The not very 'mini' budget

Inflation, gilts and gambling

There was nothing “mini” about that budget.

Leaving aside the energy price support – and yes, I mean leaving aside what might turn out to be the largest peacetime fiscal intervention in British economic history with an estimated cost of £60bn for the next six months – the government just announced tax cuts worth £45bn by 2026/27 on their own costings. This was the biggest tax cutting budget in decades.

I, like many others, was expecting a large fiscal package. This was well above the higher end of my expectations. Huge.

But rather than just use a thesaurus to come up with synonyms for ‘big’, I thought it would be more useful to list my three big takeaways.

Inflation.

Capping energy price rises means measured inflation will be lower than would otherwise have been the case. That is self-explanatory. The Treasury’s plan for growth reckons that the intervention will lower the peak in headline CPI by around 5%. That feels a little bit high to me but definitely in the right ballpark.

But counter intuitive as it may sound, an energy price intervention that lowers the headline rate of inflation makes further tightening from the Bank of England more, not less likely.

The MPC are not hiking in response to high energy prices. They are hiking because core inflation is running at running at around 6% and they believe a tight labour market is generating domestic inflationary pressure.

As the MPC explained yesterday:

There have been further signs since the August Report of continuing strength in domestically generated inflation. In and of itself, the Government’s Energy Price Guarantee will lower and bring forward the expected peak of CPI inflation. For the duration of the Guarantee, this might be expected to reduce the risk that a long period of externally generated price inflation leads to more persistent domestic price and wage pressures, although that risk remains material.

The labour market is tight and domestic cost and price pressures remain elevated. While the Guarantee reduces inflation in the near term, it also means that household spending is likely to be less weak than projected in the August Report over the first two years of the forecast period. All else equal, and relative to that forecast, this would add to inflationary pressures in the medium term. (my emphasis)

In the MPC’s collective view – which is what matters here – the energy price support lowers headline inflation but adds to domestic inflationary pressure. That means more rate hikes.

And one rather imagines they will take a similar view of £45bn of tax cuts. I’d guess a few MPC members watching this statement might be reconsidering how they voted yesterday.

Gilts

The gilt market is not especially happy today. At the time of writing the yield on the 10 year is up 0.21% whilst most other comparable bonds are up around 0.02/0.03%. That’s a big (yes, I guess I should have looked up some more synonyms) under performance.

The reasons are pretty straight forward. Issuance this year is going to be a lot higher:

To fund the cost of this package, the Debt Management Office Net Financing Requirement (NFR) in 2022-23 has been revised upwards, from £161.7 billion in April 2022 to £234.1 billion in September 2022. This will be financed by additional gilt sales of £62.4 billion and net Treasury bill sales for debt management purposes of £10.0 billion, relative to April.

That’s £70bn more for the market to swallow this year – something not exactly helped by the Bank’s programme of quantitative tightening.

Plus of course the market is moving to price in a higher path of rates from the Bank of England.

I think it is important to be clear on the mechanism here through which fiscal expansion is pushing yields higher. It is easy to tell a story of ‘markets losing faith in UK credit worthiness”. That might generate clicks, but I don’t think it’s right.

The mechanism I see is: fiscal expansion adds to demand which pushes the BOE to tighten more which lowers gilt prices and pushes up yields. Alongside the straightforward story of gilt supply and demand.

Things can get very bad in the gilt and currency markets without the need for even scarier stories.

The gamble.

In the final analysis this fiscal event is a gamble, both economically and politically.

Stepping back, in economic terms, the government has just chosen to launch a huge demand side stimulus into an economy which has an inflation problem and where the central bank is committed to offsetting it. Yes there are plenty of supplyside reforms alongside this – but none of them will bare fruit inside the next 18-24 months.

The analogy is overdone. But this does feel more Barber than Lawson.

And it’s a political gamble too. Cutting the 45% rate of tax, abolishing the bankers’ bonus cap and cancelling a rise a corporation tax during a cost of living crisis is… bold.

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