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19 October 2022

The UK is in the grip of a credibility crisis

Jeremy Hunt may have overthrown the mini-Budget, but markets still demand a plan to avoid further economic turmoil.

By Emma Haslett

The UK’s fiscal credibility is the reason our economy has historically been so stable: it has kept borrowing costs low, the pound strong and ultimately helped to control inflation. If anything goes wrong, markets reasoned, the government and the Bank of England will find a way to fix it. That makes the UK a relatively safe place to invest, build a business and create jobs.

All that came crashing down after the mini-Budget last month. “Credibility translates itself into real economic and financial market metrics pretty quickly,” said Simon French, chief economist at Panmure Gordon. “Lenders need to take a view on what decisions [their borrower] will take because their money is being locked away.” He points to “credibility signals” as an important factor in how lenders decide how much to charge for their money. “If you start to cast doubt on the wisdom of those decisions, you will require higher interest rates in order to absorb the risk that they might do something stupid.”

Even before Kwasi Kwarteng delivered his mini-Budget on 23 September, watchers of those credibility signals had already seen red flags go up. “What took place before was relevant,” said French. “The siloing of the OBR [Office for Budget Responsibility], the briefing against the Bank of England and the sacking of Tom Scholar signalled that the institutional checks and balances were being, if you’re being charitable, diluted; if you’re being less charitable, they were being sidelined.” 

The mini-Budget itself added two extra red flags: first, it indicated that the people with the keys to the UK economy weren’t the types to think through their decisions properly and, by rejecting the OBR’s forecasts, it also indicated they weren’t prepared to take advice from experts where it was needed. Second, it pitted the government against the Bank of England: after the Bank had spent months preparing investors for inflation-controlling measures such as higher interest rates and a bond sell-off, the reaction of the pensions market forced it to step in and start buying bonds – essentially an inflationary move. When parents fight, it makes the children nervous.

Credibility itself is an intangible thing, but the impact of its loss can be measured. French estimates the government is being asked to pay an additional 0.75 percentage points to borrow (this extra risk premium has already been nicknamed the “moron premium” by the economist Dario Perkins). Yael Selfin, chief economist at KPMG UK, said the mini-Budget will add “one and a quarter percentage points” to interest rates over the long term. As a result, “we’re predicting a fall in house prices of between 10 and 15 per cent,” she warned. 

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Meanwhile, Hunt has reduced the length of the energy price guarantee from two years to six months. That means inflation is likely to spike to 11.9 per cent when it ends next April, according to economists at Goldman Sachs, and household energy bills have been predicted to rise 73 per cent in that single month.

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How can the government restore credibility? “We need a plan,” said Selfin. “We had a plan that wasn’t going to work, so the government backtracked, but they haven’t really replaced it. It’s now a bit of a patchwork. They’re just putting a plaster over it and trying to buy some time.”

Selfin suggested that markets are giving the government until the announcement of its medium-term fiscal plan on 31 October to come up with a watertight replacement; after that, its credibility may be lost completely. “[Truss] doesn’t have a lot of time in the sense that people aren’t very patient,” she said. “But the longer we are in this limbo, the more the actual cost in terms of the impact on the economy, in terms of potentially higher cost of capital – more uncertainty, people postponing investment and everything else.”

Even when the government does have a plan, it won’t automatically regain the credibility it has lost. “It requires hundreds of small decisions on a daily, weekly, monthly basis to do it,” she said. “Lots of small actions that suggest you have started to read the room, you’re starting to listen to experts.”

What won’t happen is a “seminal moment” in which government bond yields suddenly drop. “It’s going take months and probably years to convince people that our political class have worked out that people listen, investors listen,” said French. “If they keep hearing incoherent, contradictory thoughts, they will put their money elsewhere. You need to regain that trust.”

Selfin, meanwhile, believes there’s only one way credibility can be fully restored in the UK: “A new Prime Minister.”

[See also: The market revolt against Liz Truss does not prove that austerity was justified]