The writer is president of Queens’ College, Cambridge, and advisor to Allianz and Gramercy
It’s been a long time since we’ve experienced a G7 economy what the UK has been through in the past six days: disorderly moves in its currency and bond markets, loss of confidence in policymakers, direct central bank intervention in the government bond market, pressure for an emergency rate hike and a warning from the IMF.
If the disturbance is allowed to continue, the resulting adverse economic and financial effects for the UK, which are already worrying, are only just beginning.
The catalyst for this momentous time in British economic history was an overambitious policy package aimed at generating economic growth and lowering inflation. Structural reforms to boost economic growth and the stabilization of energy prices, both welcomed moves, have been accompanied by an alarmingly large, relatively regressive and unfunded tax cut.
Against the backdrop of global market jitters, this unleashed record-breaking rises in UK government bond yields, a new record low for the currency and mounting risks of market disruptions and financial mishaps. Also unusually, it led to a disapproving IMF statement that is more familiar to developing countries than to a G7 country.
The first attempt to pacify the situation included statements of holding operations by the Bank of England and the Treasury. These had some effect, but not enough to counteract the rise in yields, which in the case of the 30-years rose above 5 percent to levels last seen in 1998. The intensification of the already large and sudden market movements threatened both failures to meet collateral requests and other concerns from non-bank counterparties.
The widening dislocation of the fixed income markets has forced mortgage lenders to withdraw their product offerings at an astonishing pace. The few homebuyers who were able to take out new mortgages saw their monthly payments rise. Meanwhile, the Bank of England resisted all emergency measures, continuing to shine the spotlight brightly on the Treasury.
The central bank’s stance changed again on Wednesday as evidence of market stress mounted mounting. The BoE could no longer sit on the sidelines and announced direct market interventions through the “temporary” purchases of long-term government bonds.
Forget the fact that this explicitly goes against the intent outlined in August to sell securities (the now-delayed program called quantitative easing) and raise interest rates more aggressively, as reiterated on Tuesday by the Bank’s chief economist. Concerns over the further strengthening of policy inconsistency in the UK gave way to the immediate priority of stabilizing markets in turmoil.
It would never be easy for central banks to end too many years of suppressed interest rates and massive liquidity injections, and the adverse market conditioning they brought with them. Now this inevitably bumpy transition has become a lot harder and more consistent.
That said, what’s at stake here goes well beyond a disorderly tightening of financial conditions and a significantly higher risk of market crashes. Real damage is being done to the UK economy. The longer this is allowed, the greater the structural damage to the country’s ability to grow tall, sustainably and inclusively.
UK households and businesses are already grappling with material inflation and recession concerns – now exacerbated – the outlook of significantly higher borrowing costs and damaged wealth. The combined result of all this is yet another stagflationary blow that runs counter to the government’s basic goal of promoting growth and managing the cost of living crisis.
Fortunately, there is a way out – but the implementation window is not large and will already be closed. It consists of postponing the government’s announced tax cuts until next year and beyond; the BoE raises interest rates ahead of its scheduled November 3 meeting; the Treasury spends more time explaining how its structural reforms will boost sustainable growth; much more targeted protection of the most vulnerable populations; and close monitoring of imbalances in the non-banking financial sector.
The ever-growing comparison of Britain’s economic situation with that of struggling developing countries is troubling, both nationally and internationally. If they persist, they will further damage the credibility of policy making, making it even more difficult to restore financial stability in the context of a growing economy.
The government and the BoE must act now before the situation becomes even more problematic.