There have been two notable responses to the rise in yields on UK gilts – government debt – in recent days. The first is to point out that the interest rates businesses and mortgage holders pay will rise even further. This will be painful. As Nicholas Macpherson, the former Treasury permanent secretary, has argued, it is likely that the Bank of England will raise rates to a level where a recession next year becomes inevitable.
This, of course, has significant political implications. The Conservatives’ path to re-election is very dependent on reducing inflation as quickly as possible and ensuring living standards are rising by October 2024. As I argued in March, the fact the UK economy has outperformed the dismal predictions of late 2022 might initially seem like good news for Rishi Sunak but if it turns out that higher growth is accompanied by persistent inflation, he has a problem. The economic and political cycles now increasingly look misaligned from the government’s perspective.
The second response is the argument that, with two-year gilt yields reaching levels higher than in the aftermath of the mini-Budget, Sunak is no better than Liz Truss in maintaining the confidence of the markets. This argument comes from two directions. Labour wants to damage Sunak’s reputation for being a reassuring influence on the markets; Truss apologists want to argue that the market turmoil of last autumn was not really her fault, that high gilt yields happen and that there was nothing particularly catastrophic about her time in office.
Neither position is valid.
It is necessary to draw a distinction between the causes of the rise in gilt yields. The current increases reflect inflation expectations and anticipated interest rate rises by the Bank of England. The markets look at a tight labour market (unemployment is currently falling, nominal wages are rising), assume that inflation is going to remain strong and anticipate that the Bank of England base rate will peak at a higher level than previously expected (5.75 per cent, not 5 per cent). It is all about inflation expectations.
The market behaviour of last autumn reflected not immediate concerns over inflation but anxiety over the longer-term sustainability of the public finances. This was caused by a fiscally reckless mini-Budget and a destructive approach to our independent financial institutions. That is why the big increases in yields were for longer-term borrowing. Truss and Kwasi Kwarteng spooked the markets, which then caused further turmoil by triggering leverage problems for pension funds, making a bad situation worse.
What has happened with gilt yields is not evidence that the Prime Minister has lost the confidence of the markets. Nor is it evidence that Truss didn’t lose the confidence of the markets. It is revealing that the pound is currently strengthening when last autumn it was collapsing. Truss was directly culpable; Sunak is not (even if hard-pressed mortgage holders may not draw the distinction).
There is a criticism, however, that can legitimately be made of Sunak, even if Labour will not rush to make it. The markets appear to believe that the UK is almost uniquely vulnerable to higher inflation. The extent of our problems – the vulnerability of our supply chains and the tightness of our labour market – is greater than elsewhere. There are many factors driving inflation but Brexit, which Sunak supported, is one of them.
[See also: PMQs today: Rishi Sunak comes out fighting]