The market reaction to Friday’s UK mini-budget threatens to go from bad to worse. After Friday’s savage sell-off of sterling and UK government bonds more drama followed on Monday, with the UK currency getting a pounding in Asian markets, before recovering ground in the belief that Bank of England action was imminent.
In the event the bank said it would respond to events at its next meeting, but not immediately, while the Treasury promised early publication of a medium-term strategy for the public finances. Neither intervention looks likely to convince the markets and sterling was soon on the slide again.
The fallout is dramatic. Since the mini-budget the UK interest rates market has jolted higher, with the cost of 10-year borrowing for the UK government breaching 4 per cent and the markets betting that Bank of England interest rates could go above 6 per cent by next spring from 2.25 per cent now. This would be an extraordinary pace of increase and would be painful news indeed for borrowers.
It would signal an era of loose fiscal policy and tight monetary policy trying to offset it. The Bank of England will fear that lower taxes and a weak sterling will add further fuel to inflation – and will act accordingly.
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The bottom line is that the UK is planning to borrow massively more to bridge the gap between tax and spending, and this has spooked investors. Tax cuts on the scale announced for higher earners also threaten to push up inflation by putting more money in people’s pockets, hence the need for yet more interest rate increases more quickly. A promise to cap energy bills has an unpredictable cost.
By taking a huge gamble on future economic growth the new chancellor, Kwasi Kwarteng, risks undermining the credibility of UK policy. Investors fear that the national debt could now be on an unsustainable path as government borrowing soars, with the outlook further dimmed by a large deficit on the current account of the balance of payments.
A lower sterling value should boost its exports, but Brexit has clearly been having the opposite impact. If markets lose confidence in UK policy, the long-term economic cost will be high. Market dramas can ebb and flow but a turbulent few weeks lie ahead and it remains to be seen if market nerves settle a bit.
The economic links between Ireland and the UK are still significant. For Ireland the fall in sterling against the euro – while a lot less dramatic that its fall against the soaring dollar – will make life harder for exporters to the UK, many of whom are SMEs hit hard by rising energy costs. So will slower UK economic growth and cuts in consumer spending caused by higher interest rates. Cross-Border shopping from the Republic on the other hand will be encouraged as the euro will buy more in Newry and Derry.
The UK experience also shows that the Covid-19 era when governments got a free bet on extra spending as central banks printed money is now well and truly over. This reimposes normal constraints on all governments, including our own. To use the famous phrase of Margaret Thatcher, the former UK prime minister referred to repeatedly by the new administration, “you can’t buck the markets”.
