On the 23rd of September, Kwasi Kwarteng, the newly appointed chancellor of the exchequer under Liz Truss unveiled his new mini-budget in hopes of combatting the cost-of-living problem. As promised by Liz Truss during the leadership race, the mini-budget was filled with tax-cutting policies to try and kickstart the UK economy. Some of these policies include cutting the basic rate of income tax from 20% to 19%, axing the 45% highest tax band for people who earn over £150,000, as well as reversing the 1.25% rise in national insurance. However, when the budget was announced, it had the opposite effect on the UK economy.
As shown by the graph above, the announcements caused the pound to plummet to levels not seen since the 2008 financial crisis. Therefore, this budget has had the opposite effect on the UK economy as Liz Truss had hoped, worsening the cost-of-living crisis instead of combatting it. How can a simple decrease in tax rates have such a negative effect on the economy, and what can the UK government and the Bank of England do to combat these negative effects?
Part of understanding why the mini-budget had such a negative effect on the markets is understanding the difference between fiscal policy and monetary policy. Fiscal policy is the use of government spending and taxation to control economic conditions. Monetary Policy on the other hand, as defined by the Bank of England is “action that a country's central bank or government can take to influence how much money is in the economy and how much it costs to borrow.” The bank can do this by changing interest rates as well as buying bonds through quantitative easing. The goal of the central bank is to keep interest rates at 2%. For a country to respond to a crisis adequately, fiscal policy set by the Government and monetary policy set by the independent central bank must work in tandem. However, as we will see, if these two policies oppose each other, it can lead to disastrous consequences.
On the 22nd of September, a day before the mini-budget was unveiled, the bank of England set interest rates at 2.25%, its highest level in 14 years. This signalled to the world that the UK was combatting the rising level of inflation. Because of this many expected the UK government to follow a plan of contractionary fiscal policy e.g., tax rises to work with the central bank to lower inflation, however, Liz Truss and Kwasi Kwarteng stuck to their plan of tax cuts. This signalled to the markets that the UK was not adequately dealing with the rising inflation causing a mass sell-off of the pound.
The move by the UK government to lower taxes was met with both national and worldwide disapproval with the IMF saying that “the nature of the UK measures will likely increase inequality”. The Bank of England Chief economist Huw Pill stated that “It is hard not to draw the conclusion that all this will require significant monetary policy response”. This was followed by a short-term plan by the Bank of England to purchase government bonds to increase the flow of credit to the economy.
However, the most noticeable effect of the mini-budget is on the UK population. The population was already struggling with the cost-of-living crisis caused by rampant inflation but the drop in the value of the pound will make being able to afford imported goods much more difficult. This also affects businesses, as many import their stock from foreign countries, making the cost of running their business that much more expensive. The rise in interest rate from the central bank also affected homeowners as many may no longer be able to afford their now much larger mortgage rate. Pension funds also took a blow as the value of UK government bonds decreased due to a market sell-off.
Since the outbreak of the mini-budget, the only bit of news yet to steady the ship is the plan by the central bank to buy long-dated government bonds, with nothing of substance yet to come from the Tory government. However, with Labour becoming an increasingly popular alternative according to polls, Liz Truss must come up with something soon if she wants to save both the economy, as well as her leadership.
Edited and Reviewed by Tanish Bagga.
References/ Further Reading:
· Michael Race, BBC News, 2022, “Income tax to be cut by 1p from April”, https://www.bbc.co.uk/news/business-63007219
· Bank of England, 2022, “Monetary policy” https://www.bankofengland.co.uk/monetary-policy
· Kevin Peachey, BBC News, 2022, “UK Interest Rates: How high could they go?” https://www.bbc.co.uk/news/business-57764601
· Rachel Davies, msn, 2022 “What is the IMF and what did it say about the Government’s fiscal plans?” https://www.msn.com/en-gb/money/other/what-is-the-imf-and-what-did-it-say-about-the-government-s-fiscal-plans/ar-AA12lQDj#:~:text=The%20IMF%20is%20an%20agency%20of%20the%20United,promoting%20economic%20policies%20in%20line%20with%20those%20goals.