loader image

Conservative Home op-ed

Sep 20, 2022

This article was first published on Conservative Home – 20 September 2022.

Last Friday was the 30th anniversary of the day the pound crashed out of the Exchange Rate Mechanism (ERM) – Black Wednesday, as it came to be known.

Many aspects of that time are worth reflecting upon, as they may have relevance for now.

Perhaps most important is that of the need for a credible economic policy, else the financial markets will punish you.

Then, the policy of fixing the pound to the Deutsche Mark in the ERM made no sense, although at first economists and the markets thought it would work. In contrast, now, the new pro-growth economic strategy of Liz Truss makes sense, although it appears that the economic consensus and markets need to be convinced.

Black Wednesday should remind us to never underestimate the power of markets. Currently, markets are in a febrile mood.

But a welcome difference is that in 1992 it was a rigid currency peg that proved unsustainable. Now, and by contrast, we enjoy the flexibility to set economic policy to suit our present needs.

For the new Truss government, the focus is for inflation to be curbed through monetary policy by an independent Bank of England and that while fiscal discipline is essential, thus curbing public spending and bringing debt down, fiscal policy needs also to help stabilise the economy. Hence, as one example, the risk of exorbitantly high energy prices is being transferred from people and firms onto government borrowing.

Another lesson from Black Wednesday is how badly wrong the consensus proved to be, even though it was convinced it was right. At that time, I thought a sterling devaluation was inevitable, whoever won the April 1992 election. Devaluation was not the consensus view. Furthermore, it was clear in my view that devaluation would be positive for the economy, as it would not only allow sterling to fall to a more competitive level but it would allow interest rates to decline and boost the economy. In contrast, the economic consensus then was that devaluation would force rates to rise and recession to follow.

In recent weeks, the U.K. has not been able to escape global trends. The dollar is now at its strongest against sterling since 1985. This is not a uniquely British situation. In fact, the dollar is strong across the board. It is seen as a safe haven, and is also rallying, as the US Federal Reserve both hikes rates aggressively and is clear in its messaging about combating inflation.

Meanwhile, the fear of inflation and higher interest rates has impacted bond markets across all western economies, pushing borrowing yields higher. This has impacted the U.K. too, although borrowing rates are still low in real terms, that is when measured against inflation.

Markets have a few concerns. They are worried about inflation, although it looks set to peak this October around 11 per cent and to decelerate next year. Capping energy prices has helped.

They are also concerned that the economy will be hit hard by policy tightening. Also, that the combination of rising policy rates and increased borrowing means that borrowing costs could rise further and trigger a more entrenched financial market sell-off.

Monetary policy is a particular concern. The worry for financial markets is that whatever exit path the Bank takes on rates there will be problems, either because sterling will be vulnerable if rates don’t rise enough or that the economy and debt servicing will suffer if rates rise too far.

Two wrongs do not make a right. Last year, the Bank made a big mistake by not hiking rates at a time when it was clear that inflation would rise and the economy was rebounding and thus would have been able to cope. The worry is that to address their credibility gap, the Bank tightens policy too aggressively now – when the economy and markets are less able to cope.

The policy rate is 1.75 per cent. The markets expect rates to reach 4.5 per cent and remain elevated. Previous experience shows that bond markets often only settle when they are sure that the increase in policy rates is near completion, and we are some way from that.

Thus, one area that merits attention is how the Bank reverses its Quantitative Easing (QE).

Total U.K. debt is £2,712 billion. Because of QE, a remarkable 31 per cent, or £838 billion, is now held by the Bank of England. This cannot be just written off, but to reduce their holdings the Bank would need to sell gilts. Unfortunately, as they extended QE in recent years, the Bank appears not to have thought through fully their exit strategy.

The ability of the market to digest both normal gilt issuance from the Debt Management Office and also additional sales from the Bank through Quantitative Tightening (QT) is a concern. Further fiscal easing may add to such market concerns. In my view, it would be better if QT was halted for now – ideally waiting instead until the budget deficit is lower, or economic growth higher. Rates and QT are issues for the Bank.

There has also been some misplaced concern about institutions – notably about the independence of the Bank of England – but one would imagine such concerns will dissipate in time as they have little foundation.

Luckily, the Chancellor can put down a marker in his imminent fiscal event. There, in outlining the policy framework, he can also address market concerns.

For instance, the freezing of energy bills and the reversal of planned tax hikes are positive developments and should prevent the deep recession that seemed inevitable only a few months ago. Indeed, the biggest threat to public finances would have been such a deep recession.

A slowdown though is already underway, here and globally. While a recession is still possible, if it happens it would be shallower and short-lived. Indeed the jobs market is still healthy.

When it comes to fiscal policy, while the markets should understand that easing is necessary to help stabilise the economy they are worried – probably unnecessarily – that it may be inflationary or not affordable.

I have outlined here before that fiscal policy and the supply side agenda can turn the economy around – with a particular focus on boosting investment and getting incentives right.

But the Chancellor will need to outline clearly his fiscal principles, so the market understands the commitment to fiscal discipline through reducing the ratio of debt to GDP. Markers may need to be laid down to guide the market’s thinking.

It is also non-inflationary because of the nature of the inflation shock triggered by supply-side factors and that, because domestic demand is slowing, the economy is not overheating. Thus, targeted fiscal easing should not force policy rates higher than they would otherwise be.

The issue of affordability though may influence the timing of fiscal measures – such as whether plans to cut income tax, to raise tax allowances, lower high marginal tax rates and create investment zones will occur in this fiscal event or a forthcoming Budget. But such measures make sense.

Finally, one lesson of Black Wednesday was how events even early in the life of a new government can have a big bearing on the subsequent election. Then, Black Wednesday occurred soon after the April 1992 election, but its shadow was cast over the May 1997 election result. Now, with an election to be called by the end of 2024, policy needs to make a successful impact quickly.