I described here the events of recent days, and the Chancellor’s mini-Budget and reactions to it, as “epochal”. I may rather have undersold this.
Without wishing to seem flippant, those of us who genuinely believed Boris Johnson was the worst Prime Minister in our lifetimes may shortly have to revise that view. That is a pretty extraordinary turn of events.
Markets: contempt for budget
The financial markets have treated Kwasi Kwarteng’s £45 billion of tax cuts, and the proposed £72 billion rise in borrowing this year, with utter contempt. After understandably subdued trading over the weekend, the pound’s value against the dollar fell at one stage on Monday to its lowest level ever – since the Americans declared independence, as several wags put it.
The chances are it will reach parity some time soon – a pound would buy you just one dollar. The pound at its lowest point had already fallen 24% since the start of the year.
The yield on 10-year gilts, the usual benchmark for the value of Government debt, hit 3.8%. It was 1% a year ago and has been thereabouts for some years. That 3.8% figure, which reflects a sharp fall in the perceived value of that Government debt, was last seen during the financial crisis of more than a decade ago.
I’ll explain why that is important later. This is a useful guide, making it clear other currencies have also suffered from the strength of the dollar, which is another factor in all this.
Big rise in interest rates forecast
The markets are forecasting that base rates, which earlier this month went up to 2.25%, will be at or around 6% in a year’s time. Those three figures, the gilt yield, the value of the pound and interest rates, along with a fourth, the rate of inflation, are inextricably interlinked. When one moves, the direction of the others can often be assumed.
As we know, inflation has taken off and is probably running at about 10%. Some expect it to go higher.
One of the most interesting comments of the past few days came from Ed Conway, the well-connected Economics Editor at Sky.
He tweeted that he had spoken to an unnamed financial adviser to the Government, who said he had “outlined clearly to them in recent weeks how febrile the markets were and how it was critical for them (the Cabinet) to address market concerns. They didn’t.”
This Government is one of the most free market-oriented for decades. They believe in low taxes, low regulation and for markets to be allowed to do pretty well what they choose. Yet when the markets make a firm judgement on their policies, they are ignored.
Kwarteng to double down with more tax cuts
Kwarteng over the weekend seemed to dismiss those market jitters while saying there would be more tax cuts to come – thereby throwing petrol on the fire and setting the scene for Monday morning’s sterling collapse.
Indeed, as I write this, one City broker has just described the Conservative Party as a “Doomsday cult”. Which is very much not the sort of thing City brokers usually say.
Let’s look at those three numbers. Base rates of 6% would be painful, but given that they peaked at 17% in the 1980s, that doesn’t sound too bad does it? But back to Conway, who explains why this is wrong.
Broadly, people then were much less indebted because their incomes were higher relative to the repayments they had to make. You have to look at the affordability of higher rates.
Conway points out that if rates hit 6% – his Tweet has been overtaken by events, because he says that figure is “not currently forecast but these days who knows?!” – then the mortgage burden would be very similar to the early 1990s, which brought about “the worst housing crash in modern history”.
The collapse in the value of the pound will make imported goods more expensive and therefore fuel inflation. As a double whammy, energy prices, which are beginning to edge lower, are denominated in dollars, so sterling’s woes should force them up again.
People’s mortgages go up, the price of goods in the shops goes up, energy costs do not reduce as fast as some had expected. Pretty bad so far?
Then let’s look at that gilt yield. To be technical for a moment, gilts, Government issuance of debt, are priced according to the income they generate. This is an easy primer.
If the face value of that debt falls because the market thinks it is less valuable or, in an extreme case, will not be repaid at all, the yield, that income, rises. The yield has shot up because Kwarteng has indicated his tax cuts are to be funded by that huge increase of Government borrowing. More Government borrowing put out onto the markets means the value of the existing debt falls – simply the law of supply and demand – and the yield rises.
Unfortunately, any further debt would have to reflect those higher yields because clearly buyers will not accept a lower rate than that already available elsewhere on the market. So funding that extra debt will be significantly more expensive than it otherwise would have been, because of the markets’ reaction to the Chancellor’s package. Public borrowing will be even higher therefore.
One option is for the Bank of England, which is in charge of gilts and putting them out on to the market, to suspend further issuance until things calm down. But this would put the Bank on a collision course with the Government, one that has in the recent past threatened its independence, though Kwarteng has since rowed back on this.
(Note in the piece Kwarteng’s reference to a “radical” plan for growth. This was made a few days before his mini-Budget. We know how that went.)
Bank of England’s independence may be at risk
That independence granted by Tony Blair and Gordon Brown was one of the first achievements of their administration. The aim was to allow the Bank to set interest rates according to what the prevailing economic environment requires rather than allowing them to be used as a political football.
A Government with control over base rates might be tempted to cut them ahead of an election to trigger an unsustainable economic boom that might help them retain power.
The Bank has not always got things right – it was too slow to see and head off rising inflation by putting up rates, some believe. I have suggested here before, though, how its remit to control inflation is at odds with any Government plan to inflate the economy, by whatever means.
Forcing the Bank to issue large amounts of debt at a high cost, in order to fund an ideologically motivated tax-cutting programme mainly benefiting the rich, would seem to breach that independence. Whatever else the consequences might be.