After the cabinet reshuffle, how about an economic reboot too?
By Simon French, Chief Economist and Head of Research
Last week saw an attempt at a political reset by the UK government. Media attention was inevitably drawn to the resignation of Angela Rayner from the Cabinet. But for financial markets it was the addition of economic expertise alongside the Prime Minister that generated the most questions. Was this Sir Keir Starmer recognising that his “primary mission” of fostering economic growth needed greater capability within the Number Ten machine, or did it represent a rearranging of the deckchairs on a sinking ship?
The reality is that neither explanation stacks up. Whilst the addition of former Chief Secretary to the Treasury, Darren Jones, and former Deputy Governor of the Bank of England, Minouche Shafik, brings economic firepower to the very centre of government, intellect does not change the policy trade-offs. Similarly, the fastest growing G7 economy in the first half of the year cannot be credibly described as a sinking ship. The success of these appointments will hinge on whether they can provide the Prime Minister a confidence to stand behind his Chancellor as she makes difficult decisions. Over the summer, Sir Kier Starmer didn’t support Rachel Reeves on what were - in public spending terms - modest welfare reforms. That left Reeves in office, but not in power. That cannot continue in run-in to the Budget on the 26 November.
Each difficult decision in the run-in to the Budget will require coordination across UK institutions, political courage in confronting uncomfortable truths, and an honesty with the UK’s creditors that Britain’s economic strategy is not simply a holding pattern of rising debt and sluggish productivity until the next political cycle. At present the cost of UK government debt is persistently the highest in the G7. This is financial markets telling the government it is uncomfortable over the outlook for inflation, uneasy at the debt trajectory, and doubtful that economic growth will ride to the rescue.
I would suggest that there are three areas to focus on to avoid financial markets tightening the noose further on a heavily indebted UK economy.
The first of these is better coordination between the Treasury and the Bank of England on the latter’s sales of government debt. The current approach - the Bank’s programme of active Quantitative Tightening (QT) - is widely seen as unnecessarily costly and distortive. Investors understand the need to shrink the Bank’s balance sheet - as all major central banks are doing. What they question is the wisdom of doing so in a way that competes with the Debt Management Office for the same pool of buyers, and at a time when demand for Gilts from UK pension funds is going through a rapid transition. At present, the market expects the Bank to reduce its pace of Gilt sales from £100bn/year to £75bn/year over the next twelve months - a decision set to be announced on 18 September. That figure hangs over City trading desks like a storm cloud. If the Bank of England pared back this envelope - say, by relying purely on passive roll-off of maturing Gilts, which would bring sales closer to £50bn – this would ease market indigestion. An even bolder option would be to limit active sales to just £25bn, and allow reinvestments to drift toward buying longer duration debt, where funding pressure is currently its most acute. The US is doing something similar under the stewardship of Treasury Secretary, Scott Bessent.
Clear coordination - publicly messaged and jointly defended - would reduce the sense of institutional cross-purposes. Former Prime Minister, Liz Truss, may - with some validity - shout “conspiracy” and question why such support was not in place in 2022. She is correct that when Bank and Treasury co-ordination breaks down taxpayers are the ones that suffer.
And it is on the subject of inflation where the second focus must lie. Any action from the Bank on Gilt sales must be supported by a Treasury that takes far more responsibility for controlling inflation. Simply cutting Gilt supply indigestion in isolation would amplify fears of fiscal dominance - that is, the suspicion that monetary policy will be bent around the government’s financing needs. The government needs to make it clear that it is not leaving the Bank to fight inflation alone. This is essential if institutional credibility is not further eroded.
Specifically, ministers need to recognise that many of the drivers of the UK’s sticky inflation over the past year have not been global in origin, but home-grown. The interaction of higher National Insurance contributions, rapid increases in the National Living Wage, and the pensions triple lock - as well as a suite of regulated price rises in key utilities and transport services - has created a cycle where costs imposed on businesses quickly pass through into consumer prices.
If the government wants to break this dynamic, it must be relentless in bearing down on employment “on costs” and set in train a re-examination of the pensions triple lock. The recently revived Pensions Commission should have its scope expanded to explore this policy in what would be a powerful message to markets. No bipartisan route to reviewing the triple lock looks possible without it.
By signalling that the Treasury understands the inflationary pass-through of its own tax and pension policies - and that it will act to mitigate them - it can reassure markets that the fight against inflation is genuinely a joint endeavour. That is a quite different message from the one currently received, which is that fiscal policy will keep loading costs onto the private sector, leaving the Bank with no choice but to keep rates higher for longer.
The third and final lever is perhaps the most politically charged, but also the most important for the UK’s long-term productivity outlook: energy policy.
No serious investor believes the oft-repeated government line that there is no trade-off between net zero and growth. Pretending otherwise merely undermines credibility. If the government wishes to convince creditors that growth is its overriding mission, it must embrace energy pluralism. That means signalling openness to a broader mix of generation - including far cleaner domestic gas than imported gas supply - accelerated investment in grid capacity, and a recognition that abundant, reliable, and affordable energy is one of the foundation stones of productivity growth. Investors want to see a UK energy strategy that pursues energy production in all its forms, and for those to be integrated into a wider productivity plan.
Delivered together - by both the Prime Minister and Chancellor - this package would represent a credible economic reset. It would demonstrate that fiscal, monetary and energy policy are not being run on parallel tracks, but are aligned in pursuit of stability and growth rather than ideology. Only with that coherence is there a chance that the UK’s broader supply-side reforms and capital spending programmes – areas where this government deserves more credit - will make their intended impact.
Markets can forgive temporary missteps. They are less forgiving when they sense policy incoherence. If Britain repeats the mistake of underestimating the cumulative effect of its own policies - on borrowing, on inflation, on productivity - then it risks re-living the volatility of three years ago. That would be the worst possible backdrop for an Autumn Budget already hemmed in by weak growth and rising spending pressures.
