UK Reaction: A (not so) Mini Budget

In today’s fiscal event Chancellor Kwasi Kwarteng set out the UK Government’s Growth Plan announcing a range of policies and large tax cuts to support economic growth and increase productivity. The government was keen to present today’s announcement as a “new era”, marking a significant shift in government strategy and embracing tax cuts and supply side reform as the Truss government embarks on their key aim of increasing UK trend growth to 2.5%. 

As expected, the fiscal event was not accompanied by analysis by the OBR; a full assessment of the impact of the polices on the public finances is expected to come alongside a full budget before calendar year end. But indicative costings show that this was a huge fiscal giveaway – allowing for the pre-announced energy measures – and far from the ‘mini’ budget that it had been labelled by some. Official estimates of the Growth plan (excluding energy bills support) is expected to cost £160 billion over the next five years (just under 6% of GDP). They also estimate that the energy bills support will cost £60 billion this financial year and we infer a further £110 billion or so for next. Overall, the scale of the tax cuts was just a little more than had been trailed, with the reversal of the National Insurance increase and reversal of the corporation tax hike forming the majority of the additional cost.

Key policies included:

• Cancellation of the planned corporation tax rise to 25%, leaving the headline rate at 19%

• Reversing the 1.25% increase in National Insurance

• Reducing the basic rate of income tax cut to 19% from 20% and scrapping the 45% additional rate of tax in April 2023

• Easing stamp duty on home purchases

• Freezing alcohol duties

• Introduction of ‘investment zones’ where businesses will benefit from additional tax incentives and lower regulation

The aim to raise trend growth through supply-side reform is laudable, but we believe that today’s package of personal and business tax cuts and the raft of micro policies to boost incentives to invest will fall short of achieving such a target. At present, we see UK trend growth closer to 1-1.25%. The focus on reforming the supply side economy is vital to increasing the trend rate of growth in the UK. To that end, the range of infrastructure and investment policies outlined including making the Annual Investment Allowance permanent, providing additional funds to support investment in early-stage companies and setting up Investment zones should be helpful in boosting productivity, which has remained subdued. We are more sceptical about the impact of the tax policies announced and believe they will have a limited impact on trend growth overall. The cancellation of the planned corporate rate increase will see the UK tax rate remain the lowest of the G20, however, investment in the UK has continued to lag peers since 2016.

The changes to personal taxation set out by the government will support real incomes, but at a time where the Bank of England continues to worry about the level of demand in the economy, these are likely to be offset by further increases in Bank Rate, limiting their overall impact on growth. Furthermore, the policies outlined by the government fail to address the challenges facing those who are most impacted by the current rise in inflation on the lowest incomes. Fundamentally, long-term growth is determined by labour supply growth, which has halved compared to the rate it was in the decades before 2008, the result of demographic change as much as anything, and productivity growth, in turn driven by capital investment. Today’s package may boost investment somewhat at the margin, helping raise productivity growth a little over the longer-term, but we suggest that trend growth will fall short of the government’s 2.5% target over the medium-term.

Impact on public finances

Today’s “Growth plan” has significant implications for the public finances. First and foremost it provides the first estimates of costings for the governments intervention in energy markets. The government estimates that the Energy Price Guarantee – the freeze in household unit rate costs of electricity – will cost £31 billion over the rest of this financial year, the Energy Bill Relief Scheme it estimates at £29 billion. We have sympathy with the difficulty in providing estimates for the costs beyond this financial year with an uncertain outlook for energy costs affecting the estimate for the household freeze and no clear policy on what the longer-term support would be for vulnerable businesses. If gas prices were to remain unchanged, compared to HM Treasury (HMT) estimates for the next 6-months, the total cost of the Energy Price Guarantee would be £124 billion. We hope that gas prices have some scope to fall over this period, which would reduce the overall cost of this package. Similarly the longer-term support to business is unknown. We had been considering the total package to be around £130 billion, but on the basis of today’s announcement a broader range to around £150 billion – around 6% of GDP – seems plausible, but as stressed by the Chancellor highly uncertain.  

