What the election means for the UK economy

After months of speculation, we finally have a date: the UK will head to the polls on 4 July. Given an autumn election was widely expected, the decision caught markets (and even fellow politicians) off-guard. A closer look at the economic data helps to explain why the prime minister decided on the quick campaign.

Hours before Rishi Sunak’s announcement, data showed that UK inflation has fallen to within a whisker of the 2 per cent inflation target. Since one of Sunak’s key pledges was to ‘halve inflation’, the latest figures were on the face of it a good news story for the government. 

But at the same time, April public finance figures revealed that the fiscal year has got off to a shaky start. Borrowing came in above the Office for Budget Responsibility's forecasts, while stagnant economic growth and slowing wage growth are expected to drag on tax receipts over the months ahead. 

The 20-year gilt yield (used for long-run forecasts) also rose from 4.4 per cent at the time of the Spring Budget to 4.8 per cent, reducing wriggle room further. This all left the chancellor, Jeremy Hunt, with less ‘headroom’ for possible tax cuts in a fiscal event later on in the year. Although Tony Blair-era Labour anthem Things can only get better blared as Sunak made his speech, the Conservatives seem to have concluded that the economy probably won’t get much brighter over the next few months. 

The economy

Thanks to the difficult economic inheritance, both the Conservative and Labour parties have pledged to bind themselves by fiscal rules to limit borrowing and debt. As a result, economists expect the overall stance of fiscal policy to end up very similar whoever wins in July. There is, however, still room for nuance between the two parties. Analysts at Capital Economics think that Labour might prove more successful at increasing homebuilding, while the Conservative party could regulate artificial intelligence (AI) with a lighter touch, resulting in a greater productivity boost. "Either way, our forecast that the UK’s economic growth rate will accelerate in the 2030s is based on the benefits from AI rather than government reforms," said Paul Dales and Ruth Gregory at Capital Economics. 

There is also scope for a new government to bolster confidence in the UK economy. Household saving behaviour has still not returned to normal after the pandemic, and analysis from the Resolution Foundation suggests that households saved around £54bn more last year than they would have done at 2019 rates. If a change of government boosts confidence enough to encourage spending and investment, we could see a positive impact on GDP. 

Interest rates 

Since the election result isn’t expected to alter the path of fiscal policy, it should have minimal bearing on the inflation rate. As such, there should be little economic argument for delaying interest rate cuts because of the upcoming election. Nor should there be a political one: the Bank of England’s (BoE) independence is long-held and supported by both major parties. 

Crucially, a June interest rate cut was already effectively ruled out before the election date was announced. The latest headline inflation figures came in higher than expected, while services inflation was significantly above the BoE’s forecasts. Following the inflation data, traders slashed the likelihood of a June rate cut from 50 per cent to 15 per cent. 

But analysts at ING point out that rate cuts have long been telegraphed, and warn against assuming that the BoE won’t move in June just because of the timing of the election. Luke Bartholomew, senior economist at Abrdn, expects a first rate cut in August, adding that the decision “will turn not on politics but the behaviour of inflation and wage growth data over coming months”.

Sterling and markets

Economists at ING said that “UK investors have become accustomed to political drama over the past few years, and we're inclined to think that July's election shouldn't be particularly volatile for markets”. Tellingly, Wednesday’s inflation figures elicited a greater market response than the election announcement. 

But since the "mini" Budget, gilt markets remain sensitive to any signs of fiscal “indiscipline”. Analysts at Capital Economics warn that if parties can’t offer plausible plans for public spending cuts or engage in a ‘race to the bottom’ on tax cuts, we could see elevated gilt yields – even as interest rates are cut. 

History tells us that the UK stock market tends to welcome new prime ministers. Analysis by AJ Bell investment director, Russ Mould, shows that since 1962 the FTSE All-Share has recorded a double-digit percentage gain in the first year after an election when a new candidate takes over. The effect is even stronger when there is a change of government.

For now, polling data suggests a 20-point lead for the Labour party, and analysts at ING expect ‘noise’ in FX markets as new Labour policies are announced. Yet the analysts do not expect the election to have a meaningful impact on the exchange rate, with changes in US and UK interest rates driving movements this year. They added that “as we don't see the BoE changing its policy plans due to the election, the overall implications for sterling should be limited”.