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Chancellor Kwasi Kwarteng's tax cut bonanza fails to work magic on markets

Chancellor Kwasi Kwarteng's tax cut bonanza fails to work magic on markets

As he rolled out the tantalizing spending pledges at the start of the pandemic, Rishi Sunak pledged to do whatever it takes.

Two and a half years after Russia’s war in Ukraine and a surge in global inflation prompted another chancellor, Kwasi Kwarteng, to unleash another fiscal tidal wave.

But the approach to payment is very different. And that set off alarm bells in the markets, with the pound as well as UK bonds crashing. One pundit even said an emergency rate hike by the Bank of England could be needed next week to try to stop the rout.

Kwarteng is betting that deep tax cuts and a bonfire of regulations will spur investment, spur growth and benefit the wider economy.

“This is how we will successfully compete with dynamic economies around the world,” he said. “This is how we will turn the vicious circle of stagnation into a virtuous circle of growth.”

Sunak’s language after his extensive intervention was quite different.

He has spent £376billion fighting the pandemic and its crippling effect on Britain’s economy. It was followed by the energy crisis and a £37billion cost of living support package.

But Sunak was quick to warn that tough choices would have to be made to tackle the vast debt load of more than £2trillion that had accumulated. “We can’t spend money that we don’t have,” he said.

This led to a much criticized National Insurance raid on workers and employers, and the highest tax burden in 70 years.

Kwarteng not only reversed the decision, but also scrapped plans to raise the corporate tax rate, raise the stamp duty threshold and cut income tax.

The cuts will represent an annual impact of £44.8billion on public finances by 2026-27, the biggest tax giveaway in half a century.

Added to this is a commitment to freeze energy bills for two years, at an estimated cost of £60billion for the next six months alone. The total cost could be around £100 billion, according to independent experts. Kwarteng said it was “quite fitting”, comparing it to action during the pandemic.

“A significant intervention took place at that time and it is now,” he said.

HSBC economists said that over the next two years the package was “approaching the scale of what was delivered during the pandemic”. But “the backdrop in terms of monetary conditions couldn’t be more different,” they noted.

In 2020, interest rates were 0.1%. Today, with inflation at its highest level in four decades, rates are rising and this week reached 2.25%, the highest since the financial crisis.

The pound, already on the ropes after 12 rounds with the superpowered dollar, was positively drunk after the Kwarteng announcement, plunging to a fresh 37-year low at under $1.09.

UK bonds – lots of government debt – also sold off sharply. Five-year bond yields saw their largest one-day rise in 31 years. Higher yields translate into higher borrowing costs for the Treasury.

And it will take more. The Institute for Fiscal Studies forecasts £190bn, or 7.5% of GDP, in this fiscal year – surpassed only in the post-war period by the financial crisis and the pandemic.

Director Paul Johnson said: “Early signs are that the markets, which will have to lend the money to fill the gap in the government’s budget plans, are unimpressed.” George Saravelos, head of foreign exchange research at Deutsche Bank, warned that “the pound is in danger” as investor confidence in the UK’s external sustainability is rapidly eroding.

To prevent the pound from weakening, sharp interest rate hikes are needed outside of the regular cycle of monetary policy committee meetings. Saravelos said: “The policy response required is clear: a significant Bank of England inter-meeting rate hike as early as next week to regain credibility with the market.”

The Treasury estimates that the Kwarteng cuts will stimulate the economy and ultimately create additional revenue, without estimating by how much. It calculates that if 1% is added to expected GDP growth each year for the next five years, revenue would be £47billion higher in five years – roughly equivalent to the hit of the cuts. planned taxes, despite skepticism that such growth will occur.

There was a wide reception from business groups. Kitty Ussher, of the Institute of Trustees and former Labor Secretary, said: ‘This is good news for UK business. In a time of low confidence and economic uncertainty, the focus on growth will be welcome for businesses of all sizes.

But she expressed concern that the Independent Office for Budget Accountability had not enforced the numbers rule.

“Without this, neither businesses nor Parliament have confidence that the scale of this intervention is affordable,” she said.

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