Prime Minister Liz Truss promised growth and tax cuts, but the risks of recession are growing for the UK after her economic package backfired and left the Treasury forced to raise taxes and weigh deep spending cuts.
The measures set out by Chancellor of the Exchequer Jeremy Hunt on Monday will pare £32 billion from the £45 billion of giveaways Truss's government announced last month in a mini-budget that triggered a sharp sell-off in UK assets. That will cause pain for households and businesses struggling with soaring energy costs but also limit upward pressure on interest rates.
U-turn
The decision marks a massive U-Turn, with Hunt ripping up Truss's "Growth Plan" in a desperate attempt to avert an economic calamity and salvage her premiership. He replaced Kwasi Kwarteng, who the prime minister sacked on Friday when it became clear that investors wouldn't stomach the mini-budget.
Sterling dropped to a record low in the past few weeks, and government bond yields soared on fears that Kwarteng's debt-funded giveaways would send the national debt spiraling higher. That threatened to plunge the UK into "a severe downturn driven by a continued loss of market confidence," said Martin Beck, chief economic adviser to the EY Item Club.
While Hunt's emergency response may avoid the worst-case scenario, the economy will "still decline over the next few quarters," Beck added. Dan Hanson, senior UK economist at Bloomberg Economics, said "the risks to our forecast for a 0.4% drop in GDP in 2023 have shifted to the downside."
Britain will be living with the mistakes of Truss and Kwarteng's economic experiment for some time. The cost of the government's lost credibility will take time to recover - "it is something that is quicker to lose than to gain," said David Page, head of macro research at AXA Investment Managers.
Dario Perkins, director of macro global at TS Lombard, had labeled the "moron risk premium," a measure of the additional cost of credit caused by the loss of faith in markets. Jamie Rush, chief European economist at Bloomberg Economics, estimates interest-rate penalty that emerged since early September at a bit more than Pound10 billion a year by 2025.
In an attempt to restore lost credibility, Hunt said he will take advice from a new team of independent economists stuffed full of market experts including Rupert Harrison, who advised then-chancellor George Osborne during in the last decade when the Conservative government presided over a period of austerity.
Hunt also warned that spending cuts will be needed in the weeks ahead, signaling that a budget statement due Oct. 31 will outline some of the more painful reductions. Unions said it amounted to a return to "Tory austerity."
"There will be more difficult decisions, I'm afraid, on both tax and spending as we deliver our commitment to get debt falling as a share of the economy over the medium term," Hunt said in a statement broadcast Monday morning.
His program also moves sharply away from the stimulus that clashed with the Bank of England's fight against inflation. Instead, the Treasury is now aiming to shore up investor confidence and put the public finances on a more stable footing - pushing down the agenda ambitions to jolt Britain's slumbering economy back to life.
"The new chancellor is looking to priorities market stability over growth," said Tim Sarson, head of tax policy at KPMG.
The outlook for the UK economy has been deteriorating for weeks, with inflation near its highest in 40 years sapping confidence and forcing consumers to tighten their belts. Goldman Sachs slashed its forecasts over the weekend, and a survey of economists by Bloomberg anticipates a recession starting this year followed by zero growth until late 2023.
While Hunt's decision restores some investor support and ensures a worse-case scenario will be avoided, the economy will "still decline over the next few quarters," said Martin Beck, chief economist of the consulting firm EY. "A more severe downturn driven by a continued loss of confidence."
Dan Hanson, senior UK economist at Bloomberg Economics, said "the risks to our forecast for a 0.4% drop in GDP in 2023 have shifted to the downside."
Business groups welcomed the attempt to calm markets but warned that the UK is now economically rudderless, with no long-term plan and a tax burden stuck at the highest in 70 years. Unions said Hunt's program is a return to austerity.
"Macroeconomic stability is the precondition to economic growth," said Rain Newton-Smith, chief economist of the CBI employers group.
What Bloomberg Economics Says ...
"The result of the U-turn towards fiscal prudence is that pressure on the Bank of England to hike aggressively at coming meetings has fallen. We now think the central bank will lift rates by 75 basis points in November, rather than opting for a three-digit increment."
-Jamie Rush, Bloomberg Economics.
British Chambers of Commerce director general Shevaun Haviland warned it's "a plan for today, and nothing for tomorrow." She's concerned about the double impact of a surge in energy bills due to hit at about the same time that corporation tax will increase to 25% from 19%.
"This will be a hammer blow for many who were already worried about how they will survive," Haviland said.
Truss had growth as a cornerstone of her program for government when she campaigned to replace Boris Johnson as prime minister this summer. The focus now is squarely on strengthening the public finances, which have been ravaged by slowing growth and surging inflation, which pushed government borrowing well past forecast this year.
Hunt needs to find another Pound13 billion more savings to stabilize the public finances, according to Hanson. That probably means painful cuts for much-needed investments in roads, train service and health in order to protect the workers in front-line government services, the Resolution Foundation says.
"The fact that today's announcements alone are unlikely to be enough is a measure of the scale of the problems we face," said Paul Johnson, director of the influential Institute for Fiscal Studies.
Many households will pay higher electricity and natural gas bills starting in April after Hunt said aid should be more carefully targeted. The government will maintain its freeze on energy bills at Pound2,500 through this winter as it reviews a new mechanism that will protect the public purse from volatility in global gas markets.
That means companies and households will "pick up more of the tab" for energy bills, according to Capital Economics. The uncertainty about how much it will cost may mean "inflation ends up being higher for longer next year and that the recession is deeper as a result."
Pressure is easing on the Bank of England to jerk up interest rates. While Truss's previous budget would have added to inflation, the impact of Hunt's decisions will be much more restraint. Investors are now betting the BOE's key rate will peak at 5.25%, a full percentage point lower than fears in the middle of last month.
Inflation at almost 10% is still five times higher than the BOE's 2% target, but the Treasury's lack of largess is helpful to efforts to rein in prices.
"The implication for the Bank of England is that with a tougher fiscal stance monetary policy action can afford to be less aggressive," George Buckley, an economist at Nomura, wrote in a note to clients.
Falling interest rates in financial markets also offered some respite. Ten-year government borrowing costs have dropped a half percentage point since the peak of the crisis, easing upward pressure on the cost of mortgages. Office for Budget responsibility data suggests that may reduce the Treasury's annual debt interest bill about Pound12 billion.
Even so, the UK will be paying the price for the mistakes from the Truss government for some time. Dario Perkins, director of macro global at TS Lombard, had labeled the additional cost of credit caused by loss of credibility as a "moron risk premium," estimating it has tacked as much as 0.5 of a percentage point onto the cost of government debt.
"Markets are affected by the erosion of the government's fiscal credibility - something that is quicker to lose than to gain," said David Page, head of macro research at AXA Investment Managers.
