The Daily Telegraph
The next prime minister must act quickly to reassure the markets
Simply ending the Tory leadership contest should ease investors’ nerves and work can begin in earnest
‘Extracting a stronger commitment from the Bank to get inflation back on target could enhance credibility’
The financial markets are nervous. Investors are demanding a higher yield for holding UK government bonds (gilts) and the pound has continued to slide against the US dollar. It is still too soon to talk of a “sterling crisis”. None the less, the heightened political uncertainty and large current account deficit could make UK assets particularly vulnerable to any loss of confidence.
Fortunately, the risks here are smaller than many seem to think. It is important first to put the recent market jitters in perspective.
Over the last month the yields on 10-year gilts have jumped by about one percentage point. But the yields on German bonds have also risen sharply, by around three quarters of a point.
This difference is small and can largely be explained by the fact that investors are even more worried about the prospects for the German economy. UK yields also remain lower than those in the US, and real interest rates (after allowing for inflation) are still negative. Crucially, these moves are being driven by changing expectations for inflation and for official interest rates. There is no sign that the sell-off in the gilt market is a reflection of serious concerns about the credibility of policymaking, or the creditworthiness of the Government.
The fall in the pound should be put in its proper context, too. This is still primarily a story of dollar strength, due to the US economy’s lower exposure to the energy crisis and the more aggressive increases in interest rates. Consistent with this, the US currency has also risen sharply against the Swedish krona and the Norwegian krone, and is at multi-decade highs against the euro and the Japanese yen.
The pound has still underperformed against some of its peers. On a trade-weighted basis, sterling fell about 3pc in August and is down about 6pc in the year to date. But these are still small moves in the scheme of things, and could quickly be reversed.
What’s more, this underperformance is par for the course during temporary periods of uncertainty. Rishi Sunak has been seen as the continuity candidate for prime minister, at least in economic policy terms. Liz Truss has promised to do things differently and shake things up. In the meantime, the seemingly interminable campaign for the Conservative leadership has left the Government in policy limbo.
The upshot is that simply getting this process over with should ease markets’ nerves. After all, it is not as if a Truss win would now be a surprise. It makes little sense to speculate about an imminent repeat of Black Wednesday, when a clearly overvalued pound was booted out of the Exchange Rate Mechanism in 1992, or the slump in sterling following the shock vote for Brexit in 2016. Of course, there will still be work to be done to reassure the markets. Top of the worry list for many investors is the perceived threat to the independence of the Bank of England.
There is near-universal agreement that decisions on interest rates are best made by central bankers, not politicians. Ms Truss has surely now put these worries to rest. She has consistently committed to respecting the Bank’s independence on monetary policy and repeated this at the weekend. She has made no secret of her dissatisfaction with how the Bank has done what is supposed to be its primary job of controlling inflation.
It would, therefore, make sense for the new prime minister, or her chancellor, to announce an early review of the Bank’s performance, its mandate, and its accountability.
It also makes sense to keep the existing 2pc inflation target, for now. Keeping the current target would underline the message that the Bank’s independence is not under threat.
In the meantime, extracting a stronger commitment from the Bank to get inflation back to target next year could actually enhance credibility. Investors are also worried about the direction of fiscal policy and especially the risk of large unfunded tax cuts. The more hostile newspapers have been full of scare stories about a £60bn black hole in the public finances, or tax and spending commitments topping £100bn. This is flimsy stuff. The former is based on partial analysis which takes the outlook for economic growth as given (ignoring any boost from tax cuts), and which looks only at the nominal amounts of borrowing and interest payments (ignoring the fact that higher inflation will reduce the real burden of debt).
As for that latter figure, it seems to be based on topping up the costs of every policy measure that has been floated, including a big cut in the standard rate of VAT, rather than those that are actually likely to happen.
There is room for positive surprises, too. A bold plan to ease the energy crisis, with strong intervention on the supply side as well as support for the most vulnerable households and businesses, would establish the credibility of the new team. A stronger economy should then ease fears about the long-term health of the public finances, and support sterling.
It is always important to maintain market confidence. The priorities should be to reaffirm the Bank’s independence on monetary policy and provide early guidance on the new fiscal framework, including the scale of additional borrowing and new fiscal rules. But those hoping for a market crash are likely to be disappointed.