The Chancellor’s mini-budget was intended to end the cost of living crisis and revive the UK economy. But by triggering a dramatic reaction in the financial markets, it looks as though the Chancellor has inadvertently created a cost of borrowing crisis and put the UK economy back on life support.
Last Friday’s mini-budget does mean that taxes for both households and businesses will be lower than they would otherwise have been. The problem isn’t that the Chancellor, Kwasi Kwarteng, is going to fund those tax cuts by borrowing more. Instead, the real issue is that he indicated there is more to come and he failed to lay out any means of restraint. It’s like he’s just got hold of the government’s credit card and removed the credit limit at the same time.
That’s why the financial markets took fright as they know how such a situation ends. On Sunday night, the pound fell to a record low of $1.035 against the US dollar. And by one point on Wednesday, 10-year gilt yields, which is the rate the government has to pay to borrow for a decade, had leapt from 3.30% before the mini-budget to 4.55%. Gilt yields did fall back a bit on Wednesday after the Bank of England was forced to step in to prevent it escalating into a financial crisis. But they remain much higher than before the mini-budget.
While all this may sound a bit esoteric, the moves in the financial markets have real-life implications for all of us. Admittedly, a fall in the pound helps UK exporters as their products suddenly look cheaper in overseas markets. But UK PLC is unlikely to enjoy a big burst of new orders when the global economy is heading into a recession.
And the weaker pound hurts households in two ways. First, it makes going on holiday overseas more expensive. At the start of the year when the pound was worth $1.35, buying a $5 coffee in New York would have cost £3.70. Now it would cost £4.76. That’s a 30% increase.
Second, and more importantly as it influences everyone and not just those jetting off overseas, a weaker pound means that everything the UK imports costs more. That will show up in the prices we all pay in the shops. For example, the 3% fall in the pound against a range of currencies since the mini-budget would add around 0.75% to the consumer price index over the next four years. That doesn’t sound like much, but by the end of those four years each household would be paying an extra £400 more just to buy the same stuff.
Even more worrying is the surge in gilt yields. They are rising because the financial markets have quite rightly concluded that cutting taxes when inflation is already five times the Bank of England’s 2% target will just keep inflation higher for longer and result in the Bank raising its policy interest rate further above the current level of 2.25%.
These gilt yields determine the interest rates households and businesses pay on their loans. Banks and Building Societies have already pulled their best mortgage deals and will be replacing them with ones with much higher mortgage rates. For example, someone coming to the end of their two-year fixed deal may see their mortgage rate rise from 1.2% to something like 6.6%. If they took out their mortgage with a 25% deposit to buy the average-priced house, their monthly mortgage payment would suddenly jump by £500, from £620 to £1,120. That’s an 80% increase. These households will have little choice but to reduce their spending on other items.
Higher interest rates throughout the economy should mean that inflation falls back to the 2% target a bit more quickly. That means the cost of living crisis, which is a result of high inflation, will start to ease a bit next year. But the surge in interest rates mean that we are now heading into a cost of borrowing crisis. And for a while at least, households and businesses will be dealing with both.
So while the Chancellor was hoping that economists like me would be revising up our forecasts for economic growth after his mini-budget, the reality is that the outlook for economic growth is weaker not stronger. I had thought that 2023 would be a better year for the economy. Now I’m not so sure.
A version of this article was published in the Evening Standard on 29th September