The UK is gripped by an economic crisis

London | Thu September 30, 2022

The Bank of England made a wild guess a week ago. To combat inflation, interest rates were modestly increased by half a percentage point. It was unable to comprehend the severity of the approaching storm.

Going all out for economic growth, the government of new UK Prime Minister Liz Truss presented its plan for the largest tax cuts in 50 years less than 24 hours later, blowing a gaping hole in the country’s budget and its credibility with investors while going all out for economic growth.

After UK Finance Minister Kwasi Kwarteng doubled down on his wager by suggesting that additional tax cuts will be forthcoming without addressing how they would be paid for, the pound plunged to a record low versus the US dollar on Monday. Bond prices fell, driving up borrowing costs, causing havoc on the housing market, and bringing pension funds dangerously close to bankruptcy.

The looming likelihood of a global recession and the gyrations brought on by three disproportionate rate rises from a US central bank on the warpath against inflation had already put financial markets in a feverish state. The newly elected UK administration walked into the “pressure cooker.”

Chris Turner, global head of markets at ING, said: “You need to have strong, credible policies, and any policy blunders are penalized.”

The UK central bank pulled out its bazooka on Wednesday and announced it would print £65 billion ($70 billion) to buy government bonds between now and October 14 in an effort to shield the economy from the effects of the Truss growth plan after verbal assurances from the UK Treasury and Bank of England failed to quell the panic. The IMF also delivered a rare rebuke.

Paul Dales, chief UK economist at Capital Economics, commented on the bank’s intervention: “While this is positive, the fact that it needed to be done in the first place shows that the UK markets are in a perilous position.”

The bleeding was halted by immediate first assistance. Bond prices dramatically increased, and the pound’s value versus the dollar was steady on Wednesday. The wound, however, is still open.

Early on Thursday, the pound dropped again below $1.08 after declining 1%. The yield on 10-year notes increased to 4.16%, putting pressure on UK government bonds once more. UK stocks decreased 2%.

Dales continued, “It wouldn’t be a tremendous surprise if another issue in the financial markets arose soon.

The coming weeks will be very important. The central bank had purchased some time, but urgent action would be required to restore stability, according to Mohamed El-Erian, who once assisted in managing the largest bond fund in the world and currently serves as an advisor to Allianz (ALIZF).

He told CNN’s Julia Chatterley, “The Band-Aid may halt the bleeding, but the infection and hemorrhage will grow worse if they do not do more.”

Before its upcoming meeting on November 3, the Bank of England should declare a full percentage point emergency rate hike. El-Erian suggested that the UK government delay its tax cuts as well.

The window is there, so it is possible, but if they wait too long, the window will close.

The UK government has promised to publish a detailed plan for reducing debt over the medium term at the budget on November 23, which will be the culmination of rolling announcements in the coming weeks about how it intends to change immigration policy and make it easier to build large infrastructure and energy projects to boost growth.

‘Right plan’ or ‘reckless gamble’

But it doesn’t appear to be changing its underlying policy decision to borrow extensively in order to pay for tax cuts that will primarily benefit the wealthy at a time of high inflation. The UK Treasury has also stated that the November announcement would not be pushed back.

In his first public remarks since the crisis began, Truss attributed this week’s mayhem to the turbulence on the world’s financial markets and the shock to energy prices brought on by Russia’s invasion of Ukraine.

She said on Thursday to a local radio station, “This is the appropriate plan that we’ve set out.”

The fact that her government only presented, at most, a partial strategy was one of the major issues cited by investors, former central bankers, and many prominent economists. Without an impartial review of the assumptions underlying the £45 billion ($48 billion) annual tax cuts and their longer-term effects on the economy by the nation’s budget watchdog, it was approved. It dismissed the senior Treasury official earlier this month.

Former Bank of England deputy governor Charlie Bean told CNN Business that the administration had made some “very dumb” choices. Mark Carney, his former boss at the bank, claimed that the government had “undercut” UK economic institutions, which had caused this week’s “huge knock” to the nation’s financial system.

This is a financial crisis. It is an issue that governments can address, if they so choose, he told the BBC.

British tabloids have begun to speculate that if Truss wants to recapture the political initiative and stop her government’s dismal poll ratings from falling much worse, she will have to remove Kwarteng, a close friend and political soulmate.

“Every single issue we face today was caused by ourselves. According to a former Conservative minister who spoke to CNN, “We appear to be irrational gamblers who only care about the individuals who can afford to lose the bet.”

However, she is currently making an effort to endure and stick with the Reaganite experiment.

Truss will resist raising, delaying, or abandoning tax cuts at all costs since doing so would be embarrassing and make her appear to be a lame duck prime minister, according to Mujtaba Rahman and Jens Larson of political risk consultancy Eurasia Group.

Emergency rate hike?

As the nation enters a recession, its public services are under tremendous strain, and a restive workforce has demonstrated that it is prepared to strike in large numbers over pay, the only remaining option to balance the books would be to reduce government spending, which would prove to be equally politically challenging.

The Eurasia analysts stated that Truss and Kwarteng are currently dealing with a major economic crisis as the world’s financial markets wait for them to implement unpopular policy measures.

For another eight weeks, the foreign investors who support the British economy are left in the dark, giving plenty of time for skepticism about the UK government’s dedication to responsible fiscal policies to resurface.

In this context, there is a limit to unfunded expenditure and unfunded tax cuts, and the penalty of them is significantly higher borrowing costs, according to Carney.

The Bank of England is now in a difficult situation. A week ago, the government was trying to boost growth while simultaneously putting the brakes on the economy to cool up price hikes. This week, when the government had to be bailed out, it became considerably more difficult to complete the work.

It might not be long before it needs to step in once more, this time by raising rates on a temporary basis.

“[Wednesday’s] intervention is intended to stabilize UK government bond prices, maintain the liquidity of the bond market, and prevent financial instability, but that won’t necessarily stop sterling from dropping further, with its accompanying inflationary effects,” Former central banker Bean.

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