No one likes to feel like they’ve been taken for a fool, least of all financial markets – which explains why the government’s decision to make £43bn of unfunded tax cuts has caused the pound to drop to historically low exchange rates, pushed up government bond yields and almost led to a collapse of several pension funds. The markets are confused, and they don’t like it: after the Bank of England had spent months preparing them for interest rate rises and bond sell-offs as it tries to bring down inflation, the government blundered in with a raft of measures that are, essentially, inflationary.
The International Monetary Fund (IMF) made its displeasure known almost immediately: shortly after the mini-Budget, it took the highly unusual step of issuing a stern rebuke to Liz Truss and Kwasi Kwarteng, urging them to rethink the tax cuts. The organisation yesterday reiterated that criticism, confirming just how bad the fallout from those cuts are likely to be in its global economic outlook. The IMF report forecast that by the end of next year, UK inflation will be hovering around 6.3 per cent, the highest in the G7, while growth will drop to 0.3 per cent, down 0.2 percentage points from its previous outlook in July – a “significant slowdown”, it said.
For Kwarteng in particular, this represents a challenge – the IMF is a highly respected organisation, and one that markets look to for guidance on the UK’s economic stability. After the Conservatives’ 1972 “spend for growth” budget led to a currency crisis, it was the IMF that bailed Britain out. Kwarteng needs its backing.
It doesn’t look as if this will be easy: during a press conference to launch the report, the IMF’s economic counsellor, Pierre-Olivier Gourinchas, repeated the point that the mini-Budget was “complicating the fight” against inflation. “If you think about central banks trying to tighten monetary policy, and if you have, at the same time, fiscal authorities that try to stimulate aggregate demand,” he said, “it’s like having a car with two people in the front and each of them has a steering wheel and is trying to steer the car in a different direction. That’s not going to work very well.”
Later in the day, Tobias Adrian, the IMF’s financial counsellor and director of monetary and capital markets, went further, saying that the government’s measures will force the Bank of England to raise interest rates even further than planned. “The expansionary fiscal policy basically triggered a shift in expectations as to what monetary policy is going to do,” he said. “With the expansionary fiscal policy, the Bank of England would have to raise interest rates that much more in order to contain inflation, and to get inflation back to the mandated objective.” This is an assumption that has already been priced in by financial markets: at one point after the mini-Budget, interest rate expectations topped 6 per cent.
The Bank of England was forced to step in yet again as yields on long-dated gilts continued to creep higher, while the markets continued to worry about the fallout from the mini-Budget – including liquidity in the pension market. Kwarteng and Truss’s fatal miscalculation was that they could make their changes without consulting experts such as the Office for Budget Responsibility or the IMF, and without the blessing of the central bank. Now the Chancellor’s biggest challenge is to regain the faith of those experts – and find a way to show the markets that he and the Bank of England have made peace.