The UK does a fiscal U-Turn and I expect a monetary one too

Last week was en extraordinary one for the UK which ended with the new Chancellor of the Exchequer Kwasi Kwarteng being sent to spend more time with the family he hasn’t got. So we got a new one Jeremy Hunt who probably could not believe his luck. The appointment came with something of an early fiscal U-Turn.

And by any measure, Prime Minister Liz Truss’ decision to scrap the cancellation of her former leadership rival Rishi Sunak’s rise on corporation tax is one of the biggest fiscal U-turns on record.

Over five years, it is worth £67bn, the biggest single revenue measure of the mini-budget. ( BBC )

So we have already seen quite a change and over the weekend it was a case of “More! More! More!” as Andrea True Connection would say.

Instead Hunt, installed as chancellor last Friday, is expected to issue a statement on new tax and spending measures at 11am before making a Commons statement this afternoon. ( Financial Times)

We can also review things via some media number-crunching as the £67 billion of the BBC above becomes this in the Financial Times or FT.

Truss has already reversed £20bn of tax cuts since the disastrous “mini” Budget on September 23,

I prefer the FT version as these moves are for now and no-one has any idea of the situation next month let alone in a year or two. Actually there does not seem to be much detail on what is expected today.

A cut in income tax of one percentage point next April, costing about £5bn, is expected to be put on hold, but that is only expected to represent the start of another series of U-turns. (FT)

Which are?

A £13bn cut in national insurance rates, contained in the mini-Budget and supported by Labour, is expected to survive, but Hunt has said that all other measures in the ill-fated “mini” Budget were on the table. ( FT)

So they are not sure so we are left with the rhetoric of the Institute for Fiscal Studies for the FT to cling to.

The Institute for Fiscal Studies has said a £60bn fiscal tightening will be required to make the sums add up, implying that Hunt will have to go much further in reversing tax cuts, raising taxes and cutting spending.

To be fair to the IFS they did point out that one needs to take great care with these sorts of forecasts.

There is huge uncertainty around the exact magnitude, but under a central forecast in 2026–27 we expect borrowing of £103 billion, which would be £71 billion higher than forecast in March. Much of this increase is uncertain

I have less faith in them here because with inflation so strong combined with the uncertain economic position right now combined with the fact that UK bond yields have been very volatile means this may well be next week’s if not tomorrow’s chip paper.

We forecast that spending on debt interest will be £103 billion in 2023–24, double the £51 billion forecast by the OBR in March and which was already an upwards revision on the £39 billion the OBR forecast in October 2021.

Thus this becomes embarrassing in terms of meaning anything.

 But even in 2026–27 we forecast that debt interest spending will be £66 billion, some £18 billion higher than forecast by the OBR in March, £26 billion more than forecast in October 2021 and £9 billion more than was spent in 2021–22, as a result of higher interest rates and a higher level of accumulated debt.

We do eventually get to the £60 billion or so.

Under Citi’s central forecast, it would require a fiscal tightening of £62 billion in 2026–27 to stabilise debt as a fraction of national income – so even reversing all of the permanent tax cuts in Mr Kwarteng’s ‘mini-Budget’ would not be enough

But then a simple sentence provides where I have been heading. A small change in economic growth makes an enormous difference.

Higher growth would help – but even if growth turned out to be 0.25 percentage points a year stronger than Citi expects, a fiscal tightening of £41 billion would be required to stabilise debt.

There is a real irony there because we see that a relatively small amount of economic growth would would wipe out the “black hole”. Of course the original mini-Budget was supposed to achieve that although we have little idea if it would have worked. Also to add another layer to the issue which is that we have struggled for some time to get much economic growth at all. So we end up with a multi-layed level of uncertainty replacing the “£62 billion”.

The Bank of England

The Governor Andrew Bailey has avoided some of the London storm by staying in Washington. Although of course he created his own storm last Tuesday night. He spoke over the weekend and let us start with inflation.

