Why the market vetoed the UK budget – and what that means for the changing nature of stimulus around the world

Consider the following statement about the relationship between markets and policymakers: “(They) are separated by light years of mistrust and misunderstanding. But the reality is that the market has the final say. Wall Street votes with the upward or downward movement of stock and bond prices. Their response will ultimately make or break the President’s agenda.”

These are the words of Stuart Eizenstat, adviser to President Jimmy Carter, The hard lessons learned from his failed budget in the early 1980s (which he had to withdraw) may have served as a warning to Prime Minister Liz Truss and to Prime Minister of the Exchequer Kwasi Kwarteng. By announcing an excessive budget – with good intentions and good elements – they behaved as if we were still in the pre-COVID era, where a sluggish economy and sluggish inflation gave uncontrolled tactical stimulation.

In fact, the tactical stimulus kit that politicians have used so popularly is constantly changing and now faces difficulties not unlike those faced by President Carter. face. Market vetoes can easily offset stimulus issued by politicians, vote to reject policy efforts by tightening financial conditions through higher rates, low currencies and lower stock prices.

The market swings in the UK, an unusual rebuke from investors for an overly abusive yet business-friendly fiscal scheme, served as a reminder that the reality of stimulus was in short supply. change before our eyes. This restriction on the possibility of stimulus is not limited to the UK, nor is it limited to fiscal policy.

Budget beyond assuming the old rules

The UK economy is experiencing the worst of both the US and the Eurozone. Like the US, the country has a widespread inflation problem that has pushed Bank of England interest rates to US levels (and now higher), while the Eurozone has inflation. narrower and thus less exposed to the turbulence of the ECB’s interest rate policy. Like the Eurozone, the UK is experiencing a severe energy shock that far exceeds the energy whirlwinds in the US.

Faced with the worst of both sides of the Atlantic, the incoming government has always addressed the cost of living crisis with fiscal policy. Indeed, when Chancellor Truss announced a significant fiscal boost to capped household energy bills at £2,500 over the next two years, the market did not perform well.

However, as Prime Minister Kwarteng outlined his massive tax cut, the market fell into an abyss – 10 years in the aftermath soaring nearly 100 percentage points and at one point, the pound falling 9%.

Markets see capping energy prices as a political necessity, but the new budget has parts that beat expectations for fiscal leverage and growth, including the removal of the high income tax bracket (highly regressive). Markets may have overlooked these tax cuts a few years ago – but with inflation around 10% and economic potential under strain, they fear policies pushing demand higher and threatens to put a strain on the inflationary regime, which in turn will push monetary policy to tighten further.

Although the size of the new budget is overwhelming, the purpose of these fiscal efforts is not misguided. First, protect consumers to soften the burgeoning economic downturn and second, encourage investment to drive higher medium and long-term growth potential. A smaller package, focused on the essentials, with no diminishing gifts, could have worked. What is wrong is to ignore the new realities of constraints on stimuli.

Two lessons from the Carter budget

President Carter may have told Kwarteng that despite his bold wishes, any plan must be accepted by the market. If market makers use their veto power by selling gilts (thus pushing the market rate higher), Sterling and British equities, any positive government stimulus fiscal policy can be offset by tightening financial conditions.

And while low taxes can tempt investment, an unstable currency and financial volatility can frighten it. Not to mention the risk that the plan may not be politically viable. Although Prime Minister Kwarteng said there was “no comment,” the first lesson of limited stimulus is that the market’s reaction to policy cannot be ignored.

The second lesson is about the importance of the anchor structure of the inflation regime. Carter’s budget isn’t nearly as impressive as the UK’s (in fact, the market fire was only triggered by a new government deficit estimate) but the US inflation regime has broken down. in 1980 with inflation expectations unchecked. The administration had to withdraw the budget and send it back with cuts.

Kwarteng’s problem is quite the opposite: The UK still enjoys the luxury of anchored long-term inflation expectations, but it is his budget misalignment that has raised questions about the durability of expectations. hard to find like that. The market was right to be wary of this. Recall that the original policy of capping energy prices was not vetoed, but in a world of structural inflation risks, there is a big difference between necessity and exploitation.

The future of the stimulator is changing

In March, we debated in these pages that the stimulator was “emitting but not damaged”. Our main concern then is that – with inflation so high – the use of monetary policy tactics has been limited and deprived of a slowing economy and faltering markets. interest rate cuts were once taken for granted. However, systematic stimulus measures to support the economy in times of crisis are still doable.

What has changed? We see the UK roadmap as evidence that the constraints on tactical stimulus have clearly extended beyond monetary policy to include fiscal policy. That was pointed out by President Biden’s difficult to overcome The Better Rebuilding Act, a major spending bill focused on broad social programs and green transitions, was fueled by concerns about inflation within his own party.

However, we still think that the possibility of structural stimulation remains. If Britain were to face an existential systemic risk tomorrow, similar to the COVID pandemic, it would be difficult for markets to take advantage of their veto.

Philipp Carlsson-Szlezak is managing director and partner at BCG’s New York office and the company’s chief global economist.. Paul Swartz is a director and senior economist at the BCG Henderson Institute in New York.

Opinions expressed in commentary are solely those of their authors and do not necessarily reflect the opinions and beliefs of Luck.

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