UK’s New Prime Minister And Her Agenda

UK’s New Prime Minister And Her Agenda

After winning Monday’s Conservative Party leadership election, Foreign Secretary Liz Truss will take over as Britain’s next Prime Minister. As energy costs skyrocket, she wants to reduce taxes while avoiding a devastating recession, which may significantly increase government spending. Keeping investor trust in the UK at a high level while implementing her objectives will be difficult. 

Truss’s priority right now is to put together an emergency policy package to solve the cost-of-living problem. New measures may be introduced as soon as this week, and a more comprehensive budget may be released later in the month.

We expect that £24 billion of the £40 billion of fiscal easing would be allocated to addressing the cost-of-living problem. The recent volatility in energy prices has made it difficult to predict how much of a hit the economy would take during the recession. However, assuming the recent rises hold, we estimate that £70 billion in cost-of-living assistance will be required. Preliminary data shows Truss would be open to funding a significant expenditure.

Campaign promises don’t often become official government policy, and Truss has changed her mind before. Still, we anticipate that she will reassess the mandate of the Bank of England, even if its independence seems safe. A shift toward nominal GDP targeting is less plausible than a reduction in the BOE’s ability to focus on the long-term effects of short-term inflation shocks. Truss’s unyielding attitude toward Northern Ireland has the potential to spark a costly trade war, and Brexit itself is still a contentious topic.

In our baseline scenario, the economy enters a recession this winter due to the spike in energy costs. We anticipate a peak-to-trough GDP fall of 1% beginning in the fourth quarter of 2022, even with much additional fiscal assistance planned.

We anticipate that energy-related inflation will push overall inflation to a high of nearly 15% in January. Due to concerns about sustained price growth, we expect the BOE to continue raising interest rates during the downturn, with rates reaching a high of 3% in early 2023. However, there is a chance that the BOE may raise rates more quickly and forcefully than we have projected, given energy price shocks are making inflation more persistent.

Considering she has ruled out a windfall tax on energy firms to mitigate the public finance effect of aiding people through the shock, it is probable that any package would dramatically deepen the budget deficit. Futures pricing indicates that high energy costs will stay until at least 2024, placing continuous strain on government coffers, which is the government’s biggest concern.

We anticipate inflation to peak at 15% this winter, and Truss has been vocal during her campaign about her frustration with the BOE’s approach to addressing this issue. To calm investors’ nerves, she said over the weekend that she firmly believes in the BOE’s independence. However, this does not prevent Truss from investigating its purview.

However, publications have suggested even more extreme measures, such as setting a goal for nominal GDP, and no viable alternatives have been proposed. As a result, we believe there will be various operational challenges, such as the selection of a goal, a lack of openness, and the inability to provide an immediate assessment of the prognosis. The main issue is that it might cause inflation expectations to become much more unsettled than they currently are, prompting the BOE to respond more harshly by raising interest rates far over 3%.

The Bank of England’s (BOE) present mandate might be tightened by switching from a flexible inflation goal to a stringent one, allowing it to concentrate more intently on inflation. In effect, this would mean doing away with the remit wording that gives the Monetary Policy Committee leeway to be more accommodating in the event of supply shocks. Since supply shocks have been more frequent over the past decade, a tougher inflation targeting regime would be simpler to execute from a practical standpoint. Still, it would force the next administration to tolerate a more significant rise in unemployment.

Truss’s liberal economic ideas will likely influence her leadership. In April 2023, the corporate tax rate will increase from 19% to 25% under her proposal. It remains to be seen how she’ll reconcile this and other prospective tax cuts with the government’s budgetary aim of putting the public debt-to-GDP on a decreasing trend by 2024-25.

The focus of policymakers will also remain on Brexit. The Northern Ireland protocol, developed as part of the Brexit deal to maintain the region’s access to the EU’s single market for goods, is becoming more contentious. Truss has spoken out against the protocol on several occasions and aims to get it removed by rescinding provisions of the Brexit deal. This process was initiated last year. The European Union has filed suit against the United Kingdom in response to what it views as a violation of international law.

Since it will take time for Truss’s bill to become law, a trade war with the EU is now a remote possibility. However, we anticipate the European Union’s response if and when this occurs. The UK’s trade picture is already grim due to the costs of Brexit, and additional knocks will only worsen matters.