Everyone knew Kwasi Kwarteng's first tax-cutting measures would be radical.
Previous predictions for the public finances were torn up even before the 47-year-old Old Etonian entered Downing Street. The purse strings would be loosened. Households would get help paying their energy bills this winter and next, and the measures would grow the economy growing forward.
Fiscal discipline would be replaced by a gamble on growth.
But would the end result follow the example of Anthony Barber, Ted Heath’s Chancellor whose drive to cut taxes and deregulate the economy in the early 1970s ended in tears? Or would it be more like Nigel Lawson in the 1980s, whose boom also ended in bust, but not before he and Margaret Thatcher unleashed a series of reforms that turned Britain into the world's most important financial centre.
Kwarteng has written several books, including one about Margaret Thatcher's unpopular choices in the early Eighties. In Thatcher's Trial, Kwarteng describes the Iron Lady as a “leader beset by troubles”, who many doubted. The book examines six months that began in March 1981 with an unpopular budget delivered by her then-Chancellor Geoffrey Howe.
Many told her she was wrong. Three hundred and sixty four economists, including former Bank of England governor Mervyn King, signed a letter telling her as much. But two years later, Thatcher led the Conservatives to a landslide second-term election victory.
There are parallels with today. Financial markets took fright at a fiscal giveaway that relies on a bigger economy delivering the tax revenues needed to pick up the bill.
The budget, which was anything but “mini”, was not accompanied by an official forecast by the Office for Budget Responsibility (OBR) for borrowing and growth.
“Super-sized”, “maxi”, “seismic”. The chin-stroking analysis all agrees that this fiscal event represents a distinct departure from Kwarteng's predecessors.
“To adopt that market colloquialism of a ‘bazooka’ wouldn’t quite do it justice; this is more an entire artillery regiment,” said Ross Walker at RBS.
This budget had none of the tax tinkering that became the hallmark of former chancellor George Osborne, or the temporary measures favoured by Rishi Sunak. Income tax. Capital allowances. Stamp duty. Alcohol. Tax cuts were all made permanent.
The goal? A simpler and more stable system that would make Britain more competitive. The Resolution Foundation has described it as “the largest permanent loosening of fiscal policy on record”. But will the gamble pay off?
Going for growth
The Bank of England believes the UK economy is already in recession – defined as two straight quarters of economic decline. Back in August, it forecast that the economy would shrink for more than a year amid rising inflation and falling real incomes. But that was before the Government acted to cap average energy bills at £2,500, which the Bank has already said will “materially” alter its economic outlook.
The National Institute of Economic and Social Research (NIESR) says Friday's tax cuts will end the recession within days, with positive economic growth now expected in the fourth quarter. The economy is also expected to expand in 2023.
Today's recession could also be revised away as statisticians receive more data. It happened in 2012, when headlines about Britain falling into a double-dip recession were later proven wrong.
The 0.1pc contraction recorded in the three months to June is expected to be followed by another 0.1pc decline in the third quarter. This is the mildest possible recession. When it comes to GDP at least, history can be rewritten.
But the jury is still out on whether this is just a short-term sugar rush or the long-term boost to Britain's growth rate that Kwarteng is chasing.
Kwarteng has set an ambitious annual economic growth target of 2.5pc. This compares to an average of 1.8pc in the two decades prior to the pandemic. Many City forecasters had already factored in a boost to GDP from the anticipated tax cuts. Capital Economics believes Friday's measures will add up to 0.2 percentage points to Britain's growth rate in 2023, in addition to the 0.5 percentage points increase it expects from the freeze in energy prices.
Beyond the short term though, the view is less rosy.
“With the policies more focused on boosting demand, rather than supply, our hunch is that this package will not make a big difference to the economy’s long-run potential GDP growth rate,” says Ruth Gregory at Capital Economics.
Bigger borrowing bill
This is biggest package of tax cuts since the Barber budget of 1972. In the absence of any spending cuts, the Resolution Foundation believes Britain's borrowing bill will grow by £411bn over the next five years.
Capital Economics agrees. It believes the deficit will surge to £236bn this year, or 9.3pc of gross domestic product (GDP), instead of falling to 3.9pc, as the OBR forecast in March.
“This is big,” says Gregory. “At 9.3pc of GDP, borrowing would not be far off the level it reached in the wake of the financial crisis, at 10.1pc of GDP.”
The Institute for Fiscal Studies (IFS) says borrowing is expected to remain “well over £100bn per year into the medium term”, while Britain's debt mountain is expected to get even larger, growing every year over the next five years as a share of GDP.
But some borrowing may not be needed if the economy grows faster than anticipated. Treasury analysis published on Friday showed “sustainably raising annual GDP growth” by between 0.5 to 1 percentage points every year could raise annual tax receipts by between £23bn to £47bn by the fifth year.
Elizabeth Martins at HSBC says the plan is “bold, but laden with risks”.
