Can Liz Truss be another 'Iron Lady" of Britain?

According to Reuters, New British Prime Minister, Liz Truss faces a financial markets test. If she was planning big energy subsidies only, investors might not worry too much. But she plans tax cuts – and may pick a fight with the Bank of England (BoE) and trigger a trade war with the European Union (EU).

In many ways, Britain faces similar challenges to other European countries i.e. high inflation, rising interest rates, soaring energy prices and an imminent recession. Insofar as it stays in the pack, markets won’t single it out for special attention.

Britain faces extra risks. Inflation is particularly high, Brexit has damaged the economy and the country has a chronic current account deficit meaning it relies on foreign investors to pay its bills. Truss does not want to be part of any pack. She believes that bold supply-side reforms will launch the country onto a new higher-growth trajectory.

While that is not a bad ambition, she hasn’t presented a convincing strategy to deliver it. Rather, she looks like a populist prime minister who relishes confrontation.

According to media reports she is set to declare China a threat and has questioned Britain’s special relationship with the United States. She is also taking a hard line with the EU. She also wants to change the BoE’s mandate, which is to deliver price stability.

Up to now, Britain has been in the middle of the European herd on fiscal policy. Government debt was 100% of GDP at the end of the first quarter, not vastly above the EU’s 88%. Since last September Britain had allocated 1.6% of annual economic output to cushion consumers and businesses from the energy crisis, about the same as Germany and France, according to Bruegel, the Brussels-based think tank.

It’s still unclear what extra help Truss will give to support people with spiralling energy bills this winter. But it will be expensive. Just supporting households could top 50 billion pounds over the next year, or about 2% of GDP.

Helping businesses would require another mega-package. If gas prices stay high now that Russia has suspended some gas deliveries to Europe indefinitely, the government could face similar costs the following winter and beyond.

This bailout may end up being roughly in line with the rest of Europe. Germany announced a 65 billion euro energy package over the weekend.

The difference is that Truss will at the same time cut taxes on employment and reverse a planned rise in corporation tax, costing at least 30 billion pounds a year. And she does not seem to want to cut spending to compensate.

Truss is also dead set against funding her support package via windfall taxes on energy companies. This is a missed opportunity since the sector is set for excess profits of up to 170 billion pounds over the next two years, according to the Finance Ministry calculation.

High inflation might help the government by lowering the debt-to-GDP ratio. But this is not as much of a get-out-of-jail-free card as it is for some other countries, because a quarter of British government debt is linked to rising prices and just over a third has been bought by the BoE.

One area where Britain is already an outlier is that prices are rising faster than in other Group of Seven countries. Inflation jumped to 10.1% in July, and Citigroup analysts recently predicted it could reach 18.6% early next year.

As a result, the BoE will need to jack up interest rates sharply to re-establish price stability. It’s also minded to start selling government bonds later this month. These moves are unlikely to please Truss. Not only will they deepen the recession and hit her core voters; these will make it harder to fund a fiscal bonanza.

This could lead to further confrontation between Truss and the BoE. Although many investors agree that the central bank has been slow to nip inflation in the bud, the priority now is to bring prices under control. Financial markets will not appreciate anything that looks like tampering with the BoE’s independence.

Until recently investors viewed Britain part of the European pack. Both pound and the euro have fallen sharply against the US dollar this year – and government bond yields have been rising across the world. But there are now the first signs of jitters focused specifically on Britain. The yield spread between UK and German 10-year government bonds has widened by 0.3 percentage points in the past month. In the past 10 days, pond has fallen about 2% against the euro.

Analysts forecast proving wrong

Mass vaccinations were supposed to spur a major shift in spending away from goods, toward services. The thinking was that as more people traveled, dined out and attended entertainment venues, the less they would spend on merchandise. That would, in turn, help remove some of the strains on the supply chain., but that didn’t happen.

In part because the delta wave of the virus kept massive pent-up demand skewed toward merchandise and added further strain to supply chains.

Jobs

Another basic assumption was that as the pandemic receded and schools returned to in-person learning — freeing up home-bound parents — millions more Americans than have done would return to the job market. More workers would mean fewer bottlenecks and more supply, validating the “transitory” predictions for high inflation. The bitter reality is as of October, the participation rate, which measures those employed or looking for work, has recovered less than half of its pandemic-related collapse. 

Energy

With the fossil fuel industry having cut back investment over the years, in part amid pressure from tilt toward ESG investing and in part thanks to having over-invested in the previous cycle, energy companies haven’t been able to meet rising global demand. Labor shortages have only made things worse. This led to energy prices rising 30% from a year earlier, the largest annual advance since 2005. Gasoline is up nearly 50%. The price of electricity in October increased 6.5% from the same month a year ago, the most since March 2009.

Pricing-Power

Global competition and consumer expectations for stable prices had long eroded companies’ ability to pass along higher costs. There was no US inflation surge during the escalating tariff hikes with China, for example. But that’s all changed. Large companies have pushed through price increases after having to boost wages to lure workers, along with pay for higher input costs.

Forecasting inflation “has been incredibly challenging,” says Matthew Luzzetti, Chief US economist at Deutsche Bank AG. “And risks remain skewed to the upside for the inflation outlook.”

The Federal Reserve has been off in its forecasts just like everyone else, and will need to reassess next month, when policy makers update their projections.

Credit, though, to Lawrence Summers and Mohamed El-Erian, both contributors to Bloomberg, who have been warning of a prices problem for a while.