Expansionary mini-Budget risks stimulating inflationary economic boom

Last Friday 23 September, the Chancellor, Kwasi Kwarteng, presented his first fiscal statement. The policies were very expansionary with cuts to income tax and national insurance, stamp duty reductions, and cancelling of the proposed increases in corporation tax. Net permanent tax cuts as a share of GDP are set to be more than 1.5%, estimates the Institute for Fiscal Studies (IFS). That is more than the amount in the Lawson Budget of 1988, but less than Barber Budget of 1972, which stimulated the eponymous boom. Despite these cuts the tax burden remains at its highest sustained level since the 1950s.

On the day, and prior to the market reaction, the National Institute for Economic and Social Research (NIESR) forecast that that these measures, combined with the energy support measures also announced last week and discussed in the next section would boost economic growth. Their analysis showed that the economy will come out of recession earlier now with it expected to be the fourth quarter of this year, and GDP could grow around 2% over 2023/24.

The Government has justified the tax cuts on the grounds that it will help raise the low rate of growth in the UK since the financial crisis towards its ambition of 2.5%. However, with an economy near capacity these tax cuts are likely to be inflationary.

In response to these pressures, NIESR predicted that the Bank of England (BoE) will increase interest rates more aggressively, peaking at 5% next year. Market pricing on the day of the statement is consistent with expectations of a 1 percentage point interest rate rise from the BoE in November.

There is a risk that the spending measures will place the economy on an unsustainable fiscal trajectory. The IFS estimated that medium-term borrowing is likely to be up by more than £100 billion. This raised concerns for financial markets, especially as the UK relies on lending from overseas, (see below). On the day of the statement sterling fell below $1.10 for the first time since 1985, and below $1.04 over the weekend, hitting an all-time low, before recovering slightly. The 10-year gilt yield surged 0.27 percentage points on heavy selling to hit 3.77% on the day, bringing its rise for the week to more than half a percentage point. It continued rising over the following days. The turmoil in the gilt market has also hit the UK housing sector. Around 1,000 mortgage deals have been withdrawn from the housing market in response to soaring yields and volatility as mortgage lenders face uncertainty about the long-term path of interest rates.

The Chancellor of the Exchequer and the Governor of the BoE have issued statements that they have no plans to make further fiscal or monetary statements until November when there will be a Budget and a decision on interest rates. Market movements would indicate that they have doubts that these positions can be maintained. Paul Johnson, the Director of the IFS, has commented, “It seems almost inconceivable that [expenditure] plans made last year, when inflation was expected to peak around 3%, will not need topping up at some point, unless the government is willing to allow a (further) deterioration in the range and quality of public services.” Any credible plan for higher growth will take time to implement. So, there is no obvious other mechanism for the government to use in its fiscal statement to place the economy on a sustainable fiscal trajectory of falling debt to GDP in the short term, and to reassure the markets.

The market reaction will raise the Exchequer costs of the mini-Budget, and add to the Budget deficit. Higher gilt yields raise the cost of borrowing to pay for tax cuts. The financial risk of the Energy Price Guarantee, more on which below, is with the Government – as energy prices are in dollars so the cost rises with an exchange rate depreciation. While on 28 September, and despite its previous announcement, the BoE announced it will intervene in the bond markets to buy unlimited quantities of long-term debt in order to offset a “material risk to financial stability”.

Unusually, the International Monetary Fund has commented on the mini-Budget. “Given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture … It is important that fiscal policy does not work at cross purposes to monetary policy.”

In terms of UK sub-regional impacts it is likely that the announced measures will be of more benefit to London and the South East of the UK because incomes and wealth in these areas are disproportionately higher, on average – that is, more people will benefit from cuts to income tax and stamp duty in these regions. Households in London or the South East will on average have three times the gains of those in the North East, Wales and Yorkshire. Further, the Resolution Foundation estimates almost half the gains will go to the richest 5% of households, compared with 12% of the gains for the lower half.

Beyond this there were a few announcements in the fiscal statement of interest for London:

• Overseas visitors will no longer need to pay VAT on goods shopping. In 2019, there were 21.7 million overseas visitors to London who spent £15.7 billion, according to the Office for National Statistics (ONS). London is the third most visited city in the world. As a comparison, 40.9 million overseas visitors came to the UK, and spent £28.4 billion.
• There are plans for new Investment Zones. The chosen sites will have time-limited lower taxes, and planning liberalisation to accelerate development. The Government is in early discussions with 38 Mayoral Combined Authorities and Upper Tier Local Authorities, including the GLA.
• The Government has committed to accelerate some infrastructure projects. These include the A13 London Safer Road Scheme, and the A23 Croydon Safer Road Scheme.

