UK bonds sold off as chancellor Kwasi Kwarteng unveiled a £45bn tax cut package in today’s mini-budget. Yields on 10-year gilts shot up to 3.7 per cent on the announcement, up from 3.5 per cent before the announcement and 2.6 per cent a month ago. According to Refinitiv data, this marks the sharpest increase in long-term borrowing costs since 1998. The pound fell close to the $1.10 mark against the dollar, a 2 per cent drop on the day. Equity markets were also under pressure, with the FTSE 100 falling 2.2 per cent, though this is in keeping with falls seen elsewhere in Europe.
The fiscal statement represented the biggest round of tax cuts since 1972, and saw the chancellor announce a series of policies designed to turn the UK’s “vicious cycle of stagnation into a virtuous cycle of growth”.
Borrowing will be increased to pay for the cuts, and the government anticipates that it will raise £234bn from gilt issuance in the current financial year, up from a previous figure of £161bn.
The chancellor stressed a “responsible approach to public finances”, and pledged to release a ‘medium term fiscal plan’ in due course. Kwarteng announced that the Office for Budget Responsibility (OBR) would publish a full economic forecast before the end of the year though the watchdog was not asked to provide forecasts for today’s event.
Tax cuts expected to total £45bn over the forecast period come in addition to the Energy Price Guarantee (EPG) announced earlier this month, which is forecast to cost £60bn this year alone. The total cost of the EPG remains uncertain, as it depends on the future path of energy prices. Economists at ING have argued that “given future wholesale gas prices are unknown, this amounts to an open-ended liability for the Treasury”. The Institute for Fiscal Studies (IFS) expects the package to cost “well over £100bn over the next two years”.
The huge stimulus comes as the chancellor faces a difficult public finance backdrop.
A joint report by the IFS and Citi warned earlier this week that reversing NIC and corporation tax increases would “leave debt on an unsustainable path”. The IFS’s Isabel Stockton argued that borrowing at this level would see debt continue to rise as a share of national income.
Economists caution that the fiscal sustainability of the new measures hinges on the relationship between nominal GDP growth and nominal interest rates on government debt. If the rate of nominal GDP growth exceeds nominal interest rates on government debt, then debt will rise at a slower rate than GDP, and over time, the debt to GDP ratio will shrink.
Kwarteng has pledged his belief in achieving growth through tax cuts, arguing yesterday that “taxing our way to prosperity has never worked. To raise living standards for all, we need to be unapologetic about growing our economy.”
But economists have expressed their doubts. Pantheon Macroeconomics' chief UK economist, Samuel Tombs argued that “tax cuts for the wealthiest won’t boost growth much”. Capital Economics’s senior UK economist, Ruth Gregory, argued that the government's plans were likely to put the debt to GDP ratio on a decisive upward path over the next few years, increasing “financial market nerves over the sustainability of public debt”.
Gilt market jitters have been intensified by the Bank of England’s decision to press ahead a programme of active quantitative tightening earlier this week. ING economists estimate that the new fiscal measures and QT will require private investors to increase their exposure to gilts by a record amount: £120bn this year and £210bn in 2023.
Capital Economics’s Chief UK economist Paul Dales added that “anyone expecting the MPC to change course and help finance the government’s fiscal plans will have been disappointed to see that the MPC still thinks there is a “high bar” for amending its plans to reduce its holdings of gilts”.
There are also concerns that the government’s huge fiscal stimulus will stoke domestic inflationary pressures, increasing the future path of interest rates. The BoE updated its forward guidance following the MPC meeting yesterday, stating that “should the outlook suggest more persistent inflationary pressures, including from stronger demand, the Committee will respond forcefully, as necessary.”
Dales argued that the "new 'stronger demand' clause feels like a not-so-subtle reference to the big loosening in fiscal policy. In other words, the BoE is suggesting that higher interest rates will be needed to offset the boost to inflation from a rise in public borrowing”.
Markets are currently pricing in a base rate rise of close to 5 per cent, though there is no consensus that rates will reach this peak. Pantheon Macroeconomics’s Tombs argued that “the economic outlook has not been transformed by these tax cuts, and the MPC needn’t raise bank rate to the near-5 per cent level currently priced-in”.
Economists also expect a further dip in sterling. ING economists warned that “concerns over unfunded government giveaways and debt sustainability challenges could well see the pound continue to underperform this year”.
