This may raise questions in a context of the public debt, which is already considered high (99.6% of GDP in the first quarter of 2022), the consequence of several years of negative economic shocks.
There is also a high risk of seeing some of this budgetary stimulus seeping through imports, which would increase the UK trade deficit by the same amount, estimated at around £30 billion in the second quarter of 2022 (combined goods and services). Moreover, the first evaluations carried out in the United Kingdom have emphasized that this tax program will clearly benefit the wealthiest households.
The UK therefore appears to be at a standstill in the face of the crisis, especially as the country continues to be weighed down by the consequences of Brexit.
Falling investments since 2016
In just a few years, the British economy has experienced a series of four negative shocks: the global financial crisis and the recession that followed in 2008-09, the exit from the EU (Brexit) by referendum in June 2016, the Covid-19 pandemic in 2020- 21 and finally the energy crisis in connection with the war in Ukraine after the Russian invasion on 24 February 2022.
Although three of these shocks have been experienced and are linked to external events, Brexit remains a self-inflicted crisis by the British voting to leave the EU. This shock is perhaps the most damaging in economic terms, especially by undermining the confidence of economic actors, domestic and foreign.
Indeed, economic policy uncertainty quickly rose to a record high following the Brexit shock and then remained at a high level with the onset of the Covid-19 pandemic (see Figure 1).
This high economic-political uncertainty has, over a relatively long period, resulted in a persistent weakness in business investment. In fact, in the economic literature, uncertainty is considered to be one of the decisive factors in investment decisions, along with expected demand and financing costs.
If we compare the UK with a partner country that is relatively similar but not directly affected by Brexit, e.g. France, we clearly see a growing difference in the level of business investment.
In the second quarter of 2022, business investment in the UK is 7% below mid-2016 levels (following the referendum), while it is 17% above in France (see graph 2).
Over the most recent period, UK GDP exceeded pre-Covid levels only in the first quarter of 2022. However, the first results for the second quarter of 2022 indicate a fall in GDP of -0.1% compared to the previous quarter.
In this fragile macroeconomic context, the energy crisis linked to the war in Ukraine has intensified the inflationary pressures already visible in the post-Covid recovery. Annual growth in the consumer price index stood at 9.9% year-on-year in August. Even if much of this increase is linked to the energy shock, underlying inflation (excluding energy, food, alcohol and tobacco) is 6.3%, suggesting non-negligible second-round effects.
In particular, the price of goods increased by 12.9% year-on-year, mainly due to supply constraints. This increase in inflation is transmitted throughout the economy: 80% of goods and services included in the consumption basket experienced inflation above 4%, compared to 60% in the euro area.
The sanctions of the markets
At the moment, the financial markets are pointing out the lack of coherence in the policy mix and the lack of credibility of the recovery plan. UK government bond yields rose to 4.5% on Tuesday 27 September, a record high since mid-2008 (see Chart 3). This increase in long-term interest rates is not a positive signal from the markets. It is true that the “expectation” component of long interest rates has increased under the impact of the rise in expectations of short interest rates, but risk premiums, real and nominal, have certainly been reassessed.
In the foreign exchange market, the pound has weakened by around 20% over the past year against the US dollar, reaching a value of 1.07 on 27 September.
There is certainly a dollar effect in this development in the sense that the US currency has appreciated against a large number of currencies, as is systematically the case in periods of global crisis. But the pound has also weakened relative to the nominal effective exchange rate, i.e. against a basket of 27 currencies, by about 7% since the start of the year.
What is the effect of such depreciation on inflation? The Bank of England (BoE) has a rule of thumb to assess this. The transmission of a depreciation of the pound to inflation occurs in two stages as follows: first the effect on import prices (between 60% and 90%), then the effect ultimately on consumer prices, assuming firm profit behavior is constant, depends on the import intensity of consumption, estimated at around 30% in the UK. Finally, the transmission coefficient is between 20% and 30% depending on the BoE.
An effective depreciation of 7% will therefore lead to an increase in the price level between 1.5% and 2% since the beginning of the year. This is not insignificant and underlines the boomerang effect of the financial markets’ deciphering of the policy mix on economic activity.
Ultimately, this market development following the announcement of the stimulus plan has further contributed to the tightening of financial conditions, increasing the likelihood of a recession in the coming months. Most of the growth outlook for 2023 remains pessimistic: According to the OECD’s preliminary forecasts published on September 26, UK GDP should stagnate in 2023 compared to 2022, pointing to a few quarters of negative growth.
Furthermore, on 26 September the Bank of England published the hypotheses for its stress test scenario for the UK banking system: the hypothesis of a deep recession in the UK and at the same time for the world economy will be considered during this exercise.
In light of the impact on financial markets of the various economic policy announcements, the BoE changed its stance by announcing on 28 September that it will immediately resume its purchases of UK government securities, at least temporarily until 14 October.
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The argument put forward is the financial stability risk to the UK system, for which it is also responsible. This reversal of attitude quickly after the government’s first publication of the recovery plan is a good example fiscal dominance, the principle that monetary policy depends on fiscal policy. This change in monetary policy resulted in increased volatility in the financial markets.
To reduce this, the dilemma between fiscal policy and monetary policy will need to be resolved quickly, either by asserting the central bank’s determination to fight inflation or by clarifying the government’s strategy for financing his action plan.