A week ago, the Bank of England took a stab in the dark. It raised interest rates by a relatively modest half a percentage point to tackle inflation. It couldn’t know the scale of the storm that was about to break.
Less than 24 hours later, the government of new UK Prime Minister Liz Truss unveiled its plan for the biggest tax cuts in 50 years, going all out for economic growth but blowing a huge hole in the nation’s finances and its credibility with investors.
The pound crashed to a record low against the US dollar on Monday after UK finance minister Kwasi Kwarteng doubled-down on his bet by hinting at more tax cuts to come without explaining how to pay for them. Bond prices collapsed, sending borrowing costs soaring, sparking mayhem in the mortgage market and pushing pension funds to the brink of insolvency.
Financial markets were already in a febrile state because of the rising risk of a global recession and the gyrations caused by three outsized rate increases from a US central bank on the warpath against inflation. Into that “pressure cooker” stumbled the new UK government.
“You need to have strong, credible policies, and any policy missteps are punished,” said Chris Turner, global head of markets at ING.
After verbal assurances by the UK Treasury and Bank of England failed to calm the panic — and the International Monetary Fund delivered a rare rebuke — the UK central bank pulled out its bazooka, saying Wednesday it would print £65 billion ($70 billion) to buy government bonds between now and October 14 — essentially protecting the economy from the fallout of the Truss’ growth plan.
“While this is welcome, the fact that it needed to be done in the first place shows that the UK markets are in a perilous position,” said Paul Dales, chief UK economist at Capital Economics, commenting on the bank’s intervention.
The emergency first aid stopped the bleeding. Bond prices recovered sharply and the pound steadied Wednesday against the dollar. But the wound hasn’t healed.
The pound tumbled 1%, falling back below $1.08 early Thursday. UK government bonds were under pressure again, with the yield on 10-year debt climbing to 4.16%. UK stocks fell 2%.
“It wouldn’t be a huge surprise if another problem in the financial markets popped up before long,” Dales added.
The next few weeks will be critical. Mohamed El-Erian, who once helped run the world’s biggest bond fund and now advises Allianz (ALIZF), said that the central bank had bought some time but would need to act again quickly to restore stability.
“The Band-Aid may stop the bleeding, but the infection and the bleeding will get worse if they do not do more,” he told CNN’s Julia Chatterley.
The Bank of England should announce an emergency rate hike of a full percentage point before its next scheduled meeting on November 3. The UK government should also postpone its tax cuts, El-Erian said.
“It is doable, the window is there, but if they wait too long, that window is going to close,” he added.
The UK government has previewed rolling announcements in the coming weeks about how it plans to change immigration policy and make it easier to build big infrastructure and energy projects to boost growth, culminating in a budget on November 23 at which it has promised to publish a detailed plan for reducing debt over the medium term.
‘Right plan’ or ‘reckless gamble’
But it shows no sign of backing away from the fundamental policy choice of borrowing heavily to fund tax cuts that will mainly benefit the rich at a time of high inflation. And the UK Treasury says it won’t bring forward the November announcement.
Truss, speaking publicly for the first time since the crisis erupted, blamed global market turmoil and the energy price shock from Russia’s invasion of Ukraine for this week’s chaos.
“This is the right plan that we’ve set out,” she told local radio on Thursday.
One big problem identified by investors, former central bankers and many leading economists is that her government only set out half a plan at best. It went ahead without an independent assessment from the country’s budget watchdog of the assumptions underlying the £45 billion ($48 billion) annual tax cuts, and their longer term impact on the economy. It fired the top Treasury civil servant earlier this month.
Charlie Bean, former deputy governor at the Bank of England, told CNN Business that the government was guilty of “really stupid” decisions. His former boss at the bank, Mark Carney, accused the government of “undercutting” UK economic institutions, saying that had contributed to the “big knock” suffered by the country’s financial system this week.
“This is an economic crisis. It is a crisis… that can be addressed by policymakers if they choose to address it,” he told the BBC.
British newspapers have started to speculate that Truss will have to fire Kwarteng, her close friend and political soulmate, if she wants to regain the political initiative and prevent her government’s dire poll ratings from plunging even further.
“Every single problem we have now is self-inflicted. We look like reckless gamblers who only care about the people who can afford to lose the gamble,” one former Conservative minister told CNN.
But for now she’s trying to tough it out, and cling onto the Reaganite experiment.
“Raising, postponing, or abandoning tax cuts will be avoided by Truss at all costs as such a reversal would be humiliating and could leave her looking like a lame duck prime minister,” wrote Mujtaba Rahman and Jens Larson at political risk consultancy Eurasia Group.
Emergency rate hike?
The only alternative left to balance the books would be to slash government spending, and that would prove equally politically difficult as the country enters a recession with its public services under enormous strain and a restive workforce that has shown it’s ready to strike in large numbers over pay.
“Truss and Kwarteng are now facing a severe economic crisis as the world’s financial markets wait for them to make policy changes that they and the Conservative party will find unpalatable,” the Eurasia analysts wrote.
The foreign investors who keep the British economy solvent are left scratching their heads for another eight weeks, leaving plenty of time for doubts to surface again about the UK government’s commitment to responsible fiscal policymaking.
“The message of financial markets is that there is a limit to unfunded spending and unfunded tax cuts in this environment and the price of those is much higher borrowing costs,” Carney said.
That leaves the Bank of England in a tight spot. A week ago it was pressing the brakes on the economy to take the heat out of price increases, even as the government tried to juice growth. The task got even harder this week when it was forced to dust off its crisis playbook and bail out the government.
It may not be long before it has to intervene again, this time with an emergency rate hike.
“[Wednesday’s] intervention is designed to stabilize UK government bond prices, keep the bond market liquid and prevent financial instability but that won’t necessarily stop sterling falling further, with its attendant inflationary consequences,” Bean, the former central banker, told CNN Business.
“I think there is still a good chance they will need to act ahead of the November meeting,” he added.
— Julia Horowitz, Luke McGee, Anna Cooban, Rob North, Livvy Doherty and Morgan Povey contributed to this article.