With the goal of cutting through all the chatter and headlines around the United Kingdom’s (UK’s) woes these days, here’s my current take on the situation and its broader global implications.
First, the Bank of England hiked…
Last week, the Bank of England’s (BoE’s) Monetary Policy Committee (MPC) increased interest rates by 50 basis points (bps) — the second consecutive hike of that size, continuing the hiking cycle started in December 2021 and bringing the policy rate up from 1.75% to 2.25%, a level not seen since 2008. That being said, the MPC is not following other global central banks — such as the US Federal Reserve (Fed), the European Central Bank (ECB), and the Swiss National Bank (SNB) — in hiking rates by 75 bps to counter stubbornly high inflation.
In effect, the MPC is running the risk of looking “soft” on inflation, particularly for a country that is experiencing acute inflation dynamics and has a long history of generating inflation. With the UK labour market at its strongest since 1973, loosening fiscal policy (see below), together with other central banks enacting larger rate hikes, should apply added pressure to tighten monetary policy more aggressively. In my view, however, the BoE isn’t showing much urgency to do so and thus risks losing credibility in its drive to tame inflation (more on that below).
…and then came the mini-budget
On 23 September, the UK government announced a significant fiscal policy package, worth ~9% of national GDP over the next 2½ years and putting in place the biggest set of UK tax cuts since 1972. With the British economy stalling, this government is actively seeking growth at a time when achieving price stability (lower inflation) requires a slowdown in demand, as exemplified by Fed Chair Jerome Powell’s remark that some “economic pain” would be necessary to conquer US inflation. Puzzlingly to me, the UK government’s fiscal actions seem to represent an extraordinary policy experiment designed to keep inflation high.
Markets circling GBP and gilts
In response, global investors have punished both British gilts — bonds issued by the UK government that are generally considered low-risk equivalents to US Treasuries — and the British pound (GBP). The initial market reaction saw gilt yields spike by over 100 bps (Figure 1), while the GBP declined by more than 6% against the US dollar (USD) over the same period.