Alienation nation

It has been a hell of a month in the UK. Four weeks ago, the death of the Queen marked a symbolic shift in the institutional fabric, the implications of which we have yet to work out. Her funeral was an event televised around the world and confirmed that whatever else the UK does, it remains a world leader in pomp and ceremony and projecting its imperial past to relay an image of itself far beyond its significance as a modern global power. Four days after Her Majesty was laid to rest, the realities of modern Britain were highlighted by the government’s unveiling of what was described as the worst budget (sorry, not a budget – a fiscal event) of modern times – perhaps ever.

As an economic package it was gobsmackingly awful. For the full details, see here. But in short, the government (or perhaps we had better describe them as the latest collection of radicals to hold parliamentary office) outlined a Growth Plan with the stated aim of restoring the trend GDP growth rate to 2.5%. This entailed a series of supply side measures which amounted to unfunded tax cuts totalling £45bn or 2% of GDP. The rise in NICs announced last year will be reversed; planned increases in corporation taxes are to be scrapped; the basic rate of income tax will be reduced from 20% to 19% next April and it planned to abolish the higher rate of income taxation (45%) before it did a U-turn on the idea.

As a package of economic measures, it was always doomed to fail. First, the UK’s trend growth rate is hampered by unfavourable demographics so it will be hard to raise without a very big rise in productivity. The evidence does not support the notion that companies will boost investment in response to lower taxes, thus putting a hole in the productivity-enhancing rationale for lower taxes. In addition, an influential IMF paper in 2015 comprehensively debunked the notion that cutting taxes for the well-off has any impact on growth (“a rising income share of the top 20 percent results in lower growth – that is, when the rich get richer, benefits do not trickle down”).

As a political gambit, the fiscal event is probably the worst brand-destroying exercise since jeweller Gerald Ratner described his products as “total crap” and suggested that some of the earrings he peddled were “cheaper than a prawn sandwich from Marks and Spencer’s, but I have to say the sandwich will probably last longer than the earrings.” Ratner did not last long in the job after that. The findings by the Resolution Foundation that the richest 20% of earners will benefit from two-thirds of the gains from lower taxes may not directly have influenced voters, but they know well enough when they are getting a raw deal. This has contributed to Labour’s opinion poll lead widening from 12% four days ago to 24% today (chart below). Just as in 1992 when the perception of Tory economic competence was shattered by sterling’s ejection from the ERM, so the fiscal events of recent weeks could have the same impact on the current government.

Indeed, it was the pound that was initially the centre of attention in this fiasco as it briefly plunged to all-time lows against the dollar early last week. But it is the gilt market, where rising yields forced pension funds to scramble for cash to meet margin calls on their hedging instruments, where attention is focused and BoE action to calm the market (the merits of the BoE's actions are a subject for another day). To the extent that mortgages are priced off the gilt curve, rising yields imply that mortgage rates are likely to rise sharply, thus making life harder for households already facing a major cost-of-living squeeze. As it is, data from Refinitiv suggest that the 129 bps rise in 10-year gilt yields in September was the biggest monthly jump on record (chart below).

What’s next?

If the last few weeks have demonstrated anything it is that handing the keys to the kingdom to increasingly ideological governments is doing no favours for the economy or the majority of most of those dependent on it. Indeed as the excellent FT infographic (below) suggests, “out of 275 parties in 61 countries, the Tories under Trussonomics rank as the most rightwing of all” with the author concluding that “The Tories have become unmoored from the British people.”

It has almost become a cliché to repeat Dean Acheson’s 1962 quip that Britain lost an empire but failed to find a role but it goes to the heart of the Brexiteer fantasy that somehow leaving the EU would restore past glories. What many of us pointed out is that it would actually weaken Britain, exposing those weaknesses that could be masked by remaining within the EU. But at least Britain could console itself with the fact that it had a stable political system, not prone to chaos, and administered by a competent civil service.

Chaos is now the watchword in government and whilst the competence of the civil service is not in question, the firing by Kwasi Kwarteng of his most senior Treasury official sends a bad signal about the quality of advice the government can expect to receive. The fact that the OBR’s offer to provide an economic assessment of the government’s fiscal plan was rejected also calls into question the form of scrutiny to which the government is prepared to be subjected.

