The BFD | An Attempt to Calm the Financial Markets

Steve Schifferes
City, University of London
Andrew Burlinson
Catherine Waddams
University of East Anglia
Brian Scott-Quinn
University of Reading
Morten O. Ravn
UCL
Steven McCabe
Birmingham City University

Professor Schifferes was Marjorie Deane Professor of Financial Journalism and the first Director of the Financial Journalism MA at City from 2009-2017, and is currently an Honorary Research Fellow at CityPERC.

Professor Brian Scott-Quinn who formerly worked in the City of London in the international bank credit and capital markets, is the founder, and chairman, of the ICMA Centre for financial markets at Henley Business School, University of Reading.

Morten O. Ravn is a Professor of Economics at UCL. He is a Co-Editor of Quantitative Economics, a Fellow of the European Economic Association, CEPR Research Fellow, and a member of the board of the Danish National Research Foundation.

Having graduated from the University of Manchester in 1984 with a degree in management, Dr McCabe spent time in industry as a management trainee before commencing an EPSRC research-sponsored MSc in Management at Birmingham University in 1988.

Newly installed UK chancellor, Jeremy Hunt, has unveiled a raft of changes to Kwasi Kwarteng’s September 23 mini-budget, which essentially amounted to a rollback on most of its headline points.

The September mini-budget, which included £45 billion in unfunded tax cuts, created significant volatility in financial markets in the weeks after it was announced. The resulting impact on the cost of borrowing for the UK also filtered through to consumer mortgage rates and pensions.

Hunt has indefinitely postponed a planned cut to the basic rate of income tax and rolled back most of the other taxation plans from the government’s growth plan. Only the repeal of the National Insurance increase and the cut to stamp duty remains because they are already in the process of being signed off by parliament.

Financial market reaction

Steve Schifferes, Honorary Research Fellow, City Political Economy Research Centre, City, University of London

The government appears to have stabilised the financial markets with an emergency statement by the new chancellor, Jeremy Hunt. The statement was brought forward by two weeks, in an unprecedented move designed to calm recent financial market turbulence in the weeks following ex-chancellor Kwasi Kwarteng’s September 23 mini-budget.

The interest rate on a key measure of government debt, 30-year gilts, had been rising sharply over the weekend to 4.8%, but fell back to 4.4% immediately ahead of Hunt’s statement. Such drops are uncommon in this market, which has now stabilised. The cost of government borrowing has still not recovered to the 3.5% level of before the mini-budget, however. Similarly, the pound strengthened from US$1.11 to US$1.13, but remains 18% below its level one year ago.

In addition to scrapping £32 billion of the £45 billion in unfunded tax cuts announced in the mini-budget, Hunt also announced there would be further public spending cuts. Most importantly, however, the government has abandoned its commitment to fund an energy price cap – expected to cost £60 billion this year alone – beyond April 2023.

It will replace the scheme with a more targeted measure to be developed by the Treasury in the meantime. This will substantially reduce the deficit for the next two financial years – the original time period for the plan, announced in September. This will not have a direct impact on the Office of Budget Responsibility’s five-year deficit forecast, which discounts temporary measures, but it will lower the amount of debt interest payments the government will have to make.

But there are limits to how far his announcement can completely reassure the markets. Investors are likely to continue to add a “risk premium” when it comes to the UK, which means the markets will still demand higher interest rates when lending to the UK government than before the mini-budget. Among other issues, concerns remain over political instability, with the fate of the prime minister Liz Truss, in particular, remaining unclear.

Additionally, the increased likelihood of a UK recession (which would reduce government revenues) has increased. This is partly because the Bank of England is now expected to raise interest rates more sharply than previously planned, and also because the global economy – especially in the US, Europe and China – is slowing down faster than anticipated.

The next test for the government will be the Office for Budget Responsibility forecast and full budget statement on October 31. Despite buying some time, the fate of this government is still in the hands of the markets.

Business certainty

Steven McCabe, Associate Professor, Institute for Design, Economic Acceleration & Sustainability (IDEAS), Birmingham City University

Businesses tend to be successful when there’s confidence that the government has a coherent plan for the economy and is consistent in its implementation. The past three weeks have been anything but coherent or consistent. Hunt’s five-minute emergency statement consigns Trussonomics to the bin and acts as a warning to future governments about ignoring the markets.

The reversal of Kwarteng’s unfunded tax cuts, as well as the review of the energy support scheme – expected to cost more than £100 billion before it was cut from two years to six months – means public finances are on a surer footing. Creating a sense of stability and showing there is a grownup in charge will restore confidence among the international financial markets. This will be excellent news for businesses which, although they will be paying more corporation tax after last week’s U-turn, can at least make investment decisions with reasonable certainty.