In early August, we estimated that the direct effects of higher energy prices – that’s not including indirect effects – would contribute around 6½ percentage points to inflation towards the end of this year. Our assessment was that inflation would peak at around 13%, and then come down sharply – other things equal – to the 2% target in two years’ time, before falling further to 0.8% in three years.

As you can see he is shuffling away the blame for half of the rise in inflation. Unfortunately for him we can look up what he told us in August 2021.

We expect inflation to fall back, reaching our target in around two years’ time.

How is that going? More specifically he thought it would peak at 4%. Now some of the energy price rise is due to the Ukraine war but he is ignoring the fact that energy price rises were already happening. So let us reduce his “swerve” from 6 1/2% to 4% meaning he has had a disaster.

The main thrust of his speech was to be found here.

We will not hesitate to raise interest rates to meet the inflation target. And, as things stand today, my best guess is that inflationary pressures will require a stronger response than we perhaps thought in August.

This has been widely reported with one missing bit.We have heard all this before from him. If we look back to September last year he ramped up the prospects for an interest-rate rise in a speech with “Hard Yards” in the title but then did not act in November and made the smallest rise ever in December ( 0.15%). Meanwhile the inflation fires were burning.

Comment

There is a lot of ground we have covered to today. But let me return to fiscal policy and the point that it is in the end economic growth which drives the figures. Next up is the fact that many who were promoting fiscal policy now seemed to have swerved to a form of austerity with no explanation of why?! The reality is that they are shuffling away from the fact that the policies they were cheerleading for threw petrol on inflationary fires.

If we return to the Bank of England there is another apparent irony in that in my view the same interest-rate increase they failed to provide last time (0.75%) is back on the menu. Also they have a fortnight to scrap their plans for £80 billion of bond sales. On the more positive front the £19.3 billion of bond purchases do seem to have helped calm things although the road to fewer bond holdings has in fact increased them.

Oh and as someone who is careful with numbers it is hard not not shake my head at all the reports on social media that the Bank of England spent £65 billion and even worse that it has lost it.

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The Bank of England stumbles again, this time in the bond market

Today it is the turn of the UK to take centre stage and we can open by in an accident of chance start by looking at things via the Bank of England. I have been pointing out for several weeks that this time around its job was simple, to defend the UK Pound. But iy would appear that even such a simple message is too much for it to comprehend.

At its meeting ending on 21 September 2022, the MPC voted to increase Bank Rate by 0.5 percentage points, to 2.25%. Five members voted to raise Bank Rate by 0.5 percentage points, three members preferred to increase Bank Rate by 0.75 percentage points, to 2.5%, and one member preferred to increase Bank Rate by 0.25 percentage points, to 2%.

Whilst ordinarily I would welcome a little divergence this was not the time for it as we see that only a third of the members got the currency memo and voted for 0.75% to match the US Federal Reserve. Actually one of them may not have done.

BOE Monetary Policy Committee Haskel: I Do Not Worry That Much About Sterling ( @PriapusIQ)

That is really rather troubling when it is part of its job and the US Dollar is rebounding around the world like a wrecking ball. Looking at the other side of the coin it is hard to know where to start with this from the newest member Swati Dhingra

One member preferred a 0.25 percentage point increase in Bank Rate to 2% at this meeting.

She appears to have missed both the currency crisis and the surge in inflation which do not seem to have reached her Ivory Tower. Someone replied to me on social media that she was “world class” which I think merits an entry in my financial lexicon for these times.

Bond Sales

I have warned for many years that the Bank of England plans for what has become called Quantitative Tightening or if you prefer reverse-QE were rather stupid. This is because under it you would find that the largest holder of UK bonds would be selling into a falling market. What could go wrong?

Even worse we all know that the UK will announce a lot more borrowing today of the order of £150 billion. So now was even less likely to be a good time for the Bank of England to start QT. And yet we got this.

all members of the Committee agreed at this meeting that the Bank of England should reduce the stock of
UK government bond purchases, financed by the issuance of central bank reserves, by an amount of £80 billion over the next twelve months, comprising both maturing gilts
and gilt sales, to a total of £758 billion.

