To borrow from Ernest Hemingway, a government loses credibility gradually, then suddenly. The UK has proved a textbook example. Since Kwasi Kwarteng’s reckless mini-Budget last Friday, the pound touched an all-time low against the dollar, gilt yields surged, banks scrambled to pull mortgage products, and the IMF issued a scathing rebuke of the Chancellor’s plans. Then on Wednesday the Bank of England stepped in to prop up the gilt market as pension funds faced urgent demands for cash. It is still only midweek. The government must act quickly and decisively to restore confidence before the list of casualties grows further.
Investors have been damning of the Truss government’s economic strategy. Soaring gilt yields and a feeble currency partly reflect the lack of faith in the chancellor’s plan to fund historic tax cuts and energy subsidies through debt, backed only by a promise of improved growth. His proposals would stoke inflation — already close to 40-year highs — and necessitate higher interest rates, when the debt burden is already at a risky level. Had Kwarteng stuck to already well-flagged plans to reverse rises in corporation tax and national insurance, even on top of the planned £150bn energy support programme, investors might have acquiesced. But with additional unexpected tax cuts, and no offsets, markets were spooked by the insouciant nature and open-ended scale of the chancellor’s unfunded commitments.
The BoE is having to pick up the pieces. It has launched the kind of emergency intervention last seen early in the pandemic, and started temporary purchases of long-dated gilts. This was vital after market turmoil heaped pressure on pension funds, which manage savings for millions, to sell bonds to stave off concerns about solvency. The BoE also delayed plans to start selling gilts from next week, which would have reinforced downward pressure on bond prices. Longer-term gilt yields fell following the announcement.
The intervention may have created some breathing space, but the BoE is in an unenviable position. Raising rates higher than previously expected will entail eye-watering increases in mortgage payments for those on variable products or coming off existing fixed-rate deals. This will happen just as households face energy bills almost double those last winter, despite the government’s subsidy. The hit to affordability will drive a significant fall in house prices. Highly indebted businesses will also be under pressure.
This is a financial crisis of the UK government’s own making. It needs to rethink its ill-conceived growth plan, and reverse a significant portion of its tax cuts. This will carry a big political cost — but not doing so might now be even more costly.
The government should also quickly provide convincing detail on how it will stabilise public finances — in a way that does not rely entirely on achieving its highly optimistic 2.5 per cent growth target — and bring forward its medium-term fiscal plan from November 23. The BoE will meanwhile need to remain alive to interventions, including on rate hikes, ahead of its November meeting. The government must show, above all, that it is listening to financial markets.
The ructions since Friday’s cavalier mini-Budget have shown that governments cannot flout due process, independent oversight and economic expertise. By severely undermining the UK’s economic and financial integrity, the new Conservative administration is gambling with British people’s money, pensions, and homes. The BoE can only prop up markets for now, but regaining UK credibility will be the task of the government. It must do so with haste.