In September of 2022, the UK’s former Prime Minister and her Finance Minister announced a mini-budget that would include major tax cuts financed by increasing the nation’s budget deficit. At a time when unemployment was almost at a record low of 3.5% and inflation was above 10%, levels not seen since the 1980s, the need for major stimulus to boost domestic demand was unnecessary.
This decision by the government saw investors flee from the UK economy and resulted in a subsequent balance of payments crisis. In the UK, 30% of the Gilt stock is held by foreigners. See figure 1
Figure 1
The UK economy is structurally weak through a combination of slow population growth and low productivity growth. See figure 2
Figure 2
Over the past 10 years productivity growth and population growth have expanded at a rate of 0.6% year-on-year (YoY). As a result of this lacklustre growth the Organisation for Economic Co-operation and Development (OECD) estimates that the potential GDP growth rate for the UK will only reach 1%. There are major concerns over the long-term price stability of the pound sterling and the UK gilts due to the weak potential growth. In the long run weak growth will limit the BoE’s ability to hike interest rates in order to combat inflation. Subsequently, there are risks that inflationary pressures could last longer than anticipated in the UK.
Recently, the BoE’s tentative estimates on inflation have shifted to a more positive view. After the chaos surrounding the balance of payments crisis of September, the BoE is predicting that inflation will fall to 5.2% in 2023, 1.4% in 2024, and 0% in 2025. The UK’s Office for Budget Responsibility (OBR) is also more positive, forecasting that inflation will drop to 3.8% in 2023, -0.1% in 2024, and -1.3% in 2025. This positive sentiment is driven by Rishi Sunak’s push for austerity and the subsequent BoE’s increased interest rate hikes. See figure 3
Figure 3
The pound had a substantial recovery from the low of 1.035 against the dollar in September of 2022 to reach a high of 1.24 in January of 2023.
See figure 4
Figure 4
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