The financial markets are nervous. Investors are demanding a higher yield for holding UK government bonds (‘gilts’) and the pound has continued to slide against the US dollar. It is still too soon to talk of a ‘sterling crisis’. Nonetheless, the heightened political uncertainty and large current account deficit could make UK assets particularly vulnerable to any loss of confidence.
Fortunately, the risks here are smaller than many seem to think. It is important first to put the recent market jitters in perspective.
Over the last month the yields on 10-year gilts have jumped by about one percentage point. But the yields on German bonds have also risen sharply, by around three-quarters of a point. This difference is small and can largely be explained by the fact that investors are even more worried about the prospects for the German economy. UK yields also remain lower than those in the US, and real interest rates (after allowing for inflation) are still negative.
Crucially, these moves are being driven by changing expectations for inflation and for official interest rates. There is no sign that the sell-off in the gilt market is a reflection of serious concerns about the credibility of policy-making, or the creditworthiness of the UK government.
The fall in the pound should be put in its proper context too. This is still primarily a story of dollar strength, due to the US economy’s lower exposure to the energy crisis and the more aggressive increases in US interest rates.
Consistent with this, the US currency has also risen sharply against the Swedish krona and the Norwegian krone, and is at multi-decade highs against both the euro and the Japanese yen.
The pound has still under-performed against some of its peers. On a trade-weighted basis, sterling fell about three percent in August and is down about six percent in the year to date. But these are still small moves in the bigger scheme of things, and could quickly be reversed.
What’s more, this under-performance is par for the course during temporary periods of uncertainty. Rishi Sunak has been seen as the continuity candidate, at least in economic policy terms. Liz Truss has promised to do things differently and shake things up. In the meantime, the seemingly interminable campaign for the Conservative leadership has left the UK government in policy limbo.
The upshot is that simply getting this process over should ease the markets’ nerves. After all, it is not as if a Truss win would now be a surprise. It makes little sense to speculate about an imminent repeat of ‘Black Wednesday’, when a clearly-overvalued pound was booted out of the ERM in 1992, or the slump in sterling following the shock vote for Brexit in 2016.
Of course, there will still be work to be done to reassure the markets. Top of the worry list for many investors is the perceived threat to the independence of the Bank of England. There is near-universal agreement that decisions on interest rates are best made by central bankers, not politicians.
Liz Truss has surely now put these worries to rest. She has consistently committed to respecting the Bank’s independence on monetary policy and repeated this in interviews at the weekend.
She has made no secret of her dissatisfaction with how the Bank has done what is supposed to be its primary job of controlling inflation. But this dissatisfaction is shared by many in the markets and indeed by the general public.
It would therefore makes sense for the new Prime Minister, or her Chancellor, to announce an early review of the Bank’s recent performance, its mandate, and its accountability. But it is hard to see why this should worry the markets, given that something has clearly gone badly wrong.
It also makes sense to keep the existing 2% inflation target, for now. It would take time to come up with a better alternative, and keeping the current target would underline the message that the Bank’s independence is not under threat.
In the meantime, extracting a stronger commitment from the Bank to get inflation back to target next year could actually enhance credibility. An early and constructive meeting between the new Chancellor and the Bank Governor would surely help.
Investors are also worried about the direction of fiscal policy and especially the risk of large ‘unfunded’ tax cuts. The more hostile newspapers have been full of scare stories about a £60 billion ‘black hole’ in the public finances, or tax and spending commitments topping £100 billion.
This is flimsy stuff. The £60 billion ‘black hole’ is based on partial analysis which takes the outlook for economic growth as given (ignoring any boost from tax cuts, or supply-side reforms), and which looks only at the nominal amounts of borrowing and interest payments (ignoring the fact that higher inflation will reduce the real burden of debt).
As for the figure of £100 billion, that seems to be based on topping up the costs of every policy measure that has been floated, including a big cut in the standard rate of VAT, rather than those that are actually likely to happen.
There is plenty of room for positive surprises, too. A bold plan to ease the energy crisis, with strong intervention on the supply side as well as immediate support for the most vulnerable households and businesses, would quickly establish the credibility of the new team. A stronger economy should then ease fears about the long-term health of the public finances, and support sterling.
In short, it is always important to maintain market confidence. The priorities should be to reaffirm the Bank’s independence on monetary policy and provide early guidance on the new fiscal framework, including the scale of additional borrowing and new fiscal rules. But those hoping for a market crash are likely to be disappointed.
This piece was first published in the Daily Telegraph on 5th September 2022
Plain-speaking Economics 
Julian, I note that you mention the “creditworthiness of the UK government” in relation to its GBP denominated liabilities – Gilts. Do you believe that it is any way possible that the UK govt could ever be forced into a default on its liabilities denominated in its own currency (it has negligible foreign currency debt more than matched by its foreign currency reserves)?
The UK govt can always make any payment it is obliged to make, or chooses to make, in its own currency. Why is the creditworthiness of Gilts still a discussion point amongst serious commentators?
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