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Fiscal vs Monetary Policy: The UK’s Dilemma.

“In this jittery environment – there could be no reasons for more jitters”

Despite the IMF chief’s call for no “more jitters”, the sacking of the UK’s Chancellor on Friday (14/10), alongside a further fiscal policy U-turn, dashed their hopes of steady progress. But, how did we get here?

Kwasi Kwarteng’s mini-budget announcement in mid-September had a ‘pro-growth,’ ‘expansionary’ headline, but caused concern due to its financing and lack of approval by the Office for Budget Responsibility (OBR). The potentially unsustainable budget deficit, and the expansionary fiscal stance which conflicted with the Bank of England’s (BoE) deflationary policies led markets to price in higher interest rate rises, therefore reducing the price of gilts (government bonds).

However, panic spread due to pension funds’ heavy collateralisation through gilts, leading to calls for more collateral, and a mass sell-off of gilts by these funds. This sparked a downward spiral, causing further falls in gilt prices and igniting fears of a ‘run.’

Therefore, to prevent mass defaults on pension funds, and safeguard the finances of connected banks, the BoE stepped in and purchased these gilts, reducing the yield (i.e. the interest rate). But, like many G20 Central Banks, the BoE is tightening monetary policy to ward off inflation. Hence, this move served to undermine their credibility and muddy their inflation-targeting objectives. The announcement that the BoE would stop this bond-buying procedure on Friday should have re-established their policy tightening strategy and credibility, ultimately helping to re-stabilise market expectations. However, the sacking of Kwarteng, and the U-turn on the mini-budget, including a backtrack on the proposed decline in corporation tax, meant that a gilt sell-off re-started and prices fell, while currency markets remained turbulent. Truss’ fragile position as Prime Minister is likely to continue driving financial instability.

Alleviating This Uncertainty Via Communication

There are multiple issues stemming from this crisis in policy, but some uncertainty could be resolved through communication. Despite having no other option, Andrew Bailey (Governor of BoE) put himself in a difficult position on Wednesday by announcing the termination of gilt-buying on Friday. As long as the action was taken, the power of strong communication is illustrated here, as this helped stabilize expectations, and shore up BoE credibility as an inflation-targeter. On the other hand, Kwarteng’s failure to pre-warn business leaders about the mini-budget scared markets, unraveling the negative shocks. Furthermore, these shocks were amplified as he reportedly did not communicate certain elements with cabinet ministers, and failed to include the OBR.

Until Friday, there appeared to be coherence between No. 10 and No. 11, however Bailey’s “you’ll have to ask the Chancellor,” response to questions regarding Kwarteng’s absence from an IMF meeting, and early departure from the conference on Thursday, highlighted growing tensions between the BoE and UK politicians; giving further insight into the conflict between fiscal and monetary policy in the UK.

The Blame Game: Not So Independent.

While the past few weeks have seen monetary and fiscal policy work in opposite directions, Georgieva’s comments that fiscal policy should not undermine monetary policy illustrated the importance of the latter. That said, the Bank of England’s actions following unreasonable fiscal policy illustrates the opposite of this, unbalancing the see-saw of whether fiscal policy should support monetary policy (or vice-versa). Meanwhile, the independence and credibility of the BoE has been threatened, both by fiscal policy, and the risking of moral hazard through its recent buying of gilts. This illustrates a need for strong communication from monetary and fiscal policy makers in order to regain stability and transparency. Ultimately, if we are to learn from the 1970s, monetary policy needs to be allowed to lead, with politics stepping in to support those who will be hurt. This forces a dilemma for myopic politicians regarding the seemingly correct (in the long-run), but unpopular action to take.

Yesterday’s (Monday 17/10) events seemed to be taking this route, with financial markets stabilizing. On the other hand, some argue that the new Chancellor went too far, and that through tearing up Truss’ entire ‘manifesto,’ he is now the de-facto Prime Minister. Furthermore this has led to calls for a general election and stemmed questions of whether credibility can ever be restored to Truss’ leadership. Again, the lesson may be one of communication, but only time will tell whether trust can be regained once this breaks down – and until that point, political instability will continue to undermine the financial and monetary stability of the UK.