Sterling falls after new British government announces budget
The newly formed British government laid out its fiscal plans on Friday morning – and the reaction from global financial markets has been astounding.
why does it matter: Essentially, the markets treat the UK the way they do emerging markets, which are seen as not having the same reliable and disciplined economic policy-setting institutions as the wealthiest nations.
- Far from the unique crises now facing Britain, we are in a world upside down compared to the world that prevailed during 2009-2019. Policymakers around the world will want to be aware that deficits may return to importance again, even in rich countries.
News leadership: The government led by Prime Minister Liz Truss has announced a budget that includes wide-ranging tax cuts, along with helping Britons facing high energy bills this winter.
- The package was larger than analysts had expected, amounting to about 1.4% of UK gross domestic product, according to JPMorgan. For comparison, the additional spending next year included in the Biden administration’s signature healthcare and climate package is expected to be closer to 0.14% of US GDP.
- The prospect of a higher deficit sent UK bond prices, with the five-year yield rising by about half a percentage point, to 4.02%. This was the largest single-day move ever, according to Bloomberg.
- This coincided with the pound’s slide in the currency markets to $1.09 as of 11:55 AM ET, its lowest level against the dollar since 1985.
Between the lines: Usually, when leaders of a developed country such as Britain lean toward expansionary fiscal policy, the effect is higher interest rates but also a higher currency, as investors seek to take advantage of higher growth and those higher rates.
- This is, for example, what happened after former President Donald Trump’s surprise victory in the 2016 election. The feeling that the US was going to cut taxes – leading to an even larger deficit – under his leadership led to a 6% rise in the dollar index over the following weeks.
- This pattern we are seeing in Britain – of higher rates and a weaker currency – is what you would expect to see in countries where investors lack confidence in governance institutions to prevent deficits from spiraling out of control and fear the value of their bonds. Swelled away, or worse.
- This will escalate pressure on the BoE to raise interest rates more than planned, as fiscal stimulus and a weaker pound will tend to exacerbate inflation. This, however, makes a recession more likely.
while: The new government’s decisions to fire the chief civil servant from Britain’s Treasury and release this financial plan without the traditional review process from an independent financial agency also contribute to the sense that economic policy-making has skewed in the world’s sixth-largest country. Economie.
what are they saying: Krishna Guha and Peter Williams of Evercore ISI write in a client note that the UK government is “moving forward with extraordinary ambition, even recklessness” in its fiscal policy.
- “[I]R is conducting a high-risk experiment regarding the placement of binding financial market restrictions on an advanced economy with its own central bank, large domestic financial system, and local currency debt.
recovery: Around 2010, there was a lot of discussion about the “bond market vigilantes,” the supposed role that financial markets play in punishing any country that does not show sufficient fiscal rectitude.
- It became a kind of rhetoric, and in hindsight it wasn’t the right lens to apply to a country like the United States at the time that had insufficient production and very low inflation. But now we see what bond-guarding really looks like in Britain.
- It is a reminder that the economic conditions of that era were in fact opposite to those of this era. The problem then was insufficient global demand. Now it is one of the insufficient global supply.
Bottom line: The era when policymakers ate free lunch when contemplating policies to stimulate their economy is over, as the bond and currency markets tell the British government loud and clear.