Newly appointed UK chancellor Kwasi Kwarteng — the third person to hold the post so far this year — presented his bumper mini budget to the House of Commons on Friday morning.
Alongside the biggest tax cutting spree for 50 years, Kwarteng confirmed the cost of freezing the UK’s energy price cap.
Spiralling energy bills have helped to propel UK inflation to an almost 40 year high of 9.9% in August. The government hopes that its energy support measures could reduce the prospective peak inflation by five percentage points.
The average annual residential energy bill will rise to £2,500 on October 1 and remain there for the next two years, a saving of £1,000, according to government analysis, as a result of the support.
This is expected to cost the government £60bn over the next six months, with the full cost of the package not yet known. This funding will be provided through elevated Gilt issuance.
In response, the UK Debt Management Office has piled on an additional £62.4bn of Gilt sales for the 2022-2023 funding year, a 50% increase on what was unveiled after the Spring Statement six months ago.
The Spring Statement promised a return to a pre-Covid level of funding, with the £124.7bn forecast falling in line with the £125.5bn annual average in the five years before the pandemic.
But instead, Kwarteng and his boss, the new prime minister Liz Truss, have opted to continue the elevated post-pandemic funding volumes with their Gilt-fuelled cap on energy prices.
Of course, the £193.9bn of expected funding pales in comparison to the £485.8bn printed during the height of Covid, much of which went to funding the furlough scheme.
However, unlike in 2020-2021 there is no central bank buying scheme to swallow up the deluge of supply. To the contrary, the Bank of England is set to start selling off its £758bn of Gilt holdings from October 3, offloading £80bn over the next year.
The UK now faces the prospect of funding in a market free from the support of the central bank, with investors left to pick up the slack.
Of course, other plans for financing the energy price cap were floated before the government sunk them.
Former Shell employee Truss has refused repeated calls to tap the extraordinary profits made by companies like her former paymasters.
Although former chancellor Rishi Sunak introduced a one-off windfall tax on energy profits in May, which is expected to bring in £5bn during the following year, an extension or expansion was shot down by Truss on her second day as prime minister.
BP reported its largest quarterly profit since 2008 during its second quarter earnings, making $8.45bn. Shell and Centrica both reported high profits of their own during the period. The bulk of the profits earned during this quarter falls outside the remit of Sunak’s windfall tax.
Doomed to repeat it
A slew of tax cuts will heap further pressure on to the UK’s purse at a time when funding costs are spiralling upwards.
Ahead of the mini budget, analysts at the Institute for Fiscal Studies said that the anticipated reversal of the National Insurance rise, confirmed by Kwarteng on Friday, would lead to a £30bn drop in government revenue.
The 1.25% rise was introduced during the last prime minister Boris Johnson’s tenure with the aim of financing health and social care. Instead, Kwarteng stated these costs will be made up through general taxation — despite his plans to slash taxes across the board to stimulate growth.
The basic rate of tax rate was cut 1% to 19% and the 45% higher rate of income tax was abolished in favour of a single 40% rate. Meanwhile, next year’s rise in corporation tax from 19% to 25% was cancelled.
These cuts are the largest since Anthony Barber’s “dash for growth” budget in 1972 — the “worst of modern times,” according to Paul Johnson, director of the Institute for Fiscal Studies.
Much like Truss and Kwarteng, Conservative chancellor Barber and his prime minister Edward Heath faced a looming election and stagnating economy, with the budget expected to pull the UK out of its rut.
Instead, inflation spiralled and the newly - and supposedly temporarily - floating pound took a pummelling. The 1973 oil crisis further fuelled inflation, while repeated miner and train strikes forced Heath to implement measures to restrict the consumption of electricity.
A general election followed in February 1974, ushering in a Labour-led minority government, which went on to secure a slim three seat majority in a further general election just under eight months later.
To some, the UK looks set to repeat history — repeated rail strikes this year have brought the country to halt, the price of gas has rocketed after Russia’s invasion of Ukraine and after Friday’s budget the pound has taken a beating.
Picking up the slack
Cable hit a 37 year low moments after Kwarteng concluded his debut budget, with sterling initially slipping below $1.11, having dropped $0.05 in the 17 days since Truss became PM. Analysts at Rabobank expected the pound to slip further, anticipating $1.08 on Friday, but it surpassed even these expectations, falling to a record low of $1.03 on Monday.
Furthermore, while sterling slipped, Gilt yields soared. The return on the five year note jumped just over 57bp on Friday morning, propelling it to 4.13%. Paper in the same tenor started 2022 with a yield below 1%.
A weakening currency and rapidly rising bond yields will put the UK’s finances under immense pressure at a time when it is needed most to alleviate a once in a generation cost of living crisis.
“With the cost of the energy price guarantee highly dependent on wholesale energy prices, investors are worried the Treasury has effectively committed to open-ended borrowing,” said analysts at ING.
Such borrowing is at odds with Kwarteng’s promise to cut the UK’s debt to GDP ratio, a plan for which is expected before the end of the year.
Despite a sharp rise in borrowing, the Bank of England has affirmed its commitment to its mandate, stating on Monday that it will not hesitate to intervene in the market if needed.
The bank suggested a willingness to step in to maintain its 2% inflation mandate, stating that it will raise rates if required in an attempt to calm a spooked market.
These spooked markets must remain on the side of the Debt Management Office if it is to meet the elevated funding needs set out by Westminster.
The UK is reliant on the “kindness of strangers,” former Bank of England governor Mark Carney said in 2017, suggesting that the country depends upon on foreign investors to fund its historically large deficit.
With the Bank of England set to eschew Gilt buying in favour of selling, the UK’s bumper borrowing will be every more reliant on this kindness — and it must avoid tarnishing its reputation to keep investors coming.
This article was updated on September 27 to reflect the UK's worsening situation.