The fact that the government has back-tracked on cutting the 45% tax rate is a further forced error from both a political and market angle. It was slated to cost only £2bn and will not change the market’s view of the unfunded tax giveaway. The real error is failing to find ways to plug the revenue gap resulting from NIC cuts and income tax reductions. Markets will not easily be assuaged although the fact that yields fell following the announcement suggests that they expect more backtracking in the weeks to come. Politically, the government now looks weak because it has performed a U-turn despite Liz Truss’s assertion yesterday that she was committed to abolishing the 45% tax rate. Moreover, if market pressure does force the government to find savings, it may be forced to cut spending further. It is pretty certain this will not be a vote winner. Public services have been stripped to the bone in the last decade and voter appetite for further austerity is limited.

I concluded my last blog post more in hope than expectation by noting that “voters will be hoping that she [Truss] can deliver them out of the dark place into which Boris Johnson led them. Surely she cannot do worse. Can she?” A month in the job and she has more than lived down to expectations. Every prime minister it seems, manages to be worse than the last. This is not a cycle that the country can afford to continue. In the words of Martin Wolf in an unusually strongly worded FT opinion piece, “these people are mad, bad and dangerous. They have to go.”

In Liz we Truss(t)

Three years and 43 days ago, I asked “If Johnson is the answer, what is the question?” I never did get an answer to that question. As the blond bombshell moves out of Downing Street to be replaced by Liz Truss, a similar question can be asked of her. But whereas Johnson “only” had to deal with the difficulties of Brexit, Truss has two problems to contend with. On the one hand, she faces arguably the most toxic combination of economic circumstances in living memory. On the other she leads a fractured and fractious party which seems in many respects to have lost its way. How she deals with these issues will not only define her premiership; it may well determine the future of the current incarnation of the Conservative Party.

Over the summer, as the Tory Party devoted its efforts to matters other than governing, there was a distinct sense that many voters felt abandoned as the cost-of-living crisis intensified. This has been reflected in polling data which give Labour an 11 point lead – not by any means terminal for Truss but not a good position from which to start. Aside from the cost-of-living issues, there are a whole lot of other matters in her in-tray which her predecessor singularly failed to tackle (indeed, probably made worse): the increasing strain on the NHS; generally low morale amongst public sector workers and the dreadful state of the criminal justice system to name but three domestic items. Added to this are international matters such as maintaining relationships with the EU and dealing with Russia and an increasingly assertive China. Perhaps Rishi Sunak can console himself that the leadership contest was a good one to lose.

Big government is back

However much Truss may profess her love of a small state and associated low taxes (her campaign pledges included unfunded tax cuts), all western European nations now realise that the state will have a big role to play in keeping the economy – perhaps even the wider social fabric – intact. Nowhere is this more evident than in the debate over how to provide support to consumers whose energy bills will spike sharply this winter in the absence of intervention.

Despite her opposition to “handouts” Truss really has little choice – politically and economically – other than to cap household energy bills which would otherwise rise by 80% in October, with the average household paying £3549 per year (150% more than in winter 2021-22). The prospect of a further 50% rise in January 2023 would mean that the average household would be required to pay 17% of its net income in the form of energy costs. To get a sense of how big this increase is in real terms, see the chart below based on calculations by the Resolution Foundation. This would make its presence felt in inflation, which the BoE estimated in August would hit 13% at the end of 2022 and would feed through to affect other prices where energy is a significant input cost. The fact that the price cap is likely to rise even more than the BoE assumed suggests that inflation would rise even further with Goldman Sachs suggesting that this could push inflation above 20% in the early months of next year.

On the basis that many businesses would go to the wall if the full costs of energy were passed on to the consumer, the government is believed to want to limit the rise in energy bills to around 27% (restricting average household bills to a still-significant £2500 per year). But this will not come cheap. It has been suggested that freezing household energy bills at current levels could cost up to £100bn (over 4% of GDP) as the government subsidises the difference between the price paid by the distributor and the consumer, with another £50bn expected for business support. What then becomes important is how the subsidy is funded. 

