Placing your Truss in the Bank of England Nick Keeling

As expected, Liz Truss has been voted by a small majority of a small minority to be the next prime minister of the UK. The rest of us will get the chance to vote on her record, rather than simply her promises, in a few years’ time. But what does this development mean for rates and yields?

Initially we may see calmer markets. Investors do not like uncertainty and a change in the top job, on the back of ever greater pandering to the party support, certainly prompted some concern, albeit mostly from Liz Truss herself. Her comments on reviewing the Bank of England’s independence were a concern to most economists, investors and hopefully the wider public. Some of her other fiscal policies also appear unhelpful in this economic climate, but there will be a hope that some of the more bombastic rhetoric will be toned down once away from the campaign trail.

There is no doubt that the UK has seemed like a rudderless ship since Johnson resigned, with little leadership, notwithstanding trips to Ukraine, evident through the summer. Foreign investors in particular, with a choice of international investment opportunities, don’t need many excuses to look elsewhere. Simply having a functioning and, hopefully stable, government is a step up and may reduce the volatility we’ve recently been seeing in gilt markets.

Over the medium term, the direction of gilt yields will rely on central bank policy, which will be influenced by growth and inflation (putting aside global policy influences for a second). Fiscal policy could therefore have a significant part to play. So, what has Truss said she’ll do?

The most decisive policy impact could be the pledge to help with the cost of energy bills. Some reports suggest this could take the form of the government limiting planned rises in the retail energy price cap, which would significantly reduce future expected inflation and boost growth. Truss has also promised to cancel the national insurance rise and reverse Rishi Sunak’s policy to increase corporation tax. An emergency budget has been promised as soon as possible and there are reports of the Treasury drawing up options for other potential tax cuts, including raising the higher rate tax threshold.

Of course, there is no free lunch and government borrowing could have to rise by up to £100bn to pay for these policies. Recent government borrowing figures have overshot expectations and the headroom in the OBR’s previous forecasts has likely disappeared due to higher inflation and lower growth; the war chest is close to empty. Despite the unfortunate probability of spending cuts for areas of the public sector that probably cannot afford them (yes, like local government), the majority of the funding is likely to come from borrowing. We will have to wait and see what investors think about funding higher UK deficits, but higher yields are the likely outcome.

The policies around taxation and energy bills could well reduce the depth of the recession the UK economy will experience. Allowing households to retain more money will support consumption and therefore growth. Employment will remain higher than otherwise, further supporting spending. All good news.

But not necessarily. Unlike targeted handouts for those in need, the Bank of England is likely to consider such broad-based fiscal loosening as inflationary, whether or not energy bills are frozen; the CPI rate is after all already in excess of 10%. Rightly or wrongly, the Bank believes there is a significant risk of current high inflation becoming embedded and is on a mission to make sure that this is not the case. Tax cuts will boost spending, allowing businesses to raise prices more easily and fuelling inflation. It is not difficult to see that tax cuts will therefore lead to persistently higher interest rates.

Of course, we won’t know what the potential outcomes are for rates until we see policies enacted, but at first glance the risks to our forecasts for Bank Rate and gilt yields lie on the upside.

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