While the measures in the UK mini-budget aren’t surprising, they still highlight an important shift in policy towards lower taxation, higher government borrowing and some degree of de-regulation and supply-side reform.
-- Budget highlights: The government will scrap the 45p top rate of income tax, replacing it with a 40p rate and will also cut the basic rate of income tax by 1p in the pound to 19 per cent in April 2023 - a year earlier than the government had previously committed to. Chancellor Kwarteng also said that the government would cancel its recent increase in National Insurance contributions and confirmed that there will be a cut in Stamp Duty on home sales.
-- Market reaction: At the time of writing, it looks as if the UK bond market is focusing more on the debt and deficit implications, which are more immediate, rather than on the potential growth implications further down the line. Gilts are falling sharply in price terms (which is to say that bond yields are rising) on the news of tax cuts.
-- The impact on government borrowing: Weak to half a percentage point. This is the biggest increase in long-term borrowing costs since 1998. The tax cuts, which all else being equal will reduce government income, as the UK is set to spend heavily to subsidise energy costs for consumers and businesses. The government puts the cost of the energy rescue scheme at GBP 60 billion for the first six months. A large part of this borrowing will need to be financed by selling gilts. The UK Debt Management Office increased its planned bond sales for the 2022-23 fiscal year by GBP 62.4 billion to GBP 193.9 billion.
-- Pound sterling on a weakening path: Two-year gilt yields have jumped 70 basis points higher this week, probably factoring in prospects of extra rate hikes. The energy price cap is likely to keeping a lid on headline inflation, albeit at a very high level. At the same time, this is weighing on the currency. The prospect of growing deficits has pushed the pound to the lowest level (against the dollar) since 1985. We expect Truss’s energy bill freeze to push down headline inflation. We now look for headline inflation to peak at 11% in October, lower and earlier than our previous peak of 15% in January.
-- What to make of inflation: The deceleration out of double-digit inflation under the energy bill freeze is likely to guard against risks of inflation expectations de-anchoring. At the same time, we expect the expansionary nature of the fiscal intervention to result in somewhat higher GDP growth, core inflation and wage growth over time, which raises the risk of more aggressive Bank of England rate rises.
-- Recessionary impulse coming through: It’s pretty clear that near-term economic activity is weakening. Earlier this morning, the key purchasing managers’ index for UK manufacturing fell more than expected in contraction territory, in line with our base case that recession is approaching. It’s hard to say whether the new invest zones and tax simplification will boost growth prospects in the near term, even though it’s possible that we’ll see some long-term benefits.
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