Despite the big measures today, the Chancellor did nothing to address the phenomenon known as “fiscal drag”, which pushes people into higher income tax brackets as pay rises. Tax allowances usually rise in line with inflation but were frozen last year by Rishi Sunak until 2026.
With inflation so high, the IFS calculates that middle earners are still set to lose out, despite the massive giveaway, with only those on over £155,000 paying less tax overall.
While the Chancellor’s fiscal bazooka was met with cheers from his own benches, the mood on financial markets quickly soured.
Kwarteng had not even stepped up to the despatch box before sterling was deep in the red on currency markets, nursing a 1pc hit as speculation over the tax cuts mounted.
In the hours after Kwarteng’s speech, the losses worsened as worries over the Chancellor’s borrowing gamble grew.
Sterling plunged by more than 3pc against the dollar to hit a new 37-year low of below $1.10, the biggest drop since the early days of the pandemic. Crumbling confidence in recent months has triggered a near 20pc plunge versus the dollar and a 13pc drop against a basket of currencies this year.
Jane Foley, currency strategist at Rabobank, says the pound suffered a “battering”. But she and City traders fear it could soon slump to new lows.
“Concerns over the UK’s fiscal position combined with its recessionary outlook and extremely high level of inflation leave the pound extremely vulnerable,” says Foley.
Financial contracts suggest there is a 50pc chance of sterling now tumbling to a record low against the dollar of $1.05 by the end of the year. The odds of the pound falling to parity with the dollar have jumped to one in five this year and 40pc within the next 12 months.
Antoine Bouvet, a strategist at ING, says the market could even be “underpricing the chances of parity”, describing it as a “perfect storm” for the pound and UK bonds.
“A daunting list of challenges has arisen for sterling-denominated bond investors, and the Treasury’s mini-budget has done little to shore up confidence.”
The market turmoil spread to bond markets as investors brace for a flood of debt issuance by the UK Government.
UK debt interest costs soared to their highest level since 2011, ramping up the cost for Kwarteng of borrowing to fund his tax cuts.
The benchmark 10-year gilt yield jumped by more than 30 basis points to 3.8pc with UK borrowing costs rising far faster than other major countries in recent months. The five-year gilt yield rose at its fastest pace on record in yesterday’s rout.
Gilt yields are rising fast as Kwarteng embarks on a risky new strategy and markets expect to be hit by glut of UK government bonds. In addition to the extra £62bn of gilts that will be sold by the Government this year, the Bank of England is upping the pressure on UK bond markets by dumping £40bn of the UK sovereign debt it holds over the next 12 months.
Bouvet warns the “already impaired gilt market is no longer able to accommodate more supply” and the Bank of England’s bond sales.
“The additional borrowing comes at an inopportune time for gilts,” he says.
The stunning moves on bond markets will have huge implications for the Government’s borrowing costs.
The 0.5 percentage point increase in gilt yields since Thursday morning would add £5bn a year to borrowing alone if sustained, according to the IFS. The huge rise in gilt yields this year could add almost £20bn in debt interest costs by 2026/27, official figures suggest.
Capital Economics says: “Markets are growing ever more concerned about the longer-term fiscal outlook.
“Without a major boost to the supply-side, today’s fiscal package just means more inflation, higher interest rates and a higher debt ratio in the future.”
Rates to rocket
One man who will be scratching his head at Friday’s events is Bank of England Governor Andrew Bailey.
The huge package threatens to boost demand just at a time when rate-setters are attempting to temper it to bring down inflation. The Bank may be forced into more interest rate rises not only to battle the inflationary effects of the stimulus jolt but also to prop up the pound as its freefall gathered pace on Friday.
Markets are betting on a huge one percentage point increase in interest rates at November’s meeting. This would be the biggest hike since Black Wednesday in 1992.
It would also take the Bank’s base rate to 3.25pc and push up mortgage costs for millions of homeowners. Traders now believe the Bank will now lift interest rates to 5pc by next spring – levels not seen since before the financial crisis.
George Saravelos at Deutsche Bank believes the only way for the Bank to “regain credibility” is to raise interest rates with a “large, inter-meeting hike as soon as next week”. He says the Bank needs to send a “strong signal that it is willing to do whatever it takes to bring inflation down quickly”.
JP Morgan economist Allan Monks says: “The Bank of England will need to tighten more in order to retain as much of its credibility as possible.
“Markets expect rates to rise to over 5pc – a reaction that cannot be explained by the mechanical impact of today’s fiscal easing alone, and instead reflects a broader loss of investor confidence in the Government’s approach.”
The sharp jump in gilt yields following the statement could also force the Bank into a rethink on its plans to shed £80bn of government bonds from its balance sheet. The plans include the sale of around £40bn of gilts in a move that will put more upward pressure on borrowing costs.
Investors will be waiting some time for Bailey’s verdict on the package with the Governor next scheduled to speak in mid-October in Washington. However, Bank chief economist Huw Pill will speak early next week in what could be the first hint of how Threadneedle Street will react.