Beyond Currency

Kwasi Kwarteng appeared from self-imposed exile yesterday to reveal that he warned Liz Truss that she was moving too fast with reform that she wanted to introduce in the immediate wake of her election as Conservative Party leader.

He said his policies tried to drive the economy forward and warned Rishi Sunak over the likely rise in taxes.

Kwarteng appears to have failed to grasp the severity of the situation facing the UK economy, and still has no answer to questions about how his plans were to be funded. The single lack of understanding came close to derailing the entire financial system, as pension funds came close to being forced to sell off longer-term assets which are the cornerstone of their portfolios.

It was a veiled criticism of Kwarteng's inexperience when Andrew Bailey spoke recently of how much harder it is to regain the market's confidence than lose it in the first place.

Jeremy Hunt will deliver his plans for repairing the hole in the UK's finances to Parliament next Thursday. Although he may provide a mixture of spending cuts and rises in taxation, it is believed that he plans a freeze on public spending, which the Opposition will challenge as a return to austerity.

The Bank of England is expected to turn more dovish in its attempts to bring inflation under control in the New Year.

Various think tanks have reviewed the Central Bank's Monetary Policy Committee member's voting performance at meetings held since rates began to be raised last December. The conclusion is that they are reluctant to hike rates and will either vote for smaller hikes or abandon the policy entirely.

Bailey's comments at news conferences following meetings have been almost apologetic. Technocrats working for the Bank of England have been tasked with finding when inflation will begin to fall naturally if interest rate hikes are tapered or ended altogether.

Many feel the rise in inflation is due to circumstances beyond the Bank of England's control, and a tightening of fiscal policy will have a far greater effect.

A lot will depend on next week's budget delivered by Chancellor Jeremy Hunt as it is generally accepted that the country will start a long and painful recession this quarter.

Latest projections indicate the impending recession may cause an economic contraction as great as 10%.

In its latest forecast, the Bank of England that the economy will shrink over the course of eight quarters beginning with the current period. The projection is based on a forecast that short-term interest rates will reach 5.25%.

The vote at last week’s MPC meeting was 7-2 in favour of a seventy-five-basis point increase. The two who voted against it were Silvana Tenreyro, who voted for a twenty-five-point hike and Swati Dhingra, who voted for fifty points.

The appointment of Dhingra has made the overall position of the Monetary Policy Committee marginally more Dovish. This was her second meeting, and she has now voted for hikes below the agreed level on both occasions.

Tenreyro, appointed in 2017, is considered a bit of a dove, having voted for small hikes at two of the past four meetings. But she appears to be more considerate about her view considering several factors when casting her vote.

The continuing tightening of monetary policy is beginning to slow activity in the housing market.

With mortgage lenders having withdrawn close to a thousand products from the market due to uncertainty over the path of long-term interest rates following the mayhem created by the recent mini-budget, borrowers are facing difficulty securing finances.

The cost of building land reached its highest-ever level as limited supply, and increasing demand drove builders to reduce the stock levels in their land banks.

Recent data showed that builders are slowing down housing starts, which will have a knock-on effect throughout the market.

This is a significant factor in the slowdown in the economy, which will ultimately lead the country into recession.

When Liz Truss and her Chancellor Kwasi Kwarteng announced their mini-budget containing a series of unfunded tax cuts, it caused such alarm in the markets, especially amongst pension funds, that the Bank of England was forced to step in.

Andrew Bailey, the Bank's Governor, held talks with representatives from the hours of having to implement emergency plans for a market meltdown. Treasury, Bank Chairmen, and the Office for Budget Responsibility to try to have the measures reversed, considering what they could see happening in real-time,

Representatives of the OBR, whose report on the effect of the measures was ignored and remained unpublished, met with Kwarteng as they tried to impress on him the gravity of the situation.

Although the UK economy is now sailing in calmer waters, the issue of balancing the books remains and is due to be addressed by Chancellor Jeremy Hunt next week when he presents a full budget that has been produced with full input from the OBR.

It is expected that the £60 billion hole in the Government's finances will be closed by making cuts to public services and a series of tax increases. The split is believed to be £25 billion of tax increases and £35 billion of spending cuts.

The Bank of England hiked short-term interest rates by seventy-five basis points as it continues to battle inflation.

In his press conference following the announcement, Andrew Bailey spoke of the UK facing the prospect of its longest recession in history. While it won’t rival the recession caused by the Pandemic for depth, it will continue well into 2024.

Following its biggest hike since 1989, the eventual high may reach 5.25%. Bailey believes that rising inflation will moderate quite soon and begin to fall in the second quarter of 2023.

Meanwhile, the country faces the prospect of a significant economic contraction, with unemployment doubling from its current level of 3.5%, its lowest level since 1974.

Bailey was unabashed about the Bank of England continuing to hike interest rates despite the country facing a tough couple of years, saying that the situation would be far worse if prices continued to rise unchecked.

With the Bank of England set to agree to the biggest hike in short-term interest rates in more than thirty years later today, analysts are beginning to consider how much further the Central Bank is willing to go in its fight against inflation.

With consumer prices hitting 10.1% in September, the tactic of hiking by bigger increments is still open to question. The widespread belief is that once rates reach neutral and move into restrictive territory, their effect on demand will become exponentially greater.

However, that idea is not universally accepted as the cause of the rise in inflation is not driven purely by supply and demand or any particular asset bubble.

The amount of money in the system following the relief provided to households during the Pandemic is one factor that rate hikes won’t affect, as is the rise in energy prices.

While it is the demand for gas that is driving inflation higher, that level of demand has been limited by the rise in prices that is driven by outside influences.

The Bank of England has begun to reverse its programme of quantitative easing, which began in 2009 when the country faced a deep recession and banks were not lending to each other. Under the programme, they purchased Government Bonds from financial institutions which provided liquidity to the market.

This drove interest rates to historic lows and encouraged businesses to continue to borrow money to fund expansion and speed recovery.

The BoE sold a relatively small number of bonds, valued at around £750 million, out of its stock of around £850 billion.

The UK is the first G7 nation to begin to withdraw support.

There have been calls for Sunak to extend the windfall tax on energy companies that he introduced when he was Chancellor of the Exchequer, as BP announced its third quarter profits yesterday.

The Bank of England’s MPC will begin its latest meeting today, culminating possibly its largest hike in interest rates in more than thirty years.

Speculation is growing that rates will increase by seventy-five basis points to try to lower inflation. This will bring short-term rates to 3%, with another hike likely in December.

There has been severe criticism of the Bank’s policy of gradual rate increases that have taken place at every meeting since last December.

The Central Bank has been increasing rates gradually to not slow growth to such an extent that it drives the economy into recession.

The Bank’s Governor has already acknowledged that the country is heading for a period of contraction growth in any event, so it is curious that they are only planning to increase the size of hikes now.

In a couple of weeks, Jeremy Hunt will present MPs with what it is hoped will be a carefully crafted plan to combat the gaping hole in the country's finances.

Whatever he does, it is bound to be unpopular. Presenting a budget at a time when the economy is struggling always is, and introducing plans that give the financial market confidence that the economy will recover and grow always costs the man in the street, whether through reduced services or by higher taxation.

One issue yet to be decided is the triple lock on the state pension and whether the country can afford to increase benefits such as universal credit.

Increasing the State Pension in line with inflation will cost an extra five billion pounds, which Hunt must find elsewhere.

One plan that is being discussed is a freeze on foreign aid. The UK provides almost fourteen and a half billion pounds in foreign annually, with Ethiopia, Nigeria, Somalia, Afghanistan and Yemen receiving the most, according to 2020 statistics.