This piece was first published on Conservative Home – 06th September 2022 – despite its title it is more about the need for the new Government to be mindful of the febrile state of markets.
There are many target audiences that the new prime minister and Government must focus on.
A key one is the financial markets – or the ‘Gnomes of Zurich’ as Harold Wilson famously called them in the late 1960s. Then it was worries about the balance of payments that led to a devaluation of the pound against the dollar in 1967. Wilson felt this had been forced upon him.
Financial markets were very different then to now. For a start currencies were fixed, not floating. But the underlying message was the same. Economic policies needed to be credible, with Britain paying its way in the world.
Now, for the markets it is what is said as well as what is done on policy that is critical.
When he was Governor of the Bank of England, Mark Carney described the UK as depending upon the kindness of strangers. That is because Britain has a large current account deficit and thus needs to attract capital inflows.
This is not normally an issue. Indeed, the UK has often been seen as an attractive investment destination – just look at the foreign money that pours into property, as one of many examples.
But if there is a change in sentiment there can be trouble – especially if the overseas money in British assets like gilts and equites decides to leave and speculators short the pound. That is the fear now. But if they analyse the new policies on offer financial markets should be reassured, not frightened.
In contrast the euro area does not have such a current account deficit; instead, there the problems are seen within the system. Some of the individual euro countries do have deficits and in the days before the euro, for instance, the lira would have weakened, but that is not possible anymore.
Hence it is the Italian economy that takes a hit. Indeed, its income per head is lower now than at the turn of the century. Moreover, now, imbalances build up within the euro system – through Target 2 imbalances.
So flexible currencies such as sterling can sometimes help ease problems in the real economy. Fluctuations in the pound are inevitable.
The problem is if it collapsed and weakness spread across all financial assets. The media is increasingly asking if the UK faces the risk of a financial crisis. In recent weeks the pound has weakened against the dollar and the yields on government borrowing have also risen.
The combination of a weaker pound and rising yields of recent weeks is not a good sign. But the dollar has been strong against all currencies. For instance the yen has weakened to its weakest against the dollar since 1998.
The challenge for Britain. has been that the pound weakened against the euro too in recent weeks. That being said, a few weeks earlier it had been the euro itself that was under downward pressure.
Also, higher yields were not specific to the UK over the last month. Yields have risen across western markets, led in particular by the firm message from the US Federal Reserve about higher American interest rates. This has led to the expectation that policy rates will rise across many countries. Indeed the markets now think British policy rates will peak around 4.25 per cent versus their current 1.75 per cent level.
But the challenge for Britain and Western Europe is perhaps greater because of the nature of the inflation shock which has been exacerbated by the war.
Of course one must not be complacent. I have worked long enough in the markets to know that when they smell blood there can be trouble. The fact that foreign holdings of gilts and of British equites is high adds to this risk. Thus the markets will see how far they can push things.
Back in February, on these pages, I asked in a column whether a sterling devaluation was possible. That was well ahead of thinking, but it was a justifiable question at that time, as not only was monetary policy set to tighten but also the UK was tightening fiscal policy though higher taxes unnecessarily.
At that time a weaker pound seemed like a necessary shock absorber to help the economy. Now, I would argue that things are different, with a new prime minister and a welcome and sensible shift in policy.
An additional problem in the last few weeks, though, has been the perception of a policy vacuum. This has been partly because of the long drawn-out leadership campaign. It has not been helped by a lack of comments from senior Bank of England officials.
While the US Federal Reserve has been providing clear guidance there was silence and a lack of clarity here, with one deputy governor suggesting that rates could rise further now, only to say they could then fall next.
What then will the market focus on in terms of the new premier’s policy?
First, a policy towards energy prices. This is needed and it needs to be credible. The Johnson Government has already provided £37 billion of assistance this year to address the cost-of-living crisis. But as the war has persisted the energy crisis has worsened and thus further action is needed.
The good news from Truss is that news of this will be forthcoming imminently. Markets are likely to see this as positive for the economy.
Second, removing the confusion that has surfaced about the Bank is important. Everyone I speak to in the City says the same thing: the Bank has little credibility and is suffering from a communication problem. Neither is expected to be fixed.
But the market misinterpreted comments from Truss during the leadership campaign, believing that politicians were now going to set interest rates – and also that this might possibly mean rates would remain low.
Yet Truss has been clear throughout. The Bank will retain operational independence over monetary policy and would thus continue to set policy interest rates.
Of course it is clear Truss is keen for the Bank to do a better job and keep inflation under control. And she is right to think that; the City thinks the same. Thus, her welcome call for a review of the Bank’s remit. Such reviews, commonplace in other countries such as Canada, aren’t radical.
Third, is the need to use fiscal policy to stabilise the economy. Kwasi Kwarteng has said monetary and fiscal policy need to work together. He is right.
The new Government must explain the narrative to the financial markets so that they understand the new policy stance. Monetary policy needs to curb inflation, fiscal policy to stabilise the economy.
Without fiscal easing – that is sticking with current tax increases – there would likely be a deep recession. With fiscal easing – as endorsed by Truss – the recession may even by avoided, or at least be milder and short-lived. Such fiscal easing is necessary, affordable and non-inflationary.
Markets need to be convinced of the latter. The nature of our inflation shock is supply-side factors and poor monetary policy, not an overheating economy. Domestic demand is softening. Thus fiscal policy is not inflationary and should be eased.
It is also affordable. The maturity of our debt is very long term and alongside the still low rates at which the UK can borrow means that borrowing should be seen not as a constraint but as a policy option.
The new Government needs to be mindful of the febrile state of markets. This reinforces the need to articulate clearly the new policy agenda and to hit the ground running. Markets need to take note.