It may well take some time for the dust to settle on Kwasi Kwarteng’s first Budget (yes, ‘Budget’: if it looks like a duck, walks like a duck and quacks like a duck, then it’s fair to call it a duck).
The initial reaction from most economic commentators and in the financial markets has been a loud boo! There are some things I would have done differently. But the overall strategy is sound and sentiment should recover as the economic benefits become clearer.
There are two aspects I particularly liked. One is the emphasis on breaking the ‘doom loop’ of weak economic growth and rising taxes, both with tax cuts and – at least as importantly – structural reforms on the supply-side.
The second is the willingness to take decisions that are unpopular but still right for the economy, such as scrapping the cap on bankers bonuses and abolishing the additional 45% rate of income tax. Policy should not be based on opinion polls or focus groups.
This is not about ‘trickledown economics’. If trickle down means anything it is about giving rich people more money in the hope they will spend it, boosting demand. Instead, Trussonomics is about improving the supply-side performance of the economy.
It is right to worry about the reaction in the markets, but not to panic. Much of the commentary here is increasingly OTT. In my view, the fall in the pound is less of a concern than the rise in gilt yields (the cost of long-term government borrowing).
The slump in sterling is still primarily about dollar strength. The US currency has been strong across the board, reflecting the relatively aggressive Fed tightening (three ¾ point rate hikes in a row), the lower exposure to Europe’s energy crisis, and safe-haven demand.
On a trade-weighted basis against a basket of currencies, the recent fall in the pound is still large (about 5% since the start of August, which might add 0.5% to inflation – if sustained), but this is not disastrous. The UK does not have an exchange rate target and should not intervene.
The rise in gilt yields is more worrying. Unlike a weaker pound, which at least helps exporters, everyone loses from higher long-term interest rates. There is a risk of an alternative ‘doom loop’ of rising interest costs and more borrowing, offsetting the good done on the supply-side.
My advice would have been to delay the announcement of the cuts in income tax (which is what seems to have most spooked the markets) until a full Budget later in the year. These cuts are the right thing to do, but would not come into effect until April anyway.
This would have allowed Kwasi Kwarteng more opportunity to set tax cuts in the context of a full medium-term plan for the public finances, with a full OBR analysis. (The fiscal documents published yesterday do go into more detail, but few read beyond the speech.)
Nonetheless, the surge in gilt yields is not disastrous, either. Like the fall in the pound, it partly reflects a global rise in interest rates. UK 10-year yields have risen nearly 3%-points in the past 12 months, but French yields are also up 2½%, and the US and Germany 2¼%.
To some extent too this reflects a long-overdue adjustment – and probably an overshot. The markets are now speculating the Bank of England may have to raise official rates (still only 2.25%) to as high as 5%. That would be right at the upper end of what might be the ‘new normal’ (4-5%, based on 2% inflation and the new target of 2.5% for real growth).
But I suspect that UK rates will still peak out between 3-4%, partly because higher levels of debt make the economy more sensitive than usual to higher rates. UK bond yields have now also risen to levels that should attract international buyers, especially with an under-valued currency.
In short, talk of ‘market meltdown’ and a ‘sterling crisis’ is still overdone. It may take more time to win over investors and the general public, but the most important thing is to get the economics right. This is a good start, despite the negative headlines.