The Government announces measures to address the cost of living crisis

The key cost of living development this month was not the latest data, discussed below, but instead the announcement of the Energy Price Guarantee. From October, the scheme will cap household energy bills at an annual average of £2,500. If the Government had not acted, soaring wholesale costs meant the Ofgem price cap would have been set at a much higher £3,500. Industry estimates projected that the cap would then rise to £4,650 in January 2023 and over £5,300 in April. The BoE projected, prior to the mini-Budget, an October inflation peak of just under 11% year-on-year, quite close to current levels. This may seem like a relatively modest revision from August’s projected inflation peak of just over 13%. However, energy price movements between the two meetings might otherwise have pointed to an inflation peak closer to 20%.

Vitally, the Government will also introduce a cap for business’ energy bills corresponding to wholesale prices of £211 per MWh for electricity and £75 per MWh for gas. This is likely around half the cost that firms would have faced over winter without any government measures. If business energy costs were left uncontrolled, firms would likely have been forced to pass these on to consumers in higher prices – or else go out of business, resulting in layoffs.

Nevertheless, inflation remains very high by the standards of the last 30 to 40 years and the outlook is still uncertain. Households still face a 25% increase in already-high energy bills in October. Lower-income households tend to devote a higher share of spending to energy, meaning they will be the hardest hit by continuing cost increases. The business energy price cap is only set to last six months for most firms. Only “vulnerable” companies and charities will receive further help beyond that point – and the Government has not yet defined who will qualify.

The household and business energy price caps will also be immensely costly for the Exchequer. It estimates that over the first six months the household scheme will cost £31 billion, and the business scheme will cost £29 billion.

Overall, the latest policy announcements are clearly a boost for households and businesses in the near term. Inflation is unlikely to keep soaring upwards by as much, instead peaking soon at a pace close to current levels other things being equal. Yet households will still face an energy price cap roughly double its level last October. Other essential costs like food and housing continue to rise. And there is no guarantee that gas prices will be below the new cap in two years’ time – let alone in six months when business support expires. To fight the cost of living crisis on a sustainable basis, policy still needs to do much. Energy policy will need to step up efforts to reduce dependency on imported natural gas. Monetary policy will need to continue to fight domestic inflationary pressures. And other areas of policy are likely needed to support many households this winter.

The Bank of England raises interest rates again

At its September meeting the Monetary Policy Committee (MPC) of the BoE raised interest rates by 0.5% to 2.25%, the highest level for 14 years. This is the seventh consecutive meeting of the MPC to raise interest rates from 0.1% in December 2021. It was on a split vote with five members voting to increase rates by 0.5%, three by 0.75%, and one by 0.25%. In the words of the MPC minutes, “a tight labour market with wage growth and domestic inflation well above target-consistent rates justified a further, forceful response from monetary policy.” There is likely to be further interest rate increases as Government action to increase demand through the Energy Price Guarantee and tax cuts will otherwise raise prices where labour supply is tight.

The BoE notes that, “In the near term, the Guarantee would lower and bring forward the expected peak in Consumer Price inflation (CPI). This should restrain expectations of above-target inflation further ahead”. In August, there was a modest fall in annual CPI to 9.9% from 10.1% in July, reports the ONS. There will be a further rise in inflation when the Energy Price Guarantee comes into effect, as this is set higher than the current price cap. The ONS has concluded that the energy rebate which is taken off bills from October will not be reflected in the CPI.

Typically, earnings rise faster than prices, and so living standards improve. It remains the case that earnings have not kept pace with CPI this year, with earnings growth perhaps being lower in London than the UK, (Figure 1). This ongoing contraction in real earnings is contributing to the cost of living crisis.

Figure 1:

Jobs exceed pre-pandemic levels

Perhaps because of falling real earnings the unemployment rates in London and the UK remain low, UK vacancies remain high, and the number of jobs has been recovering. In the quarter to June 2022 the number of jobs in both London and the UK exceeded pre-pandemic levels (at December 2019) for the first time, according to ONS figures, (Figure 2). Historically, London’s job numbers had been growing faster than across the UK, while they also fell further during the pandemic. In that time there has been some restructuring of the London economy. Jobs fell across many sectors before re-bounding. For example, the share of London jobs in Construction fell from 5.2% in December 2019 to 4.2% a year later before recovering to 5.0% in June 2022. On the other hand, in Wholesale and retail there was growth in the share from 10.8% to 11.7% in December 2022 before retrenchment to 11.1%. Accommodation and food services saw a decline in the share of London jobs from 7.6% to 6.5% between December 2019 and 2020, and its share remained unchanged at June 2022. Professional services has seen a steady rise in its share of London jobs from 13.4% to 14.2% to 14.9% over the two and a half years.

