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Will new UK fiscal plan restore credibility?

October 17, 2022

The British pound has rebounded and borrowing costs dropped for the UK government after Treasury chief Jeremy Hunt shredded the controversial "mini-budget." But some economists think the country isn't out of the woods.

The skyline of the Canary Wharf financial district in London on October 7, 2022
The UK's plan for unfunded tax cuts sparked a run on the pound and hurt pension fundsImage: Alberto Pezzali/AP Photo/picture alliance

Financial markets reacted positively Monday after the United Kingdom's new finance minister ripped up Prime Minister Liz Truss' tax-cutting economic stimulus package.

Chancellor of the Exchequer Jeremy Hunt, who was appointed to the role only on Friday, said he was scrapping "almost all" of the unfunded tax measures, saying "stability" was now the government's No. 1 focus.

In the three weeks since it was announced, the controversial so-called mini-budget sparked chaos in the financial markets, causing a run on the pound and sending British pension funds to the brink of insolvency. The crisis required the intervention of the Bank of England (BoE), the UK's central bank.

UK Finance Minister Jeremy Hunt takes part in a TV interview on October 15, 2022
UK Finance Minister (Chancellor of the Exchequer) Jeremy HuntImage: Chris J Ratcliffe/Getty Images

Why tax cuts during high inflation?

"It was a blatant misjudgment by the British government to want to implement such a debt-financed fiscal policy in an environment of high inflation," David Kohl, chief economist at the Swiss private bank Julius Baer, told DW.

Kohl said the UK was alone in trying to cut taxes, having just spent tens of billions on COVID subsidies while offering billions more to offset the skyrocketing cost of energy.

Before Monday's announcement, Truss had already U-turned on the most vexing part of her government's proposal — the removal of a 45% tax band for the wealthy during the worst cost of living crisis in decades.

As well as scrapping other tax cuts including a 1% saving for all taxpayers while proceeding with a plan to hike corporation tax to 25%, Hunt curbed the government's flagship energy price freeze —  a measure that caps annual utility bills for the average family to 2,500 pounds ($2,858, €2.911).

The measure will now only run until April next year instead of late 2024, costing taxpayers significantly less than the expected 100 billion pounds.

Labeled the worst fiscal policy error in decades, the UK mini-budget caused such turmoil that Truss was forced to fire her original finance minister, Kwasi Kwarteng, barely a month into the job. The loss of investor and public confidence has sparked speculation that the prime minister, who only took office herself on September 6, will be next.

Is Hunt now running the show?

"Pretty much everything she [Truss] has done in the past 42 days has now been reversed by Hunt over a long weekend," said Paul Dales, chief UK economist at the London-based Capital Economics.

Dales wrote in a research note that Hunt's decision would reduce the 72 billion pounds fiscal hole to 40 billion pounds. He said that the relief in the UK gilts (British government bonds) market as a result of the U-turn could reduce government borrowing costs by between 7 and 16 billion pounds.

Pound rallies, bond yields fall

The UK currency rallied by as much as 1.4% on the about-face, having regained almost a tenth of its value since almost hitting parity with the US dollar after the unveiling of the mini-budget. Yields, which move inversely to prices, on the 30-year UK bond fell sharply to 4.37%, having veered above 5% at one point last week.

Victoria Scholar, head of investment at Interactive Investor, said the markets were "responding positively" to the new chancellor's policy reversal. She said Hunt's focus on reassuring the markets and reinstating confidence appears to have worked so far.

Chris Beauchamp, chief market analyst at IG, said investors see Hunt as more of a "safe pair of hands" and "for now the market seems happy to give the new chancellor time and space to put the government's house back in order."

More financial headwinds approach

Other analysts, however, warned that the UK's reprieve may only be temporary amid stubbornly high inflation and a looming recession.

"Trussenomics may have been ripped up and fed to the shredder but the author of the big gamble remains in power, and has the final say on the direction of travel," said Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown.

"Investors are craving more stability but, given the flip-flopping we've had so far in her super-short tenure, economic policy uncertainty remains and that's likely to be the key driver in the bond markets and on foreign exchange desks," she said.

Abrdn Investment Director James Athey said his firm was still betting against the UK pound.

"Sterling is still on very shaky ground given the extent of our current account deficit and indeed the credibility hit that UK assets will have taken in this recent turmoil," he wrote in a message. "Many of the economic and policy concerns which we had a month ago before all this blew up still remain."

Shore Capital’s consumer analyst Clive Black told Bloomberg News the watering down of the energy cap would hit disposable incomes, cutting company earnings amid falling economic growth.

"If energy prices remain anywhere near where they are now then expect carnage in household and business finances from spring next year," Black said. 

A customer shops at a Sainsbury's supermarket in east London on February 13, 2022
UK inflation hit 10.1% in September, with even higher energy and mortgage costs expected to biteImage: Tolga Akmen / AFP via Getty Images

Is Austerity 2.0 on the cards? 

Hunt is still due to deliver a fuller medium-term fiscal plan as scheduled on October 31, which many analysts say will likely herald a new era of deep austerity.

"There will be more difficult decisions I am afraid, on both tax and spending, as we deliver our commitment to getting debt falling as a share of the economy over the medium term," Hunt warned Monday.

There has been speculation that critical areas like defense, health care and education will face painful cutbacks.

The Conservative government of former prime minister David Cameron was widely criticized for its first round of austerity measures in the wake of the 2008/9 financial crisis. His program was criticized for undoing progress in tackling child poverty, while a 2017 study in the British Medical Journal linked austerity to 120,000 extra deaths.

Political economist and economic justice campaigner Richard Murphy wrote on Twitter that Hunt's statement was "all about transferring the cost of economic uncertainty from the government onto UK households."

"Hunt might save government finances. The cost will be the most staggering personal debt crisis, with millions of victims. Callousness on a staggering scale," he warned.

Edited by: Uwe Hessler