Traders are concerned about the Bank of England's failure to raise interest rates fast enough, not a minor adjustment to the 45p tax band
Source - Daily Telegraph - 26/09/22
On Friday the pound fell fairly sharply against the dollar. In early trading on Monday that continued, and at one stage the pound was at its lowest ever exchange rate versus the dollar, though by late afternoon trading it was back above its Friday close. Quite a lot of the recent sterling movement has been more a story of dollar strength than sterling weakness – the dollar is strong against almost all other currencies. But, in addition, there was a fairly clear weakening that was specific to the pound, and UK gilts markets also weakened markedly, with implied sharp rises in interest rates.
Markets do what markets do: sometimes up, sometimes down. The price is just the price, not exactly “wrong” in that it’s the market equilibrium, but of course the market equilibrium might not accurately reflect what is really going to happen – sometimes traders that bet against the market make money doing so. That’s part of how markets work.
The weakening of sterling and rises in government bond yields have been going on for a while, but they accelerated quite markedly on Friday after the mini-Budget. What markets are worried about seems fairly clear and straightforward. The Government has announced a large, fairly open-ended energy package that might mean UK borrowing exceeds £200 billion per year if the Government is unlucky with gas price movements. But the Bank of England is not raising UK interest rates rapidly enough. Markets had expected rates to rise by 0.75 per cent last Thursday. They rose only 0.5 per cent and there was even one vote on the Monetary Policy Committee (MPC) for just 0.25 percent. Markets worry that the Bank of England does not have the will to raise interest rates high enough to see off inflation.
The reduced appetite to hold UK government bonds creates a further problem. A lot of bonds are held by the Bank of England under its quantitative easing (QE) programme. Falls in bond prices mean losses to the Bank of England on these bonds. The Treasury indemnifies the Bank against such losses. So when bond markets weaken that means a rise in the budget deficit. The scale is potentially very large – by some estimates, recent movements in government bond markets mean more than £200 billion in losses to the Bank of England (and thus to the Treasury), which will in due course add to the deficit.
An open-ended £200 billion (and the rest) in energy package commitments plus a further £200 billion (and the rest) in QE losses, and a Bank of England apparently unwilling to raise rates fast enough, is a bad combination. It is no surprise that the pound and bonds are dropping.
The Government is under no illusions that it is a difficult situation. It hopes that gas prices may fall back. Recently they are down from their peak in spot markets, but futures prices are still ugly. Volatility is extremely high.
So there is little point in attempting to announce, now, a package of tax rises in future that might cover this energy package. That could easily be counterproductive – either vastly too high or vastly too little in the way of tax rises, depending on gas price movements. A short wait to see how things go before deciding what’s needed makes perfect sense from a policy perspective. But it leaves traders naturally nervous. Looking further ahead, how much taxes need to rise to cover the energy package may also depend on how successful the Government is in its target of raising the long-term growth rate of the economy.
What should be clear to anyone is that, in the context of over £400 billion in deficit-driving factors, a £2 billion cut in the top rate of tax is barely more than a rounding error. Twitter’s hysterical conclusion that market movements were some kind of response to the abolition of the 45p rate would be comical were the pressures on policymakers not so serious at present. Whatever else is going on in the complexities of market movements, we can be confident that a measly £2 billion top rate tax cut is neither here nor there.
The Bank of England needs to raise rates more aggressively at its next meeting. It was a mistake to declare its independence “sacrosanct”. The status of the MPC and its members will have to be reviewed in due course if their performance does not improve dramatically. And the Government will have to spell out more details of its deficit correction plans later in the year, alongside detailed, credible scenarios for gas prices and for its progress in raising the long-term growth rate.
But for now markets will do what they do. The government should not panic. It should focus on getting the long-term policies right. No emergency responses are required, despite all the noise the panic-mongers make in demanding them.
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