What happened: The Liz Truss government recently unveiled a two-year cap on household energy bills and a six-month cap on corporate bills. These measures could cost £150 billion – 6% of GDP – over the next two years. Then, the new chancellor revealed tax cuts expected to amount to around £45 billion by 2026/27 as part of a ‘mini-budget’. Measures include cuts to income tax, payroll tax (National Insurance) and stamp duties, as well as the cancellation of a planned increase in corporate tax. The government also announced supply-side reforms, including the establishment of investment zones across the country, steps to increase the workforce participation rate and changes to planning laws to speed up approval of new construction projects.
Impact on the fiscal position: Since the government has not announced corresponding cuts in public spending, the fiscal stimulus is set to be financed by debt. This will lead to an increase in the fiscal deficit and public debt. In fact, over the past month, committee members revised upwards their forecasts for both indices. They now see public debt as a percentage of GDP rising to more than 100% over our forecast horizon, in contrast to last month’s forecast of a decline. Further upward revisions are expected in our November post. Moreover, gold bond yields have risen over the past week in response to the government’s plans, with the 10-year bond yield now exceeding 4%. This will increase the cost of borrowing.
Impact on monetary indicators: Reducing energy prices means that inflation is now likely to peak at just over 10% in the fourth quarter, lower than previously expected. However, the pound has fallen in the past few days due to investor uncertainty about financial sustainability. A weaker pound, along with increased demand from stimulus measures, is likely to fuel inflation in the medium term. This, in turn, will lead to further interest rate hikes by the Bank of England – including, most likely, at unscheduled meetings. On September 26, Bloomberg commented that money markets see a 165 basis point rate hike by the next BoE meeting in November.
Regarding inflation, analysts at Goldman Sachs said:
“We are now looking at headline inflation to peak at 10.9% in October, which is much lower and before its previous peak of 14.8% in January. […] A rapid deceleration of double-digit inflation amid a frozen energy bill is likely to guard against the risks of declining inflation expectations.”
Impact on GDP growth: Fiscal measures should boost economic activity in the near term given the status quo of no tax cuts or energy bill subsidies. However, households are likely to save, rather than spend, a large portion of their windfall tax gains — especially if consumer confidence remains near the current record low. Moreover, stronger monetary tightening is likely to partially offset the fiscal easing. Announced supply-side reforms can support growth in the long term, although measuring their impact is not feasible as many of them are yet to be clarified. In any case, long-term growth is expected to be well below the government’s 2.5% target.