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Doha: The United Kingdom (UK) has long had a reputation for sound policy-making, but the past few months have been a roller-coaster ride in comparison. Indeed, Liz Truss set a new record as the UK’s shortest-serving Prime Minister (PM) when she resigned after just 44 days in office. Her major policy blunder was the so-called “mini budget” which was rushed through to general scrutiny by the UK’s Office for Budget Responsibility (OBR).
In terms of policymaking, Truss’s budget was anything but “mini” as it attempted large-scale policy changes and most importantly implied wide fiscal deficits due to unfunded tax cuts. Financial markets reacted aggressively with a sharp devaluation of the GBP (Chart 1) and yields on UK government debt (gilts) rose further. Indeed, the Bank of England (BoE) was forced to intervene to save pension funds from bankruptcy as they took leveraged bets on low gilt yields.
As a result, Liz Truss resigned and Rishi Sunak took over as Prime Minister on 25 October 2022, taking over the reins of a country facing four significant economic challenges: fiscal policy tightening, monetary policy tightening, the evolving European energy crisis and Brexit-induced. Labor shortage.
First, PM Sunak, himself a former Chancellor of the Exchequer (UK Finance Minister) has already announced a significant tightening of monetary policy, effectively reversing all of Truce’s policy changes. Sunak and his chancellor, Jeremy Hunt, are seeking a combined GBP 50 billion in tax increases and spending cuts to balance the books. Whatever the details of this may include, the new budget must include significant tightening of monetary policy to rebuild the UK’s reputation. However, this will inevitably act as a significant headwind to the outlook for UK GDP growth.
Second, the highest inflation in 30 years (around 10% in September) and weak GDP are pushing the BoE to raise interest rates aggressively. A 75 basis point (bp) hike in November is likely to be followed by a further 50 bp hike in both December and February, leading to a peak policy rate of over 4% in 2023. This aggressive tightening of monetary policy will be consistent with the same. The tightening of fiscal policy noted above. Therefore, a tightening of monetary policy would also be a significant headwind for the UK outlook, with fiscal and monetary policy coming back into play rather than offsetting each other.
Third, record high European gas prices are increasing costs for producers, prices for consumers, and government spending through supporting measures such as cross subsidies and price caps. Leaving the European Union (EU) has given the UK greater policy flexibility, allowing it to be more proactive than EU countries in responding to the crisis by implementing measures to support households and corporates more quickly. However, both higher energy prices and reduced government spending are inevitably still acting as headwinds to the economic outlook.
Fourth, the supply side of the UK economy is constrained by labor shortages which are a legacy of the UK’s decision to leave the EU. The UK’s agricultural, manufacturing and service sectors were accustomed to the abundance of low-cost labor available from countries in Central and Eastern Europe.
However, that changed with Brexit, which excluded the UK from the EU’s free movement of labor policy. The global Covid-19 pandemic has exacerbated the situation and the UK is now facing acute labor shortages across many sectors of the economy. That, in turn, is causing continued upward pressure on wages and hence inflation, despite the weak outlook for demand. Therefore, labor shortages present another headwind to the UK’s economic outlook.
Overall, PM Sunak is at the helm of a country that is currently beset by several economic uncertainties that will continue to disrupt supply and demand together. On the one hand, UK consumers will face lower disposable income. On the other hand, UK manufacturers are exposed to higher costs and lower competitiveness, which affects their overall profitability. Overall, this will be negative for both consumption and investment, limiting UK growth in the short to medium term.
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