One option would be to levy a windfall tax on the profits of energy distributors. Since the cap is designed to limit the amount that distributors can charge per unit of energy such that their profit margin is limited to 1.9%, if the wholesale price of energy were to double, so profits also double. The case for a tax on these excess profits is appealing on social justice grounds. However, Truss takes the view that levying higher taxes sends the wrong signal for a government that wants to support enterprise. Consequently, it is likely that the government will fund the subsidy by increased borrowing. This will of course raise debt levels, and the idea that a future generation of taxpayers should fund the energy needs of today’s consumers may strike some as distasteful.

Suggestions that the Truss government will reverse the recent rises in corporation taxes and NICs in a budget later this month at a time when the public sector is desperate for additional funding does strike me as bad policy. As I have noted previously, the UK (in common with other western European nations) does not have the favourable demographic profile that will prevent tax cuts from putting a significant hole in public finances – in contrast to the 1980s. Back in 2010, Bill Gross described the Gilt market as resting on a bed of nitroglycerine. What was an inaccurate portrait of UK public finances in 2010 may be more apt description of the current situation.

The political dimension

We should also not overlook the political challenges that Truss will face. Although she won 57% of the votes cast in the leadership ballot, this was on a turnout of 82% implying that only 47% of those eligible voted for her. The fact that 53% of party members voted for her opponent or did not vote at all, is hardly a ringing endorsement. It should not be forgotten that Rishi Sunak polled more votes than Truss amongst MPs in each of the five ballots prior to the final one amongst party members. Although the Tories will present a unified face  in public – at least for a while – there is little doubt that the Tory party remains split along ideological lines with the Brexit fissures continuing to run deep.

The ultras in her cabinet and on the backbenches continue to see the EU as the bogeyman responsible for many of the UK’s ills. Truss herself has become a convert to the Brexit cause. Despite having supported Remain in 2016, she has had to continue to sound hawkish on Brexit in order to appeal to the party faithful. However, as every PM has found to their cost, tough talking is not the way to achieve success in EU negotiations. Worse still, with the global geopolitical situation increasingly unstable, it is incumbent on the UK to find common cause with the EU on a range of economic and political issues. Truss knows only too well that the EU issue has played a role, directly or indirectly, in the downfall of her three immediate predecessors. 

Whatever one’s views on Truss – and her approval ratings are not exactly stellar – voters will be hoping that she can deliver them out of the dark place into which Boris Johnson led them. Surely she cannot do worse. Can she?

Take it slow and steady

It has long been evident that we are heading for a bumpy economic landing but the BoE’s pessimistic outlook delivered in this week’s Monetary Policy Report nonetheless came as a shock. According to the BoE, CPI inflation is set for a peak of 13% by the fourth quarter of 2022 whilst real output growth more or less flatlines over 2023 and 2024 and unemployment is projected to rise. All this is taking place at the same time as the Conservative Party is set to choose a new leader – frankly, this would be a good contest to lose given that politicians are almost certain to be blamed for the cost of living crisis heading our way. 

It has become fashionable in recent months to lay the blame for the inflation surge on the BoE. Liz Truss, the current front runner to replace the hive of inactivity that is Boris Johnson, argued recently that “the best way of dealing with inflation is monetary policy and what I have said is I want to change the Bank of England’s mandate to make sure in the future it matches some of the most effective central banks in the world at controlling inflation.” I am not sure which central banks she is referring to. In the US, inflation is already above 9% and in the euro zone it is within a whisker of this rate (according to Eurostat, it is likely to have hit 8.9% in July). Admittedly Japanese inflation is at 2.2% but this is after years of disinflation with real GDP growth averaging just 0.5% per annum since the turn of the century. 

Prominent Tory politicians, such as current Attorney General Suella Braverman, have suggested that “interest rates should have been raised a long time ago and the Bank of England has been too slow in this regard.” But this is to conflate a number of issues in the monetary policy debate. In my view there are a number of questions which should be tackled separately: (i) did central banks become complacent in the wake of the GFC by holding rates too low for too long; (ii) was the policy response around the time of the Covid outbreak appropriate and (iii) would higher interest rates have prevented the current inflation spike? 