We can look at the situation with a wider context. Yesterday the yield for the US ten-year rose by 0.2% to 3.7% so bond markets generally were in decline and in fact not far off a rout. That is exactly the wrong environment to be selling bonds into. If we now look at the UK we see that the UK ten-year yield has doubled since the 2nd of August when it was 1.75% as opposed to the 3.5% overnight.

We are in fact seeing a serious problem with QE which again is something I have warned about over time as it was never a free lunch.The Bank of England pays Bank Rate on it so is now paying 2.25%. You do not need to take my word for  it because rumours of a change in the rules give it away.From Bloomberg.

UK Prime Minister Liz Truss’s new government has looked at changing the Bank of England’s money-printing program to save the UK taxpayer billions of pounds at a time when the public finances are under increasing strain.
Under the option, interest paid on some deposits held by commercial lenders at the BOE would be scrapped, potentially saving more than £10 billion a year, based on calculations with the benchmark interest rate at 2.5%.

Is this why the Bank of England insiders limited their votes to give us a 2.25% Bank Rate?

Once the BOE’s benchmark interest rate is around 2.25%, the interest paid on reserves will be greater than the income from gilts and, under the QE indemnity with the Treasury, the government will start transferring funds to the BOE.

This is a generic iissue by the way and I note that others have been catching up with my warnings in this area. Let me illustrate from a land down under.

But one result of the change in the Bank’s balance sheet is that the Bank will report a substantial accounting loss in its 2021/22 annual accounts and, as a consequence, negative equity. ( Reserve Bank of Australia)

Okay so how much?

Over the past year, valuation losses on the Bank’s holdings of domestic bonds due to the rise in bond yields were around $40 billion. In addition, because we purchased many of these bonds at a price higher than their face value, the amount of this ‘premium’ will also be recorded as a loss over the life of the bond.[5] Over the past year, this accounts for a further $5 billion valuation loss.

So some 45 billion Aussie Dollars. Actually it will be even more now because in the subsequent couple of days Australian bonds have also seen rising yields of around 0.2%.

The Mini Budget

Everybody knew that the UK was going to be borrowing quite a bit more after today’s Mini Budget. Many of the plans were leaked so we had a pretty good idea although the ending of the 45 pence income tax rate was a bit of a rabbit out of the hat. For our purposes we got some more detail on the extra borrowing.

The Treasury said it would ask the Debt Management Office to raise an additional £72bn in the current financial year, revising the total upwards from £161bn in April to £234bn in September. ( Financial Times)

The extra borrowing combined with the expectation of sales from the Bank of England has put the skids under the UK bond market. Those looking at new mortgages will be concerned to see the UK five-year yield reach 4%. Some of this is an initial panic but the Bank of England has got this all wrong and looks incompetent when as I pointed out earlier the new government was known to be a tax-cutting one.

One point I will make is that those higher mortgage rates ( I use the five-year yield as a leading indicator) will rather undermine this.

We’re cutting Stamp Duty Land Tax which will help more people to move, promote residential investment and boost first-time ownership. ( HM Treasury)

Our political class seem unable to grasp why first-time buyers always need “Help”

Comment

This is a big event in fiscal terms and we have as a theme charted the changes here from perceived austerity being in fashion to now where the UK government looks to be a clear fan of fiscal expansionism. Actually I think the help for energy bills was inevitable and other countries will do the same. The real issue to my mind is the ongoing failure to address a major cause of our problems which is the supply of energy. Our political class chant a mantra about wind power when as I type this it is producing a mere 2 GW this morning.

A lot has been made about there being no forecasts from the Office for Budget Responsibility today. I am much less bothered about that because the first rule of OBR Club is that the OBR is always wrong. Also if it is independent why can it not produce its own forecasts? Also of the 3 members of its Responsibility Committee 2 are alumni of HM Treasury so we are being taken for fools with the “independent” line and we should scrap it and save the money.