After 11 days in animated suspension amid pageantry, pomp and ceremony in which the United Kingdom simultaneously mourned the loss of a Queen and celebrated the succession of a King, it’s back down to mundane, hum-drum earth with a great big bump.
Putin’s malign inflation influence and the increasingly chaotic response
However desperate Putin’s last roll of the dice may be, as he ups the ante in Ukraine with his partial reserves’ mobilisation and (yet again) threatens nuclear escalation, his overarching strategic intention of causing dislocation in the West using energy as his weapon is certainly having a significant impact.

Politically, the fall of Mario Draghi’s technocrat government in Italy over the summer after it failed to deal with the cost-of-living crisis, now to be replaced by a far-right coalition led by Georgia Meloni of the Brothers of Italy Party, widely described as neo-Fascist, is sure to create unease among western governments both in NATO and the EU.

But alongside national energy policies which are being re-written on the hoof, nowhere is this more apparent than in economics as governments and central banks struggle to know whether to ride the boom-bust tiger, to anaesthetise it and tame it, or to prod it with a big stick and make it even more angry. These are not merely challenging times, to borrow a hackneyed phrase: they are downright bizarre. For students of rational economics brought up on the theories of Milton Friedman and John Maynard Keynes, or the philosophies of EF Schumacher and others, the policy responses of today will not be found among the conventional textbooks of our youth. What we have today is the economics of the surreal.
But the pre-2020 foundations were wobbly already
The problem is inflation. That much is obvious. But inflation is merely the visible and painful symptom of a deeper malaise whose roots go back a decade-and-a-half to the Global Financial Crisis and the subsequent conspiracy to maintain ultra-loose monetary policy with rock-bottom nominal interest rates (negative real rates) and embedding central bank liquidity injections into the economic fabric. Growth became mediocre, economies became increasingly flabby, less efficient and, despite low unemployment, productivity gradually declined leading to the erosion of real incomes. Collectively many were already in poor shape to deal with the subsequent overlapping and unpredictable exogenous shocks of a pandemic and a major war in Europe.
Central banks with the bit between their teeth pulling one way…
Last week we saw yet another entirely predictable round of interest rate rises: three quarters of a percentage point in the US to 3.25%, swiftly followed by a half-point in the UK to 2.25%. When looking at why the dollar is strong and sterling at $1.06 is relatively weak (it is not alone: the euro and the yen are weak against the dollar too) at its lowest level since the early 1980s, aside from investors intuitively gravitating in times of stress towards the perceived safety of the dollar as the dominant reserve currency, among other factors (homegrown economic risk etc, discussed later) that full point or 44% spread between the two nominal rates of return is significant. Both domiciles began the current interest rate cycle from zero; the Bank of England began raising rates in December, the US Federal Reserve (Fed) not until March. But the Fed has been significantly more aggressive since while the Bank of England has been more tentative. Currency investors chase money, momentum and margin. Plus ca change.
…while governments go the other
But while the main western central banks (the Fed, the Bank of England, and more reluctantly the European Central Bank) are committed to regaining control over inflation using monetary policy and interest rates to slow down consumer demand, most governments’ fiscal policies are pulling in precisely the opposite direction, however much they might protest that their sympathies lie with their electorates and the burden of the cost-of-living crisis. Put simply, the central banks are jamming on the brakes while governments with one eye, if not both, on their electoral prospects, still have their right foot planted firmly on the accelerator, notably in the pursuit of the Nirvana of carbon-net zero.
Interventions will have longer-term consequences, intended or otherwise
It was Ronald Reagan who famously said, ‘the nine most dangerous words in the English language are “I’m from the government and I’m here to help”’.

