A winter recession to be avoided
A deteriorating deficit
Twin deficits hit sterling
Avoiding recession means supporting aggregate demand but that will boost inflation and worsen the current account. The twin deficits problem is back and that has hit sterling. The BoE was already planning to raise interest rates and they will now likely have to hike faster and further. In normal circumstances sterling would rally in response but the pound has been weak. This is partly because other central banks are also raising rates and the US dollar has been strong against almost every currency. But last month, when UK inflation came in much higher than expected, interest rate expectations rose but sterling weakened on the day – many commentators have noted that behaviour was akin to an emerging market currency.
We can see this in credit default swaps which measure the cost of insuring against default. They rose throughout Europe, notably in Germany, following the invasion of Ukraine. But in the UK, they have risen further to almost double the rate for Germany.
Three reasons why we will avoid a financial crisis
So, are we headed for a full-blown financial crisis in the UK? My guess is that we might just avoid it for several reasons.
First, although yields on conventional gilts have risen, they remain well below inflation. And the average maturity of UK debt is very long, so the risk of a ‘debt spiral’ is low.
Second, although this week’s fiscal event will boost government borrowing, the deficit is on an improving trend. Sterling looks cheap to many investors – and tourists – and our new Chancellor, Kwasi Kwarteng, will probably be able to say that the fiscal rules will be met by 2025.
Third, the likely cost of the energy bill support scheme is falling. In effect the government has a significant short position in gas futures, which have been falling with prices for this winter, in the UK and Europe. They have almost halved since their peak in late August. High prices have attracted increased supply and reduced demand by more than expected. And it looks like an important gas terminal in Texas will reopen in November with near full capacity so we will be able to get liquid natural gas (LNG) from the US.
Much will depend on the weather this winter. A still, cold, winter would boost demand and reduce supply from wind turbines. So, let us keep our fingers crossed that it’ll be warm and windy. We might then keep the car on the slow road to lower inflation and sustainable growth.