Foreward: Othordoxy Lost and Found

Against a backdrop of escalating inflation and a gradual unwinding of unconventional monetary policy, global interest rates are gradually returning to more familiar levels. Ultimately this is a good thing, as it will support the more productive use of capital. But this process was always going to be tricky as the draining of liquidity would expose a number of financial markets to risks they had not had to manage for half a generation. This observation is as true in the US as it is in many emerging economies. And so the ill-fated and short-lived government of Prime Minster Liz Truss provided both the initial concern that the UK would move decisively into the realm of heterodox policy and the ultimate realisation that it was an example that the rest of the world will not now follow. I argue that we can now put behind us the concern that we will raise the inflation target or pursue an unsustainable set of fiscal policies. The commitment to an unfunded energy price guarantee and a slug of tax cuts announced by Chancellor Kwarteng at his Mini-Budget on 23 September promised to inject demand into an inflationary economy. We calculated this was something in the region of some 3 per cent of GDP in the first year. This boost to demand served to trigger a rapid upwards revision in the path of Bank rate from a peak in the range of 3-4 per cent to over 6 per cent. Such a large and rapid change in short interest rate expectations, triggered a large fall in gilt prices and other financial asset prices. The fall in gilt prices was amplified by margin calls on collateral offered by pension schemes using liability-driven investment strategies. And ultimately triggered a run in that market with 30-year and index-linked gilts exposed to extraordinarily large price changes. The Bank of England was forced to step in as market maker of last resort from 28 September to 14 October to stabilise the ensuing fire sale and offer an ongoing repo facility, which will remain in place until 11 November. These operations did not re-ignite Quantitative Easing but the timetable for Quantitative Tightening was pushed back somewhat, quite understandably given the market turmoil. The revision in gilt prices and the direct action of the Bank of England does in no way represent, as opposed to much market commentary at the time, fiscal dominance. Rather it simply outlines that the market believed that it was observing a non-cooperative game between the central bank and the Treasury; if the sequence of debts were going to be higher than so would the sequence of interest rates. With the defenestration of both Chancellor and PM, we have returned to a clear commitment to fiscal probity under Chancellor Hunt and PM Sunak. And one that the Labour Party, which is now somewhat more likely but by no means certain to form the next Government, will not question. The reversal of the greater part of the Mini-Budget measures and the reduction in long term interest rates means that the fiscal hole can be filled with relatively small changes in taxes, for example, by reinstituting the NI increase or redesigning the energy price guarantee. The bigger danger now is that we decide collectively to demonstrate fiscal credibility by adopting an excessively restrictive fiscal policy and limit support for poor households or rein in critically important elements of public investment. The next fiscal event will now take place on 17 November. The good news is, at the end of this cycle, the commitment to sound money, and price stability is firmly at the centre of the policy nexus for another generation. It is hard to see either political hue moving away from the aim to stabilise public debt relative to GDP and maintain the imperative for price stability. The problem with that approach is that it will not by itself nurture faster economic growth and prosperity across the country. But that is perhaps a question for another day.