The economics of political chaos

On 23 September, the Chancellor announced a mini-budget that set out the Government’s growth plan to incentivise economic activity. On 17 October, the Chancellor took that growth plan and reversed the vast majority of the tax measures, including the reduction in corporation tax and the reduction in income tax with the basic rate staying at 20p “indefinitely”. We now have a new Chancellor of the Exchequer in Jeremy Hunt after Kwasi Kwarteng was sacked, the 4th Chancellor for 2022. Now, of course, we even have a new Prime Minister for good measure. Those are the politics. But what of the economic impacts?

Was it actually necessary to scrap the mini budget? The last three weeks has seen politics intertwined with economics to an extent rarely seen, the last time being thirty years ago when John Major’s government was forced to come out of the EU’s Exchange Rate Mechanism, the event being infamously known as “Black Wednesday”. There are certainly some similarities, such as the panic caused in the financial markets. However, there are also a number of striking differences.

Let us look at these differences beginning with inflation. Over the last 12 months, the inflation rate has increased month on month, with a small blip in August. The September rate shows the pattern continuing at 10.1%. The factors for the rise in inflation – high and volatile energy prices and rising oil prices – remain the same but, this time, an additional factor has been the 15% rise in food prices. Nevertheless, the domestic price guarantee scheme and the Energy Bill Relief Scheme, designed to cap electricity and gas prices, were seen as stabilizing markets. However, this was based on the premise that the domestic support scheme would last for two years. At the fiscal statement on 17 October, the Chancellor announced that this would finish after 6 months only in April 2023 and then reviewed. Any chance that this would act as a check on inflation has seemingly now been removed, leaving significant question marks over the evolution of interest rates for the next six months.

Interest rates are used by Central banks as the main tool in controlling inflation. By dampening demand, there is a better chance to bring demand into balance with supply. But higher interest rates also act as a brake on investment at a time when the Government is trying to stimulate economic growth. At the moment, interest rates stand at 2.25%, high in some people’s eyes but still at historically low levels. However, the Bank of England has already given clear indications that interest rates are likely to increase by a further 0.5% next month.

As we know, energy markets have been extremely volatile for over 12 months. Beginning after the pandemic lockdowns, surging demand as businesses began to reopen led to major hikes in wholesale gas prices. As we know, this volatility has been exacerbated by the Russian invasion of Ukraine. However, looking at prices trends in the energy futures markets, August saw a high of 640p/therm after Russia shut down the Nordstream 1 pipeline but as of 19 October, futures prices fell to 185p/therm. Whilst we expect gas prices to rise for the winter months, that rise may not be as high as anticipated.

Whereas energy prices may be showing fragile signs of stabilising, that is unlikely to be the case for oil prices. In the past fortnight, the major oil producing countries within OPEC announced that production would be cut by 2 million barrels a day from 1 November. Markets reacted by increasing the price of Brent Crude by $10 a barrel in 24 hours. Cutting production by this level even as a short term measure will undoubtedly increase transport costs which are already excessive. Increased transport costs will add to existing inflationary pressures.

There are many reasons for the cost of living crisis – rising prices and wages fueling inflation, higher interest rates, volatile energy markets. September’s mini budget was intended to provide stability and induce economic growth. The fact is it has done the exact opposite. It has caused substantial uncertainty in the financial markets, costing the UK public finances billions of pounds and further increasing the pressure on business. It was inevitable that the Government would have to act and reverse many of its measures. But the impact goes further: it has increased the level of uncertainty for businesses across the country, which actually undermines economic growth.

Dr Charles Trotman is the CLA's Chief Economics Adviser