Investing.com – On September 23, the new UK Chancellor, Kwasi Kwarteng, announced a series of measures to cut taxes and energy bills in an effort to spur economic growth. The new program this month revealed a cap on energy prices, the removal of the top rate of income tax, a planned increase in the corporate tax rate, a cap on bankers’ bonuses, the end of the “green tax” and other measures which will be announced during October and November.
In this context, Bill Papadakis, macro strategist at Lombard Odier, and Kiran Kowshik, FX strategist at Lombard Odier, analyze the current situation in the country and outline three perspectives given the announced measures:
1. A cap on energy prices should reduce the risk of peak inflation and winter recession.
The most significant effect of the energy price cap will be a significant reduction of the potential inflation peak, which is now probably 4-5% lower than expected in the absence of the price cap. A reduction in inflation, particularly in energy prices, will have a positive effect on real incomes, easing pressure on the UK consumer who faced a “cost of living crisis”, improving the outlook for near-term growth.
The total amount of fiscal easing is very large and is likely to increase the deficit by more than 5% of GDP in the years 2022 and 2023. But the effects of tax cuts on growth are less clear as they target high-income households and businesses are likely to contribute less to the effective demand.
In addition, the sharp tightening of monetary policy that is likely to come will dampen growth in the longer term. Although it acts with some delay and its full effect will not be felt until the end of 2023, the sharp increase in mortgage rates and the more general tightening of financial conditions will constitute a significant drag on growth. We therefore expect a small net increase in growth in 2023, bringing our forecast for the year as a whole to +0.1% (versus -0.3% previously).
2. A strong reaction from the BoE will push interest rates up sharply.
The Bank of England held its last day before the publication of the mini-budget, and has yet to take any action on rates in response.
During the meeting, the Monetary Policy Committee (MPC) did not decide on a 75 basis point increase, raising the policy rate by only 50 basis points to 2.25%. On Wednesday 28 September, the Bank of England was also forced to step in and buy government bonds, while postponing the start of its active selling program to 31 October. The size of the latter remained unchanged. The intervention was seen as a necessary response to increased risks to financial stability.
We believe that significant fiscal easing in the face of very high inflation requires an aggressive response from the Bank of England. The fact that it has decided not to implement an emergency hike and has launched an emergency bond purchase risks raising doubts about its political independence (ie its willingness to help the government finance its growing deficit directly through bond purchases). Therefore, a strong message must be sent at this time.
Market expectations for interest rates changed significantly after the tax event, with interest rates peaking around 6%. If the Bank of England does not meet these expectations, it will ease financial conditions, which will increase the risk of inflation. This should lead to excessive rate hikes at the last two meetings this year, 125 basis points in November and 100 basis points in December, bringing the bank rate to 4.50% by the end of the month. After that, we expect smaller increases and a peak in rates around 5.50%.
3. Further decline in sterling.
In early September, we had a bearish view on , with the recent deterioration largely linked to higher energy prices. At the time, our outlook did not include concerns about how the deficit would be financed. In light of recent developments, we believe that the situation has changed and we now see a new downward trend for the currency.
In the absence of significant adjustments or unwinding of expected tax cuts, we think it could eventually reach 0.95. This figure is close to the peak of the pandemic, which was also reached after the great financial crisis of 2008-09, the Brexit vote and during the Covid-19 pandemic. Sterling’s performance should be similar going forward. It should be noted here that while both the pound and the euro have fallen against the US dollar for most of 2022, overall the pound has held up relatively well. Therefore, it is now possible for the British pound to underperform.
The risks could even point to further depreciation of the pound. This would roughly translate to EURGBP at 0.98, the peak seen since the Great Financial Crisis. A more extreme scenario of a sudden stop requiring a return to balance of payments equilibrium would involve an even greater depreciation of the British pound (30%). However, we assume that this scenario is less likely, so there is still tail risk.