The answer to (i) is undoubtedly yes. The decline in inflation in the years prior to 2008 buttressed central bank credibility and their actions to inject liquidity in the wake of the GFC without triggering a surge in consumer prices gave rise to the view that they really had conquered inflation. Modern macroeconomics also has a lot to answer for, with the dominant paradigm in academia and central banks having little to say about the inflation process (I touch on this below but a more detailed look is a topic for another day). Thus the recent spike in prices blindsided central bankers who had, frankly, grown complacent. 

With regard to (ii) there is a valid argument to suggest that the Covid-induced collapse in output was a supply side shock to which central banks responded by stimulating demand, which was inevitably going to lead to inflation as demand outstripped supply. Admittedly, this view has only emerged with hindsight but there is a ring of truth to it (even if it is understandable why central banks reacted as they did in 2020). As to whether higher interest rates would have prevented the inflation spike, the answer is unequivocally no. Monetary policy cannot hope to impact on the type of supply shock posed by a huge rise in energy prices.

What does the empirical evidence suggest?

All of this raises an uncomfortable question for central banks which is far less clear cut than they think it is. The standard response to rising inflation is that the credibility of central bank policy requires higher interest rates to bear down on inflation expectations. The economist John Cochrane has been looking at this in a US context (a shorter overview of some of the key points can be found in this blog post). His starting point is the classic 1972 paper by Robert Lucas (even after 50 years it is still heavy going) which demonstrated that money is neutral with regard to the real economy. But as Cochrane pointed out, “our central banks set interest rates. The Fed does not even pretend to control money supply. There are no reserve requirements. We need a theory of inflation under interest rate targets.” At the current juncture, there isn’t one.

Modern macroeconomic models rely on the Phillips curve to propagate inflation dynamics (this postulates there is a negative relationship between unemployment and inflation). In Cochrane’s words, “the Phillips curve has been a disaster, especially lately” (a subject I looked at briefly here). Indeed, Roger Farmer has argued that we should replace the standard Phillips curve with a ‘belief’ function in which nominal output in the current period depends only on what happened in the previous period (see my blog post on this issue). Cochrane concludes on the basis of his analysis that there is no need for central banks to overreact to the surge in inflation: “If the Fed does nothing, inflation may surge for a while, but it will not explode. Inflation will eventually come back on its own, so long as fiscal policy does not create more inflation. The Fed’s inaction does not spur more inflation or set off an inflation spiral.”

I find this conclusion rather comforting since most of the models I have ever used demonstrated only a tenuous relationship between interest rates and inflation. The chart above illustrates the impact of a simulation exercise conducted using my structural macro model of the UK in which Bank Rate is raised by 100 bps relative to baseline and held there for four quarters. After 12 quarters, output is reduced by 1.4 percentage points relative to baseline but the level of consumer prices only declines by 0.1% (note that the impact on wages is far larger).

Another way of looking at the relationship between interest rates and the macroeconomy is to look at vector autoregression (VAR) models which capture the linear dependencies amongst time series by modelling each one in terms of past values of all series in the system. VARs are designed such that we do not need to know the structure of the economy but instead capture how changes in one variable affect other variables in the system. This makes them sub-optimal as forecasting models but very insightful as a method of assessing how shocks percolate through the economy. The model used here contains series for real GDP growth, CPI inflation, Bank Rate and the nominal sterling exchange rate index. The impulse response functions shown in the chart above suggest that the impact of higher BoE interest rates on UK inflation is limited (purists will quibble about the specification of the model and the analysis may come across as a bit back-of the-envelope).

Key takeaway

Based on the evidence, those who argue that the BoE is too far behind the curve (the same applies to other central banks) and that huge interest rate rises are needed to curb the current inflation spike are misguided. The most likely impact of such action will be to crimp economic activity thereby making life harder for those already being hit by the cost of living crisis.

As Cochrane notes: “Why do we not know answers to such basic questions? I think we have been a bit guilty of studying the world as we wish it to be rather than the world we are in.” He goes on to point out: “How is it that we’ve been playing with interest-rate based models for 50 years, yet such basic questions are still unanswered? … As I look at the effort to build monetary models based on interest rate targets, we have been guilty of playing with far too complex models that we don’t really understand.” This is not an argument for central banks taking their foot off the pedal. However, it is an argument for due care in the monetary tightening process. If the economic downturn is as nasty as the BoE predicts, the calls for rate cuts in a year’s time will start to become louder.