Additional measures announced today are estimated to cost a significant amount extra, including £19 billion (0.7% GDP) this financial year, £27 billion next year, then £31 billion, £39 billion and £45 billion in subsequent years – over £160 billion over five years – and an increase of 1% of GDP per year rising steadily to 1.5% by 2026-27. This is a sizeable fiscal boost and in different circumstances might be expected to provide a meaningful boost to GDP. However, much as the government’s previous drive for austerity amidst a dearth of aggregate demand a decade ago was ill timed, so its fiscal largesse at a time of excess demand will struggle. The government’s intentions to boost supply side growth are admirable. However, we doubt that the £9 billion in household tax reduction and on average £20 billion (0.7% of GDP) over the next three years will provide much boost to labour supply – something that is materially affected by the UK’s demographics and to a lesser extent changes to migration. We are also doubtful that maintaining the UK’s lowest tax rate in the G20, a policy estimated to cost £12 billion next year and an average £17 billion in the next two years will have a significant impact on UK business investment, as this has already underpinned the worst business investment in the G7 over the last 7 years. As such, our concern is that much of this stimulus will boost demand, without lifting supply. As we discuss, this will likely force the BoE to tighten policy further to restore UK price stability, restraining much of the growth that this stimulus might otherwise deliver and raising the governments financing costs at the same time. 

A full estimate of the impact on the public finances will have to wait until the OBR provides its assessment later this year and it remains unclear why the government chose to enact such a broad fiscal announcement without the assessment of the independent OBR. Nevertheless, the deficit will be materially higher over the coming years and the Treasury has already indicated that gilt sales will rise by £62.5 billion and net T-bill sales by £10 billion this year. The OBR had estimated a deficit for this financial year of £99 billion (3.9% of GDP) and £50 billion next (1.9%), with the run rate of finances to date broadly in line with this year’s forecast. Measures announced today would increase this by around £100bn this year and £120 billion next. Admittedly, a lower inflation outlook after the energy packages will reduce some of the governments funding costs, but the broader rise in gilt yields will lead to an increase in others. Hence while we will await the OBR’s estimate later this year, an expectation of public deficits of around 8% of GDP this year and 6½% next seem plausible. In terms of debt, this reduces the chances of debt to GDP falling over the next couple of years and depending on where longer-term rates settle, could see UK debt settling around the mid-90%s of GDP, compared to current OBR forecasts of it falling to the mid-80%s by the middle of the decade.

BoE poised to step up the pace of tightening 

The additional fiscal stimulus to bolster economic growth jars with the BoE’s aim of tempering demand to ensure inflation falls back to target in the medium term and will likely see the BoE hike more, we add in a further 50bps of total rate hikes and now expect rates to reach 4.00% compared to 3.50% prior to today’s announcements. We now expect the BoE to hike Bank Rate by 75bps in November. We had expected the Monetary Policy Committee to hike by 75bps yesterday. The committee opted for a 50bps hike, but 3 members supported a 75bps hike, while minutes highlighted that some members were awaiting a full assessment of the government’s fiscal policies at the time of the November Monetary Policy Report (MPR) to incorporate this fully into their rate decisions. We expect the MPR will show the policies bolstering growth and medium-term inflation  and will add to arguments for higher rates and for the frontloading of rate hikes, although the call between 50bps and 75bps will remain close. In addition to expecting the BoE to move by 75bps in November, we now expect a 50bps hike in December and 25bps in February and March. This remains far short of market expectations, which now expect rates to reach over 5.25% by August next year. However, we think that signs of UK recession over this winter and associated easing in the labour market already play on the Bank’s mind and mindful of not overshooting the inflation target too much to the downside in 2024 and beyond the Bank is likely to deliver somewhat less easing than currently envisioned.  

Markets reaction to the fiscal largesse

There were huge moves in bond markets following the announcement. Gilts sold off sharply following the government’s announcement, with expectation of Bank Rate rising higher. 2-year gilt yield jumped nearly 50bps at their peak, but currently trade 33bps higher at 3.82%, 10-year gilts also moved higher increasing by nearly 40bps and are currently 25bps higher at 3.72%. In currency markets, sterling initially gained against the dollar and euro, but has since fallen back dropping to be 0.7% lower to the dollar at $1.107 – close to a 40-year low. The pound has also fell against the euro by around 0.8% and is now trading at £0.881 – its weakest since February’s 2021 when the UK was in winter lockdown.