The rout in Cable says more about the BoE than the UK budget

Why the UK might become the poster-child for NGDP targeting

Sep 27, 2022

The collapse in Cable to record lows is widely seen as markets reflecting adversely on the UK mini-budget. But it is arguably more a commentary on the risks associated with the BoE’s tightening cycle.

There is no shame in underperforming the big dollar in the wake of last week’s FOMC meeting. Everyone is doing it, although GBP is obviously underperforming more broadly. SEK’s underperformance was worse, despite (or perhaps because!) of its own 100 basis points of tightening. And let’s not forget JPY (YTD). Market positioning might also have been a factor:

Normally, we would expect a fiscal expansion to be a positive for the exchange rate. In this case, however, expansionary fiscal policy is seen adding to the BoE’s tightening task, amplifying recession risks. In other words, markets are pricing-in an even bigger risk that the BoE will over do it. With UK nominal GDP running at just over 9% at an annual rate in Q2 compared to real growth of 2.9%, the UK clearly has an excess demand problem:

The market reaction at least implies that markets think the pro-growth measures will, in fact, be pro-growth, at least on a short-term basis. Given all of the historical complaints about ‘austerity’ budgets, one wonders whether markets would have been more enthusiastic about a contractionary budget? The full budget statement on 23 November may well contain measures that tighten-up on spending, so that will be an interesting test of the symmetry of the market response. Unfortunately, the BoE MPC next meets before then on 3 November, when it also releases its November Monetary Policy Report.

A fiscal tightening might ease the pressure on monetary policy, but only in so far as it delivers a hit to growth. If recession risks are the thing bothering markets, or GBP in particular, then the fiscal-monetary mix that delivers that outcome seems like a second-order issue. I would rather fiscal policy focus on supply-side issues than on ham-fisted attempts at demand management.

When Boris Johnson’s leadership was under attack, GBP sold-off, not because markets loved Boris, but because his leadership problems were seen as a positive for Labour’s election prospects. It could be that markets view recession risks through the same partisan lens.

The most problematic measure is the one that makes the UK budget hostage to gas prices. But there was always going to be a hit to the budget in trying to insulate households and business from the energy shock. The UK is hardly alone on that score. My own preference would be some combination of direct fiscal transfers and tax relief so that energy consumers still receive the price signal from higher energy prices, but are cushioned by offsetting fiscal measures.

An unfunded fiscal expansion obviously raises issues about fiscal sustainability and Ricardian offset, which in turn can be expected to undermine its effectiveness in stimulating growth. Yet the associated budget measures are for the most part not bad supply-side policy and may have some positive supply-side impacts that should moderate any inflationary implications. Unfortunately, it is more straightforward to estimate the implied demand stimulus than the dynamic supply-side effects, so markets run with the more straightforward piece of analysis.

The BoE has front-run the global tightening cycle. It was meant to start active QT through selling gilts this month. If it delays the QT program some will see that as fiscal dominance of monetary policy, but I think it is more an implicit recognition of the risks of over-doing the tightening cycle.

The UK has big supply-side problems. Investment, productivity and per capita GDP growth have all been weak in an absolute and relative sense in recent years. Brexit has inevitably increased economic policy uncertainty, which is lethal to business investment. The regulation of the supply-side of the UK housing market has immiserated the middle-class. Given this context, one would have thought that a supply-side oriented budget statement would be welcome, even if there are doubts about the effectiveness of individual measures. You might say it’s all too little and too late, but I would argue better late than never.

In her run for the Tory leadership, Liz Truss suggested that the BoE’s inflation targeting framework should be on the table for review. She has also expressed support for nominal GDP targeting. UK monetary policy was last reviewed in 2013, so a review would seem timely, particularly in the context of a big miss on the inflation target. If the BoE does tip the UK into recession, it would not be surprising to see alternative monetary frameworks seriously considered in the context of that review.

ICYMI