UK crisis offers glimpse into future for others

By Jean Boivin and Alex Brazier | When the UK government announced new fiscal measures – tax cuts on top of already announced subsidies on households’ and firms’ energy bills [1] – the financial market went into a frenzy. It questioned the credibility of those plans. We see the package of measures – even if a small share of the tax cuts has since been rolled back – ultimately leading to higher inflation. That, plus the damage to credibility, means the Bank of England will likely have to hike interest rates further, pushing the UK into an even deeper recession.

This is a clear example of a new, more volatile regime in action. In the UK and beyond, the Great Moderation – the multidecade period of stable growth and inflation prior to the pandemic – is over. And this episode could offer some glimpses into the future for other countries. Here’s how.

The Bank of England has been transparent about the fact that, in this new regime, it faces a difficult trade-off between growth and inflation. Since the pandemic shutdowns, economies can no longer produce as much without inflation surging. So, central banks must choose: raise rates enough to get inflation back down (but cause a recession) or protect growth by not raising rates aggressively (but have to live with persistent inflation). It’s one or the other – we don’t see any possibility of a “soft landing”, where inflation comes down with only a moderate slowdown in growth. The Bank of England has acknowledged this and said it will raise rates as high as needed to push the economy into a recession and get inflation back down quickly.[2]

In that context, the government’s fiscal splurge wasn’t good news for growth. It was bad news for how far rates need to rise. Prior to the government’s announcements, skyrocketing energy prices were set to eat into household incomes and reduce consumer spending – delivering much of that recession. The Bank of England had signalled that few additional rate rises might be needed.[3] Now, the unfunded energy bill subsidies, combined with the unfunded tax cuts, will put more disposable income in people’s pockets, meaning the Bank of England will have to do more of the work to hammer the economy.

This is all a big contrast to past fiscal expansions during the Great Moderation. Back then, governments were typically increasing spending and cutting taxes to counteract falling private spending and investment. They were good for growth. Now, with an acute trade-off between growth and inflation, governments can’t dampen recessions with unfunded spending and tax cuts. Attempts to do so just make life harder for monetary policy.

Unfunded fiscal commitments can complicate matters even further for the central bank. They can actually make the trade-off between growth and inflation even starker, meaning an even deeper recession is needed to get inflation down.

The UK government’s numbers don’t add up. The tax cuts and additional spending on energy bill subsidies widen the gap even further between government incomings (tax revenue) and outgoings (public spending). See the Spending up, revenue down chart. That means more borrowing.

Going on a borrowing spree when interest rates on government debt are rising is an interesting approach.   The amount of money the government is spending on debt interest costs has already more than doubled since 2019, from £30 billion in 2019 to £70 billion in the year to August 2022.[4] In our view, this lays to rest the argument prevalent during the pandemic that governments should borrow extensively when interest rates are lower than the growth rate. Interest rates on government debt are now higher than likely growth rates. Persistent borrowing means an ever-rising debt burden.

We estimate that such borrowing could be sustained only if the UK economy returned to pre-2008 growth rates.[5] That is the government’s aspiration, according to its recently published Growth Plan. But it’s fanciful. The policy measures needed to achieve it would take years to take effect – and the government has yet to even announce measures that, in our view, would get it there.

Markets are therefore questioning the credibility of the plan and the borrowing it entails. Sterling fell (though subsequently recovered as the market anticipated sharp rate hikes from the Bank of England). And gilt yields (borrowing costs for the UK government) soared to their highest level since the depths of the financial crisis in 2008 (See the Rapid rise in UK government’s cost of borrowing chart).

This is all consistent with doubts creeping in about the government’s ultimate commitment to low inflation. Markets may fear fiscal dominance, where the government’s spending and tax plans take priority over the Bank of England’s inflation-fighting objective. The government may wish to deliberately, but stealthily, stoke higher inflation as a way to erode the value of its debts. Such risks are serious and threaten the credibility of the central bank. Those fears may have been compounded by chatter in the recent Conservative Party leadership contest about revisiting the Bank of England’s mandate.

Any such doubts can be self-fulfilling: higher expected inflation pushes actual wage and price inflation higher. To combat that dynamic, the central bank would need to generate an even deeper recession to create an offsetting squeeze on prices and wages. If that is to be avoided, the government’s medium-term fiscal plan, due in coming weeks, will need to be watertight and backed with independent economic forecasts.

Putting together that the Bank needs to do more work to generate a recession and a deeper recession might be needed to ensure inflation comes back down to 2%, markets now expect the Bank of England to raise rates as high as 6% – the highest since 2000. This steep interest rate path is a reminder of how, in this new regime, it might not be possible for central banks to get inflation down quickly. The damage might be too great.

We knew there would be growth costs. Given the production constraints countries are still facing due to the pandemic, the only way to get inflation down is with activity falling sharply. In the UK, the Bank of England estimates it would take a sharp 2.1% fall in activity next year.[6] We estimate a similar cost in the U.S.

Such high rates can come with financial stability costs, too. One obvious area of concern – for the UK and elsewhere – is the housing market. If the Bank of England were to raise rates as far as 6%, an average homeowner looking to remortgage could see their monthly repayments – already the biggest monthly expenditure for most people – as much as double.[7] It would also slow down building activity and push down on house prices. In the U.S., mortgage rates have already shot up from all-time lows to reach 6%, their highest level since 2008[8] – and are set to keep rising.

More generally, the sharp rise in UK gilt yields showed how higher rates can cause financial dislocations and disruption. Many markets have become used to low and stable long-term bond yields during the Great Moderation. In the euro area, higher rates could cause more pain for highly indebted countries. The European Central Bank has already introduced a tool[9] to protect the more vulnerable countries but we think the bar for them to use it would be high.

These concerns reinforce our conviction that central banks won’t ultimately feel able to go as far as would be needed to fully tame inflation. The damage would be too great. They will – eventually – have to give up their “whatever it takes” approach to fighting inflation, we think. That might take some time, and we expect them to inflict some real economic pain, and possible financial instability too, as they push ahead with rate hikes for the time being. But as damage materializes, we think they’ll stop.

The UK is offering us a glimpse of the future for others.