Chief Economist’s Weekly Briefing – See Saw

The limelight last week was shared by the Bank of England and the Chancellor. The former delivered another 50-point rate hike trying to stem a runaway inflation. The latter sought to add some oil into the fire, with a huge set of tax cuts. But the market’s verdict was not generous. The pound tumbled to a record low of $1.035 and the gilt market on Friday had its worst day since the early 1990s.

Go big or go home. Friday’s fiscal event was described by some leading commentators as a ‘kitchen sink’ Budget with the Chancellor throwing almost everything into it, including a wide range of tax cuts and incentives. A mini-Budget it wasn’t. On the taxation side, this was the biggest cut since Anthony Barber’s “dash for growth” in 1972 comprising £45B of measures. Most of the big-ticket items were on the menu, including corporation tax, income tax and national insurance contributions. But tax cuts have a smaller multiplier and the target of these measures – high earners – have a lower income elasticity of spending. Meaning? The not-so-mini budget will only lend a soft impetus to growth, and certainly not as much as the Energy Price Guarantee scheme.

Ain’t seen nothing yet.  The Bank of England pushed ahead with another half-a-percent interest rate hike, taking Bank Rate to a 14 year high of 2.25%.  That despite evidence of a weakening economy and cutting its peak inflation forecast to “just under 11%” following the Energy Price Guarantee.  Strikingly, three MPC members voted for an even bigger rise.  Sterling is coming under pressure.  And policymakers pledged to respond “forcefully” to signs of inflationary pressures becoming more persistent; say, due to a raft of tax cuts (more on that next).  Against this backdrop, financial markets are betting on rates soaring to around 6% next year.

Setting records. Even before the new tax cuts were announced, UK public sector borrowing climbed to £11.8bn in August – almost double the OBR’s forecast of £6bn and more than double August 2019’s pre-pandemic figure of £5.3bn. This widening budget deficit, following lingering effects of emergency governmental aid during the pandemic, has caused public sector net debt to soar to levels not seen since the early 1960s, reaching 96.6% of GDP. With interest rates rising, the costs to government are now mounting, with their debt interest already at £8.2bn, the highest August figure since records began in 1997.

Plus ça Change. For light there must also be dark; for noise, silence. And so, to counter the numerical fireworks and bombast of last week’s mini (maxi) Budget, real time UK economic data was so non-eventful as to be practically worthless. Slightly fewer firms (44%) reported either paying more for goods and services or raising the price of their own wares (20%). Online vacancies rose by 2% but are down 12% on the same period a year ago. If anything, most indicators are ever-so-slightly negative, but not so you’ll notice much. Growth is weak and flatlining. Much like the last decade then.

Falling. September’s flash PMI data suggest as much. UK’s business activity is weakening; the composite PMI fell to 48.4 in September (49.6 in Aug)—its lowest level since Jan’21—deepening the contraction. Businesses remain embattled with soaring costs, weaker economic outlook and faltering demand. Service sector resilience seems to be overturning. Services PMI switched to contractionary from expansionary territory in September (to 49.2, from 50.9 last month). Manufacturing index continued to contract but less severely than in August (48.5 vs 47.3). The further drop in GfK’s consumer confidence to another all-time low suggests that the outlook for consumption remains subdued. Let’s see if the huge tax cuts and increasing government spending would help to boost confidence this winter.

Some relief. For businesses, the situation seems to have eased just a smidge last month. Slightly lower share of UK firms (44%) reported increase in prices between August and July (compared to 46% between July and June). But more than a quarter still expect the prices of goods or services they sell to increase in October, broadly stable with September. Energy prices (46%) remain the most-commonly stated reason for considering doing so. This is despite the Energy Price Guarantee announced earlier this month. Industrial action in the transportation and mail sectors in August affected 1 in 10 businesses, with over a quarter reporting drop in turnover in August compared to July. 1 in 5 expect this to continue in October.

The end ain’t near. Leading the bandwagon of hawkish monetary policy was the US Federal Reserve. The FOMC (Federal Open Market Committee) hiked its Fed Funds rate by 75 bps, taking target range to 3-3.25%. With its third consecutive three-quarter point rise, borrowing costs are now the highest since 2008. But this is far from the end, for Chairman Powell stated the current target is the lowest level that would be considered restrictive. Indeed, Fed anticipates a further 125 bps hikes this year and one more next year. The accompanying FOMC projections downgraded the growth outlook to a feeble expansion of 0.2% this year (vs 1.7% in June).

Divergent. But for now, US economy seems to be on steadier ground than its counterparts across the Atlantic. The Flash Composite PMI improved to 49.3 in September (still a contraction though) reaching a 3-month high after previously falling to 44.6 in August. Improvements were registered in both manufacturing and services, the former expanded more robustly as new orders, work backlogs and employment grew. The latter contracted less severely due to a pickup in new orders and client demand. Meanwhile, the Eurozone is on the same boat as the UK. Composite PMI in the Eurozone fell to 48.2 in September, from 48.9 in August. In services, the PMI fell to 48.9, from 49.8 in August, while the manufacturing gauge slipped to 48.5, from 49.6 last month. Output is now clearly falling in both sectors.

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