Sunday, October 23, 2022
Markets are calmer, but economic prospects are darker
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission

The past few weeks have taught us a couple of things, apart from the fact that prime ministers and chancellors do not last very long these days. Fortunately, Jeremy Hunt appears determined to outlast his immediate predecessor at the Treasury and hopes to present the medium-term fiscal plan on October 31. Given the revolving door we have seen, it would obviously be better if he were to remain in post under the new prime minister. A Sunak=Hunt partnership would be well received, but other permutations would be more problematical.

The first lesson of recent weeks is that the traditional complaint of politicians, that nothing they do seems to make a difference, has been comprehensively disproved. The former chancellor Kwasi Kwarteng’s maxi mini budget on September 23 clearly made a difference, and not in a good way, as I do not need to remind you.

Hunt’s scrapping of most of those measures and, importantly, the abandonment of the two-year energy price freeze, has also changed things quite dramatically, calming the markets in spite of political chaos and offering at least a partial fix to the damaged public finances, but with potentially very significant economic implications, of which more in a moment.

Notwithstanding Hunt’s calming measures, the second thing we have discovered is that once you have created a fiscal crisis, it is quite hard to get out of it. Until the government imploded under the now outgoing prime minister, there was no sense that the UK was in a fiscal crisis. Rishi Sunak’s spring statement in March even included a penny off the basic rate of income tax, though not until 2024, which was embodied in the projections for the public finances. That cut has now of course been abandoned indefinitely.

There was pressure on the public spending plans agreed last year because of higher inflation, and most, perhaps all, the fiscal “headroom” left by the former chancellor but two, had been eaten up by events, including the negative impact on growth of the cost-of-living crisis. But the situation was manageable and, as during the pandemic, temporary fiscal support in response to high energy prices was priced in.
Now, despite the many U-turns undertaken by Liz Truss before her resignation, and by Hunt, the fiscal crisis has not gone away. The September 23 budget acted as a wrecking ball, out of which fiscal policy will have to be tighter – with spending cuts and that planned cut in the basic rate of income tax shelved indefinitely – than if it had never taken place. Not only that but some, not all, of the rise in gilt yields, the cost of government borrowing, persists.

This is what makes the economic outlook more difficult than it was. The U-turns have brought down gilt yields from their recent highs, despite the continuing political turmoil and, now that fiscal and monetary policy are pushing in a broadly similar direction – I characterized the Kwarteng approach as push me/pull you economics - should help lower the likely peak in official interest rates. At one time markets saw a peak in Bank Rate of 6 per cent or more, though expectations have eased.

I always thought that a peak of 4 per cent was more likely, and still do so. But this is still nearly double the current rate of 2.25 per cent and more than five times the maximum rate we saw between March 2009 and the end of last year. The chancellor has helped to hose down overexcited money markets, but rates are still going up for households, most notably mortgage rates, and for firms.

Of all the U-turns, though, the most important was on energy prices. When a two-year freeze in household energy prices was announced by Truss on September 8, sadly the day of the Queen’s death, it was a game-changer. It was probably an example of overreach by the state and, as the Treasury now says, having not been allowed to say so then, exposed the public finances to the risks from high and volatile international energy prices.

It was a game-changer because, as Truss often said, it would reduce measured inflation quickly, a probable peak of 13, 15 or 18 per cent over the winter having been brought down to something closer to the latest 10.1 per cent rate.
Looking further ahead, the freeze, which would restrict average household energy bills to £2,500 a year, would guarantee a sharp fall in inflation next year. In the 12 months to September, household gas and electricity bills rose by 70.1 per cent compared with a year earlier and were the biggest contributor to the household goods and services component of the consumer prices index, which contributed about 2.8 per centage points of the 10.1 per cent inflation rate.

Under the freeze, that 70 per cent rise in household energy bills over the past 12 months would have been replaced by something closer to zero over by October next year, pushing inflation down sharply.

Now, while there will be targeted help for those on lower incomes, most households will face significantly higher prices. Cornwall Insight, the specialist consultancy, admittedly offering predictions ahead of the reference period for the new cap, offers ballpark figures of £4,348 for annual bills from April, 74 per cent above the £2,500 level, reducing to £3,697 in July and then heading up slightly to £3,722 in October. If prices were to follow that pattern, October 2023 bills would be on average 49 per cent higher than now.

The dampening effect of the freeze on measured inflation (unlike other energy support it impacted directly on the consumer prices index) would be gone. So, importantly would the key policy initiative easing the squeeze.

It will be interesting to see what the Office for Budget Responsibility (OBR) says on October 31 but we may well be back to the biggest fall in household real incomes since records began in the mid-1950s. In 2023-24, households face higher energy prices, higher taxes and higher mortgage rates. Taxes will go up even if the chancellor does nothing more on October 31 because of the freeze on income tax allowances and thresholds, which will no longer be partly offset by a small cut in the basic rate of income tax. Working-age benefits remain under threat, despite the commitment to honour the triple lock on state pensions.

Can we get through it without a meaningful recession? The energy price freeze, while expensive and poorly targeted, had headed off the most important danger, and many economists thought that in consequence we would have a mild “technical” recession, at worst. I agreed. But the outlook has now become more uncertain.

James Smith, an economist with ING, the bank, describes the change on energy prices as the most “consequential” of the U-turns and is revisiting his base case of a mild recession over the winter. Paul Dales of the consultancy Capital Economics predicts a 2 per cent decline in GDP but warns that “the shift in fiscal policy is generating an extra downside risk”.

The chancellor, in trying to deal with one set of uncertainties, has created another.