U-turn reduces tail risks but unlikely to stave off recession

On Monday, the UK’s newly appointed Chancellor of the Exchequer, Jeremy Hunt, struck a sombre note, reversing most of the ‘mini-budget’ giveaways and hinting at further tightening to calm markets and restore confidence.

This was a true reversal, with the announcement undoing £32 billion (just under 1½% of GDP) or two-thirds of the medium-term giveaways. The cuts to National Insurance contributions (the Health and Social Care Levy) and stamp duty will remain as they’ve already begun their way through the parliamentary legislation process.

The Chancellor also pledged to make energy subsidies for households and businesses more targeted and to incentivize energy efficiency from next April. Perhaps they can copy German plans to subsidise only the previous 80% of consumption to encourage frugal energy use.

U-turn if you want to

Considering the reasons for this abrupt about-face, I’d point to two factors:

1. High borrowing costs risked destabilising the economy: higher mortgage rates were set to push down house prices
2. The Office for Budget Responsibility’s borrowing forecast (and therefore the amount of action ultimately needed to balance the books) is directly tied to borrowing costs.
   By pre-announcing policy tightening, the hope is that debt-servicing costs will fall, so fewer additional real spending cuts or tax hikes will be needed in the final announcement on 31 October

We believe the UK economy is still heading for recession, but the extreme tail risks of meltdown have been diminished. The outlook for mortgage lending is similar – the U-turn on fiscal policy reduces the risk of a cliff-edge scenario, but we can expect lending to decline as it would in a ‘normal’ recession.

Risk aversion is here to stay

Even though today’s announcement led to gilts rallying, remember that the Bank of England’s credit conditions survey anticipated a sharp tightening of mortgage lending conditions even before September’s UK government debt rout.

Even if gilt yields were to fall all the way back, given the rise in volatility banks will likely remain more risk-averse about lending than before.

It’s hard to put the toothpaste back in the tube.

This blog was written before the 3.30 GMT announcement giving further details of the UK’s fiscal plans, and will be updated if significant developments change our outlook.