Figure 2:

The UK economy is weakening

Even prior to the mini-Budget the latest data from the ONS was that the UK economy was stagnating. GDP was flat in the three months to July compared with the previous three months. It was estimated to have grown by 0.2% in July. Services was the main driver of the rise in GDP, and grew by 0.4% over the month – some of this is a recovery from the reduction in COVID-19 health activities in the previous period. Within the services sector, Information and communications grew by 1.5%.

More worrying for the financial markets were ONS retail sales figures which showed that retail sales volumes fell by 1.6% in August and provided evidence that the UK economy may be heading for recession. This continued a downward trend since Summer 2021, following the lifting of restrictions on hospitality and a shift in household spending towards services, and away from retail goods. More recently, the effects of rising inflation are apparent with retail sales volumes falling by 5.1% in the three months to August, and sales values rising by 5.6%. This implies an annual growth rate in retail prices of 10.7%. It is likely that it has been the impact of rising prices that over the month to August retail sales volumes fell across all the sectors of non-food stores, non-store retailing (predominantly internet sales), food stores, and fuel.

Fears about the strength of the economy, and rising public debt levels, had already led to a sell off of sterling prior to the mini-Budget. At one point after the retail sales publication, sterling fell more than 1% against the US dollar to $1.1351, its lowest at the time since 1985. Over the month of September to the 20^th, the pound had fallen by 1.9% against the dollar, and by 1.3% against the Euro, (Figure 3). It is also a concern that the trade deficit widened by £1.2bn to £27.0bn in the three months to July, compared with the three months to April, according to the ONS. Reduced international competitiveness of the UK economy would require a currency depreciation if the economy became less attractive to overseas investors. Interest rate increases are a means to maintain the attractiveness of sterling.

Figure 3:

International economies also facing pressures

The impacts of energy shortages and rising prices are impacting the world economy more than previously expected according to the latest forecast from the Organisation for Economic Cooperation and Development (OECD). It now estimates that global GDP in 2023 will be $2.8 trillion lower than its December 2021 forecast before Russia’s invasion of Ukraine, although the OECD is still estimating growth at 2.2%.

Inflation has become more widespread. The US Federal reserve increased interest rates by 0.75% to between 3% and 3.25% – this is the highest level for 14 years. Borrowing costs are expected to climb more and remain high the Fed said. The increases in interest rates will slow down economic activity and may tip the US economy into recession. The OECD, though, is expecting growth of 0.5% in 2023.

The OECD 2023 forecast for the Eurozone is lower at 0.3%. The economic pressures are also being felt particularly strongly in Germany as it was reliant on Russian energy supplies – there is an expectation that gas use should fall by a fifth this winter to avoid shortages as the Nord Stream 1 gas pipeline is operating at a fifth of capacity. While the country is filling its gas storage facilities to maintain supplies economic growth has stagnated, according to Eurostat, and the ZEW Institute gauge of investor expectations has fallen to -55.3, its lowest level since 2011. The OECD is forecasting the Germany economy to shrink by 0.7% in 2023.

The OECD has also slightly trimmed its China forecast by 0.2% to 4.7% for 2023. The World Bank is predicting growth of 2.8% in 2022 and 4.5% in 2023 for China. The zero-COVID policy, and the public health measures to limit mobility, and contain the spread of the virus, have constrained consumption this year. China’s real estate turmoil, as evidenced by problems in financing loans to the property company Evergrand and falling house prices across 70 major cities, is being accentuated by the tightening of financial conditions with interest rate rises.

For completeness the OECD is forecasting UK growth at 0.0% in 2023. This analysis was conducted before the mini-Budget announcement.

London’s businesses continue to prosper, although consumer confidence is worsening

The current evidence points to the conclusion that London’s economy continues to grow. As reported earlier the service sector, which accounts for 90% of London’s economy, is growing. The latest Global Financial Centres Index, from Z/Yen in collaboration with the China Development Institute, finds that London continues to be the second most important financial centre behind New York.

The LET indicators, reported below, are mostly positive with increases in ridership on tubes and buses, a tight labour market, rising house prices, and positive business confidence. More negatively there are expectations of falling house prices in the next few months, and there is negative and worsening consumer confidence. Consumer confidence in London reached levels last seen during the financial crisis, although for the UK they are the worst since records began in 1974.

GLA Economics will continue to monitor these and other aspects of London’s economy over the coming months in our analysis and publications, which can be found on our publications page and on the London Datastore.