Nonetheless, problems remain. Inflation is still very high, which may require the base rate to remain elevated for months. The pound, which has risen today after Hunt’s announcement, is still lower than when Kwarteng became chancellor in early September. Many businesses are in a precarious state and beset by a range of challenges including skill shortages and the prospect of higher energy after April.

Hospitality businesses – already being squeezed by rising energy costs – will not be helped by the scrapping of the alcohol freeze. Equally, Hunt’s reversal of plans for tax-free shopping for tourists will be a kick in the teeth for those hoping to see the UK attract more overseas visitors. The retail sector is also bracing itself for tough times as people in the UK become collectively poorer and cut back on discretionary spending. More intervention may be essential to stem the rate of business closures this winter.

The real economy

Professor Brian Scott-Quinn, Emeritus Professor of Finance, ICMA Centre, University of Reading

Many politicians have referred to the “magic money tree” in recent years. In 2017, then-prime minister Theresa May warned nurses: “There isn’t a magic money tree that we can shake that suddenly provides for everything that people want.” More recently, Labour leader Keir Starmer has promised there will be “no magic money tree economics” if his party gets into power.

It’s good news then that this “magic money tree” has been well and truly cut down by the new chancellor of the exchequer, Jeremy Hunt. By trying to increase spending substantially without increasing taxes, the UK government was losing credibility – and fast – in recent weeks. So Hunt is really only accepting the reality that slowing growth around the world at the moment is making everyone, everywhere poorer. He is facing reality, which means ensuring that the UK remains creditworthy, even while the world becomes poorer.

So, where do we stand now? Central banks like the Bank of England must raise interest rates to dampen down the economy and try to stop inflation from getting out of control and causing financial instability. On the other hand, governments want interest rates to be low to achieve their growth targets. But growth is not determined by interest rates so much as by a stable and low-risk economic environment. This gives companies the opportunity to develop new products and provides households with access to new skills to supply such firms with appropriate labour.

A focus on the real economy (and today that would apply with even more force to clean energy asset growth), would be a much better policy than the tug-of-war over interest rates that has recently led to instability and loss of confidence by buyers of gilts, investors, industrialists and consumers. These are the people that matter when trying to achieve a growth target.

Targeted policies needed

Morten Ravn, Professor of Economics at University College London, UCL

This was an inescapable U-turn. The September mini-budget brought market turmoil because it caused an unsolvable policy inconsistency with the Bank of England. This inconsistency was seriously threatening the economic and financial stability of the UK economy.

The unfinanced tax cuts announced in the mini-budget immediately affected government bond prices and the Sterling exchange rate. Declining long-term government bond prices put pressure on large UK pension funds, which forced the Bank of England to support the gilt market by buying long-term government debt.

The Bank of England has, therefore, on the one hand, had to increase short-term rates to reduce inflationary pressures on the UK economy while, on the other, support long-term bond markets with its recent purchase programme. Such policy inconsistency can only persist for a short time before it risks a speculative attack on the gilt market and further downward pressure on the sterling.

The increase in inflation in the UK hurts lower-income households more than those that are better off because these people spend a greater portion of their incomes on goods and services with rapidly rising costs such as energy. Therefore, there is a need for targeted policies offering protection for the poorest parts of society – something the government should bear in mind when designing a replacement energy price support package after April.

So will the U-turn work? Markets appear to have been stabilised so far. What is still missing in an Office of Budgetary Responsibility evaluation of the fiscal framework and details about the financing of the government deficit. It is important that both of these issues are resolved quickly. This might involve very difficult spending cuts.

It is extremely unfortunate that precious time has been lost over the last few weeks that could have been used for designing these cuts in the least harmful way possible. It is also extremely unfortunate that this episode has seriously undermined the credibility of the UK’s monetary-fiscal framework. Confidence must be restored as fast as possible. It is equally important to rethink the energy price cap and replace it with targeted policies and better incentives in terms of energy efficiency.

Steve Schifferes, Honorary Research Fellow, City Political Economy Research Centre, City, University of London; Andrew Burlinson, Lecturer in Energy Economics, University of East Anglia; Brian Scott-Quinn, Emeritus Professor of Finance, ICMA Centre, University of Reading; Catherine Waddams, Emeritus Professor of Economic Regulation, Norwich Business School, University of East Anglia; Morten O. Ravn, Professor of Economics at University College London, UCL, and Steven McCabe, Associate Professor, Institute for Design, Economic Acceleration & Sustainability (IDEAS), Birmingham City University