U.K.’s New Government Announces Fiscal Contraction as Inflation Soars

• Critics fault new budget for failure to plan for long-term growth
• US quiet ahead of Thanksgiving holiday as investors anticipate lower rate hikes
• ECB policymakers show little enthusiasm for another jumbo rate increase

The new UK finance minister, Jeremy Hunt, presented his long-awaited autumn statement on the budget last week, calling for £55 billion in tax increases and spending cuts even though Britain is already in recession.

It was an effort to reverse the damage from his predecessor’s plan for £45 billion in unfunded tax cuts, which investors greeted in September by selling off UK government bonds and sterling.

Hunt’s effort has kind of worked. The pound has risen to about $1.19, moving up in anticipation of his tighter budget from the low of $1.03 in September. Yield on the benchmark 10-year government bond has moved down below 3.15% after topping 4.5% in those September days.

Michael Saunders, a former Citigroup economist who was an external member of the Bank of England’s Monetary Policy Committee until August, was quick to spot the problem in Hunt’s plan, though.

“I thought the autumn statement just had a massive big hole where a long-term growth strategy should have been,” Saunders told CNBC this week.

But this expert goes on to explain that the government had little choice in the short term, because the economy’s output potential has been permanently weakened by a combination of factors, not the least of which is Brexit.

“A part of the reason why things are so bad is because potential growth is so weak and is expected to be weak,” Saunders said.

“That’s why in the MPC’s view, even though GDP is expected to be slightly below 2019 Q4, they think the economy is in significant excess demand, in other words, has overheated, even with no growth. They think potential output growth for the next few years will be less than 1% per year.”

Hunt’s predecessor, Kwasi Kwarteng, had the right idea in wanting a fiscal stimulus for growth. He made the fatal mistake, however, of underestimating or ignoring market sensitivity to UK deficits.

Hunt’s fix is a bit of smoke and mirrors. Most of his spending cuts will come in 2025, after the general election expected sometime in late 2024. The goal was to show markets the government’s good intentions while shielding consumers from the brunt of fiscal contraction until after the vote.

UK inflation soared to 11.1% in October and Bank of England Governor Andrew Bailey warned that more rate increases would be necessary to bring it under control.

All was quiet on the western front as the United States shut down for the Thanksgiving holiday this Thursday. It is now widely accepted that the Federal Reserve will raise its overnight rate only by 50 basis points (bp) at its mid-December meeting after four 75 bp increases in a row. Depending on how inflation evolves, the Fed could ease even further next year.

Expectations for interest rate hikes at the mid-December meeting of the European Central Bank’s governing council have also been scaled back, with economists counting on an increase of only 50 bp despite ECB's insistence it will proceed with higher rates no matter how much it hurts.

In fact, recession fears are beginning to get the upper hand. Although a ferocious hawk-like Austrian central bank governor Robert Holzmann is pushing for the third 75 bp hike in a row, other policymakers are less enthusiastic.

The dovish head of Portugal’s central bank, Mario Centeno, said on Monday that even though the ECB needs to bring inflation under control, he sees a good chance that an increase of less than 75 bp could be in store for December.

ECB chief economist Philip Lane, another dove, also said on Monday that the central bank could continue raising rates into next year, but increases could well be smaller than the last two.

European inflation in October was 10.6% after the preliminary reading of 10.7% was revised downwards last week. Lane said that after the ECB has raised rates 200 bp over the past three meetings, there is little impetus for another huge hike.