After weeks of financial turmoil, the U.K. is expected to slide into a deeper recession than previously forecast, according to Goldman Sachs Research.
A series of fiscal U-turns on a government mini-budget and the appointment of a new prime minister, Rishi Sunak, have eased tensions in the bond market. But the country still faces — in the words of the government’s new leader — a “profound economic challenge.” A four-quarter cumulative decline in GDP of 1.6% is now expected, according to our Chief European Economist Sven Jari Stehn.
“The profound economic challenge the U.K. is facing is effectively the combination of the cost-of-living crisis, high inflation, a recession setting in and then navigating the fallout from this fiscal U-turn for the public finances,” Stehn says. We spoke to Stehn about the recent turmoil and where it leaves the U.K. going forward.
It’s been a turbulent period for U.K. financial markets. Can you give us a brief overview of what has happened and where we are at now?
We already had a very difficult macro backdrop because of the energy crisis, the slowdown of the economy and high inflation. Then the previous U.K. government moved very quickly to expand fiscal policy against this difficult backdrop. The combination of rapid and unfunded fiscal expansion made financial markets very nervous. Markets were unsure of how fiscal sustainability would be restored.
At the same time, the Bank of England has been more hesitant than most other central banks in the pace of tightening. It then faced this additional shock in government policy, so investors were made more nervous about some potentially very aggressive moves that would be needed from the BOE. We have now seen a U-turn on many of those government tax cuts, and markets have started to stabilize off the back of that.
The yields of gilts — U.K. government bonds — have made a round trip since the announcement of the mini-budget. They jumped and now they are back to where they started. What’s that telling us?
It tells us that market tensions have eased, and some normality has returned to U.K. markets. We are seeing more normalcy with gilts, and we’re seeing that in sterling too. Before things stabilized, we saw something very unusual: gilt yields went up at the same time as sterling moved down. This is a sign of a policy credibility issue and now that dynamic has basically reversed. It hasn’t reversed fully but sterling has now strengthened, and gilt yields have come down.
One of the underlying drivers of this have been that the high-risk premium — largely due to the uncertainty around the U.K.’s public finances and debt sustainability — has now partially unwound. Moreover, there has been a partial round trip on what financial markets think the BOE will need to do. The fiscal expansion caused expectations around the Bank of England’s bank rate to move up aggressively, but following the U-turn, those expectations have now been pared back.
How have your forecasts changed as a result of the turmoil?
We do think there is going to be a significant recession in the U.K. We expect four quarters of negative growth. Part of that is the weak data; part of it is that we now have less fiscal support from the government; but part of it is also that financial conditions, for example, mortgage rates, are significantly higher and tighter than they were before the mini-budget. So, some of that has now been undone, but a risk premium has remained in U.K. assets, and that will weigh on growth.
Cumulatively, we expect real GDP to decline by about one-and-a-half percent — that's relatively small compared certainly to COVID-19 or the financial crisis, and a bit more like shallow recessions. The reason for that is that there is still fiscal support via the energy price cap and households have excess savings that they're sitting on, and that they can use to offset some of the shock. However, the risk is still towards a sharper downturn. Especially if the energy price cap is discontinued after six months, instead of being there for two years. Additionally, on the energy markets, the situation now looks a bit more stable, but there is still the risk that we run out of gas, and with that we would have to ration gas during the winter, although that risk is lower in the U.K. than in the Euro area.
How has this impacted BOE policy going forward?
We think the BOE will step up the tightening pace relative to the last tightening step, which was 50 basis points. So, we expect a 75 basis points in both November and December, and that is because you have significant underlying inflation pressures. The labor market is very tight. We think the bank will respond by stepping up the pace of hiking. However, we no longer think they need to be quite as aggressive as we expected after the mini-budget. We took down our forecasts from November and December from 100 basis points each.
Now, beyond that, we think the bank will go up to a terminal rate of 4.75%, which is similar to our forecast for the Federal Reserve. But the risk here is that the BOE might end up doing less than that. For example, if the energy price cap is not extended beyond six months, then we think growth would be weaker, and in that case, the BOE would probably do less than 4.75%.
To what extent has the financial turmoil spilled over into other global markets? Or is this predicament unique to the U.K.?
The sharp selloff in gilts in the U.K. did influence bond yields in other countries, so there were mechanical spill-over effects, but these effects weren’t systemic in the sense that people didn't start to worry about debt sustainability in other countries, just because they did in the U.K. The fiscal expansion in the U.K. was specific.
But although it was unique to the U.K., that doesn’t mean there weren’t important lessons for other central banks. Sometimes central banks have to do conflicting things to make sure that you have both financial stability and price stability. So, in other words, the BOE was forced into buying gilts at a time when it really wanted to tighten monetary policy. Central banks have to be open to doing both of these things at the same time, if it's required.