Adding significantly to the economic confusion is a populist plethora of direct government interventions in markets and sectors. All create further new tensions. Interestingly, it matters not what each government’s purported political persuasion or colour is, they’re all at it. Take three examples: here in the UK, ostensibly centre-right Liz Truss, the alleged heir to Thatcher, has just unveiled the UK’s biggest welfare package in history and has ‘nationalised’ the price of electricity and gas; in Germany, Olaf Scholtz’s middle-of-the-road coalition has not merely bailed out but nationalised the country’s biggest gas importer, Uniper, while simultaneously launching its own welfare package to deal with energy bills totalling €65bn (on top of the €30bn programmes announced in March) as the Bundesbank forecasts inflation topping 10% and a looming recession; in Scotland, the left-wing SNP administration increasingly in thrall to its coalition partner, has directly intervened in the domestic property market, compulsorily freezing all private and council rents for 6 months and abolishing the ability of landlords to evict tenants, even those who are delinquent. Just as the central banks have found unravelling quantitative easing a far from painless job, so removing these government-built pit-props will not be achieved without difficulty.
Truss goes for broke
This week’s UK mini budget illustrates the extent to which rational economic theory is being tested to the limit. The objective is growth, an entirely laudable aim. The means by which we achieve it are also laudable: lower taxation rates, investment incentives through new enterprise zones etc, all one would usually hope for from a Tory government. But achieving growth is a gradual process; further the ambition should be to make it relatively stable, rather than volatile (i.e. trying to avoid boom-and-bust).

The economy is already measurably slowing by central bank design (verging on recession, if not already there and predicted by the Bank of England to last possibly for five quarters) but funding costs as measured by the interest rate and government bond yields have still not peaked. As previously proposed tax rises are either shelved or reversed and short-term government revenues come under pressure to the tune of £30bn a year, at the same time government expenditure is rocketing. Already announced are the household and business relief packages to deal with energy bills totalling an estimated £175bn (you don’t get ‘owt for nowt’, you will still pay, the liability is merely delayed and spread); add to that yet more money for the NHS, that voracious consumer of cash and always hungry for more.

In the absence of any restraint on public expenditure, the stress in the system is the national debt. Already close to 100% of GDP, this ratio will accelerate quickly beyond as the numerator (debt) expands and the denominator (the size of the economy) shrinks in the near-term. And while the nominal debt is rising, simultaneously the cost of servicing it is rising too, not by percentage points but in multiples. Two years ago, the cost of the Treasury’s borrowing as measured by the yield on the UK 10-Year Gilt (government debt) was 0.1%; today it is 3.82%.
But Thatcher she ain’t
Nowhere in this new world of ‘Trussnomics’ is there (so far) any attempt to get debt back under control by curtailing government expenditure. “Austerity” was cancelled by Theresa May at the 2017 Tory Party conference, a word never to be uttered by any government minister in front of the electorate again. Faisal Islam, the BBC’s overworked economics editor, described this budget as an ‘experiment’. This is an understatement – the reality is it is much more than that. It is a very big gamble, betting against the house and putting everything on red before spinning the wheel. What the government is hoping is that time (i.e. growth) will eventually bail it out, not that the economy will crumble under the weight of its own debt. For the new Truss administration, time is finite given come hell or high water a general election will be called at the latest by December 2024. She and Chancellor Kwasi Kwarteng must be keeping every finger and toe crossed.
Brutal bonds and a collapsing currency
For investors, as ever, all of this is playing out in currencies and bond markets both of which continue to be pitched battlefields. Up to the period of the Tory leadership election, the weakness in sterling was arguably much more due to the overbearing strength of the dollar, as we discussed above. However, since then it is the markets’ lack of confidence in Kwarteng’s new economic path being appropriate to today’s conditions which has precipitated sterling’s decline towards dollar parity.

As concerns rise about western economic prospects and the lack of coherent policy, the perception of increasing risk is recognised in rising yields. We have discussed the UK Gilt. In the US, the 2-Year US government bond yield has broken through 4.3% while the 30-Year, rising too, lags behind at 3.67%; that ‘inversion’ is an indicator of investors’ worry that the near-term cost to the economy of an aggressive interest rate policy applied to a level of national debt standing at nearly 140% of GDP is sufficient to run the economy off the rails (technically the US is already in recession having suffered two consecutive quarters of decline). In the eurozone, Germany’s 10-Year sovereign bond broke through 2%, to stand today at 2.11% its highest level since 2011 (it was negative as recently as March this year).

The corollary of rising bond yields is falling prices. Were it not so serious, it would be endearing that regulators, and notably the UK Pensions Regulator, still have this fond belief that bonds are a haven of tranquillity and relative calm. The UK 15-Year Gilt Index is down 41.5% year-to-date. Calm? Really?

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