Britain's failed tax experiment will leave economic scars and credibility issues, analysts say
- On Monday, Finance Minister Jeremy Hunt threw out almost all of the package of tax cuts that was announced by his predecessor less than a month ago.
- Markets cheered the news, but analysts said the market chaos sparked by the plan had dented the U.K.'s credibility and raised questions over the predictability of fiscal policy.
- Gloom also still surrounds the gilt market and pound, while the public faces high inflation and potential departmental spending cuts.
LONDON — The screeching tires of the U-turn performed by the U.K. government over its flagship fiscal policies is echoing around Westminster, with the new finance minister ripping up the program of tax cuts announced less than a month before.
The move was an effort to calm volatility in financial markets, particularly the bond market, which experienced a historic sell-off on the prospect of increased borrowing, which in turn threatened to destabilize British pension funds heavily invested in U.K. sovereign bonds.
The yield on these bonds, which reflect the cost of borrowing for the government and influence interest rates on many products such as mortgages, eased lower after the statement Monday.
The yield for short-term bonds maturing in two years was 3.69% at 11:00 a.m. London time on Tuesday; up from 3.51% before the market-roiling "mini budget" was announced on Sept. 23, but much lower than the 4.75% it reached on Sept. 27, before the Bank of England intervened with a temporary bond-buying program.
The yield on 10-year bonds, the closely-watched benchmark seen as the indicator of long-term interest rates, remains significantly elevated at 4.045%, up from 3.49% before the budget.
Gilts glum
U.K. Business Minister Jacob Rees-Mogg had previously argued bond market chaos was not caused by the government, instead blaming wider economic factors such as interest rate differentials between countries.
While bond yields have indeed been rising in Europe and the U.S., the scale of the movement suddenly after the announcement, which was only reversed after the BOE intervention, saw analysts and investors express a firmly opposite view; and Prime Minister Liz Truss admitted Monday evening her policies had gone "too far and too fast."
Antoine Bouvet, senior rates strategist at Dutch bank ING, told CNBC U.K. bonds would not be heading back to their early August levels of around 2% in the foreseeable future; but that this was due to a complex range of factors.
"The world has changed since then," he said, "and their risk premia is justifiably elevated." That includes forecasts of a U.K. recession, and though they have lowered with the budget U-turn, market expectations are still for the Bank of England to hike its base rate to over 5% from the current 2.25%. Bonds tend to become less attractive when interest rates rise, decreasing their price and sending up the yield.
The 10-year yield could rally back to 3.5% "provided we get a period of stable policy-making," Bouvet said, though this could change if there's a new prime minister — with Truss facing calls to resign — and if the BOE begins bond sales as part of its quantitative tightening, as it initially planned when it raised rates in September. On Tuesday morning the bank said a Financial Times report that it would delay these sales was "inaccurate."
Credibility dented
But, said Bouvet, there could be wider lasting effects from the botched budget.
"I think what's been damaged these past weeks is more specifically the predictability of UK fiscal policy and it will take time for investors to forget that," he said.
This sentiment was shared by Paul Johnson, director of think tank the Institute for Fiscal Studies.
"There's undoubtedly a long-term damage because there's been more uncertainty created, there's lack of stability in policy," Johnson told CNBC's Arabile Gumede Monday.
"What you've seen the current chancellor do is try to reassert that certainty and credibility, but once that credibility is lost, it's very hard to regain. And the government is going all-out to regain it at the moment."
And Tim Sarson, U.K. head of tax policy at KPMG, told CNBC's "Squawk Box Europe" that whatever the pros and cons of Truss' economic vision on its own merits, "there couldn't have been a worse time to start experimenting with that sort of trickle-down policy."
"It was just the way that it was done, the lack of clear costing, the fact that it was being done at a time when government finances are being stretched by the need to support consumers from energy, and a time when global interest rates and gilt yields are rising," he said.
Wider effects
With the ideologically-driven policy platform Truss ran on now dead in the water, there is uncertainty in many other areas.
New Finance Minister Jeremy Hunt said a broad subsidy to cap consumer and business energy prices would now only run until April. Consultancy Cornwall Insight said that could see the average household bills rise from £2,500 ($2,825) to £4,348 based on current wholesale gas and electricity market trends, potentially further stoking inflation and dampening consumer spending power.
The pound rallied against the dollar Monday, and at midday Tuesday was trading at $1.1302, around the pre-budget level. But that still represents a significant drop since the start of the year, and with little to support it amid predictions of a full-year U.K. recession.
Claire Trachet, chief executive of business advisory Trachet, said U.K. businesses would continue to receive interest from a flurry of overseas buyers looking to capitalize on a weaker pound.
"The mini-budget announcement generated mass concern from industry leaders and the investment sector following a sharp drop in the value of the pound sterling coupled with the recent surge in the country's borrowing costs. Although the reversal of several tax cuts has calmed capital markets, we are yet to see the impacts of this, and there continues to be uncertainty in the M&A sector," she said in emailed comments.
"This has its positives and negatives, as on the one side it will attract a great deal of foreign investment to the U.K., alongside new tax incentives and favourable regulatory conditions. However, low valuations mean U.K. companies entering potential M&As may get less than they bargain for, so it is a critical moment for the sector here to show resilience."
Meanwhile, the public still awaits the full government budget accompanied by an independent economic forecast on Oct. 31, which Hunt said would involve "difficult" decisions on spending.
Samuel Tombs, chief U.K. economist at Pantheon Macroeconomics, said the U-turn on tax cuts had "saved" the government £31 billion — but that an additional £40 billion in savings would be needed in order to reduce the U.K.'s debt-to-GDP ratio in three years, per its current target.
"That reduction will be very painful — and perhaps politically impossible — given the pressure on health and pensions spending from an ageing population, and higher-than-usual inflation. Some tax rises, therefore, likely will be announced in the Medium-Term Fiscal Plan as well, to achieve the required consolidation," Tombs said in a note.