A high-inflation environment will create significant issues for the Bank of England, which will likely have to raise interest rates more than initially anticipated
New fiscal amendments will not prevent the UK economy from falling into a recession in 2023 and will likely push the Bank of England (BOE) into further monetary tightening that will add to the rising cost of borrowing and further depress both B2B and B2C demand. Short-term fiscal changes, which are likely to be revealed in the upcoming Autumn budget, will likely include fiscal consolidation that will introduce targeted cuts to public investments, social spending, and the budgets of selected ministries, likely significantly reducing B2G demand opportunities. MNCs need to monitor future fiscal announcements closely, as they will be indicative of the size of the opportunity across all customer segments. Additionally, executives should work closely with local partners, who are set to experience rising borrowing and operational costs, and revisit their scenario planning results, which may help soften the impact of the upcoming demand shock.
Overview
- The government revealed what it dubbed a “mini budget” in September, which includes a number of tax cuts, including a controversial cut to the higher-income tax rate bracket to 40% from 45%.
- The negative reaction of financial markets, sparked by the likely need for greater public borrowing and concerns regarding higher inflation, has led to significant pressure on both the GBP and government bonds, forcing the BOE to intervene on the secondary market.
- Much of the panic was also caused by the refusal of the government to request independent forecasts from the Office of Budget Responsibility (OBR) and publish them prior to unveiling the fiscal changes.
- The prospect of rebellion within the Conservative ranks, as the party sank in the polls against Labour, has forced Chancellor Kwasi Kwarteng to backtrack on plans to cut the income tax rate for top earners.
Our View
In its current form, the “mini budget” will likely cost around GBP 45 billion, which comes on top of the at least GBP 100 billion in additional funding to be provided to cover the energy price cap for households. While FrontierView expected renewed pressure on the GBP even before details about the new fiscal package were announced, the depreciation of the currency was much higher than anticipated in light of the significant tax cuts and the failure of the package to address inflation and recession concerns. Additionally, the U-turn on scrapping the income tax cut for top earners will have little effect on the overall sustainability of the budget, given that it will likely reduce its cost to public finances by only GBP 2.0 billion, likely meaning further fiscal consolidation is needed. The government has signaled that it is considering social spending cuts and maintaining broad, long-term fiscal spending plans (2024–2025), which essentially equate to a cut in spending in real terms, as these were laid down before the surge in inflationary pressures. The government will also likely consider short-term cuts to convince markets of the feasibility of its fiscal package, which might risk renewed pressures from backbenchers once the package is presented to parliament. In short, the fiscal reform, in its current form, will not prevent the UK from experiencing a recession throughout 2023 and will not have a significant, positive impact on real consumption, but it will feed into the already-high inflationary environment that is expected throughout next year.
This high-inflation environment will create significant issues for the BOE, which will likely have to raise interest rates at a higher rate than it initially anticipated. Our own expectations were relatively hawkish, and we had forecasted the interest rate to reach 2.5–3.0% by the end of Q1 2023. As it stands, the rate now is more likely to reach 4.5–5.5% by the end of March 2023, assuming that the government introduces more fiscal adjustments to calm markets. While the GBP has regained some ground and should strengthen further with the BOE’s tightening, the currency will remain significantly below its average 2022 rates, coming to 1.16 to the USD for 2023, which will further add to elevated inflation and bite into households’ purchasing power.
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