UK- Political chaos to the rescue
Former Chancellor Rishi Sunak is set to become the new UK Prime Minister following a brief leadership race. Despite the political chaos of late, the news flow has been largely positive from a policy point of view. Most mini-budget measures have been scrapped, with the incoming PM likely to be fiscally hawkish. The outlook for the economy is still bleak, but a crisis at least looks to have been averted.
What started as a financial and economic crisis with the announcement of the infamous ‘mini budget’ on 23 September, has since morphed into a political crisis – one that could ultimately trigger a historic split in the UK’s oldest ruling Conservative party. Following a brief leadership campaign, former chancellor Rishi Sunak has been chosen as the successor to the disastrous Liz Truss premiership. However, the damage the chaos of the past month has done to the Conservatives has been catastrophic – the latest People Polling survey put the party on 14%, its lowest rating in UK polling history. In the past, popularity of the party has prevented divisions from driving a split. With that popularity gone, there is little keeping the various factions together. A split could mean early elections in the UK (the next election is at the ruling party’s discretion, but must take place by January 2025). This would probably deliver a Labour government with a massive majority.
The silver lining to the political chaos is that the worst of the crisis in financial markets – and therefore the risks to the economy – now looks to be behind us. The new government is likely to be as focused on fiscal discipline as the present Chancellor Jeremy Hunt, if not more so. No government will want to risk a rerun of the financial market turmoil following the mini-budget, as the disastrous economic impact of another surge in mortgage rates would be political suicide. This is not to say, however, that things will be easy. The new government will have tough choices to make over tax and spend plans given the higher risk premium on UK government bonds – which has put a large hole in UK government finances. We estimate that, after accounting for the policy U-turns of the past few weeks, the government needs to find another GBP20bn in tax rises or spending cuts. We think this will take the form of a temporary link of working age benefits to wage growth rather than inflation – meaning a real-terms cut to benefits – alongside a curtailment in public investment. Such measures will be controversial, and mean an even bigger hit to people’s real incomes, implying a deeper recession than we expect. We will therefore be updating our forecasts when there is greater clarity over the new government’s fiscal plans. The updated plans were due to be announced on 31 October, but the formation of the new government has delayed this to 17 November.
While the policy environment is in turmoil, the economy has continued to weaken. Retail sales fell sharply again in September, with sales now running 9% below the pre-pandemic trend. This shortfall is much bigger than that seen in the second national Covid lockdown of early 2021 (3%). Consumer confidence also fell to a new all-time (40 year) low of -49, as the surge in mortgage rates following the mini-budget further dampened income expectations. Combined with the tightening in fiscal policy now on the horizon, the Bank of England is now unlikely to follow through on market expectations for Bank Rate to rise to over 5% next year. Indeed, following the policy U-turns, market expectations have already been dialled back by around 60bp, with Bank Rate previously expected to peak at close to 6% by September 2023. We expect this repricing to continue, as more MPC members join Ben Broadbent in his attempts last week to steer a pullback in expectations. In the near-term we expect the MPC to hike rates aggressively, with a 75bp hike expected on 3 November, and Bank Rate to peak at 4% in early 2023. However, the risks to this view – previously to the upside – have become markedly more balanced.