The biggest issue between now and the next election is the cost of living and inflation. In turn, Liz Truss’s macroeconomic choices are the main policy response that matters. Over the next two years, supply-side reforms will not drive growth and incomes– especially given a global downturn. Thatcher’s growth reforms had only just started to work two years into her premiership. Supply-side reforms is necessary but will take time to take effect.
Truss’s macroeconomic decisions, meaning her monetary and fiscal policies, are thus key. There are broadly three approaches possible. It is essential for the country and the Conservative party she chooses the right one. Today’s fiscal event will show us which path she and Kwasi Kwarteng have chosen.
OPTION 1: Low rates while squeezing inflation by cutting people’s incomes
Sunak’s preferred option as Chancellor and the proposal he fought the leadership election on was loose monetary policy (real interest rates will soon hit -10 per cent) and tighter fiscal policy via tax rises to squeeze the deficit and keep interest rates low. He favoured tax rises to interest rate rises. Coupled with inflation this would squeeze disposable income and hopefully this would subsequently bring inflation down over time by reducing demand in the economy.
Workers were to be hit hard. The Bank of England’s prediction of a -7.5 per cent contraction in labour income in 2022 and 2023 (see table 1.E here) – the biggest drop in history – looks optimistic given regular real wages have fallen by 3 per cent this summer. Pensioners too were being clobbered, particularly those with cash savings and the five million households with fixed annuities for their private income.
Sunak aimed to protect asset owners, borrowers (most notably the Government itself), and mortgage holders (especially in London where mortgages are high). Workers and pensioners, especially those on average earnings, would be hit hard to prop up asset prices and a debt bubble – with house price inflation still at double digits. This hurt provincial England to benefit borrowers and house prices, particularly in London.
OPTION 2: Low interest rates with a higher deficit to protect incomes
Boris Johnson (rightly) knew that Sunak’s approach was politically disastrous and economically untested. Therefore he forced Sunak to intervene and protect incomes. The National Insurance threshold rose, and various cheques were issued in the post, totalling £37 billion so far. The result was the highest inflation rate in the G7 and rich world – and while incomes were partially protected, inflation kept rising.
Liz Truss’s second option is continuing this approach of low interest rates while splashing out money. Stopping National Insurance and Corporation tax rises at £30 billion coupled with further help for both low- and moderate-income households to cope with the cost-of-living crisis, all alongside prolonged low interest rates.
This risks continuing failure and even a 1970s inflationary spiral. Some inflation is embedded next year even if gas prices and food prices stop rising tomorrow. Much of our economy is inflation linked either directly or in practice – e.g. the state pension, benefits, train fares, the minimum wage, while many businesses have yet to raise prices to account for energy bills already in the pipeline. More spending will protect incomes but risks prolonged inflation.
On top of this, by keeping interest rates low the pound falls further versus the dollar, driving inflation as the price of internationally purchased goods and services rises (such as energy bought overseas). Each 10 per cent fall against the dollar tends to push prices up by 2.7 per cent over three years, around half in year one.
OPTION 3: Boosting incomes while cutting inflation via higher interest rates
The final option is tighter interest rate policy plus a looser fiscal policy centred around driving down inflation.
Some tax cuts (like those on fuel duty and VAT on fuel) directly cut inflation. Tax cuts on high effective marginal rates on labour quickly create more goods and services by boosting labour supply (like raising the income tax threshold encourages households on low and average wages to boost total hours). This was part of the reason for the Coalition’s ‘jobs miracle’, set out here. A similar effect (including for GPs) is likely at the 63 per cent effective tax rate just above £100,000.
Tax cuts can be coupled with increases in benefits for low and moderate-income households, (such as the state pension, universal credit, or child benefit). A package will be needed to support small businesses around energy prices.
The flip side is inevitably higher interest rates. This still means historically low rates – a rate of 4-5 per cent would be at the lower end of the 1990s or 2000s pre-crash, let alone the double-digit rates of the 1970s and 1980s. This will limit private sector borrowing and new bank lending (including mortgages) and strengthen the pound.
This reverses Sunak’s approach – borrowers lose out, asset prices will take a hit, and mortgage holders will lose (though outside London Truss’s tax cuts will balance this out for most). Older households will see paper wealth (especially their house price) fall but day-to-day income protected as inflation comes down.
This is the most popular option. The Bank of England occasionally asks people if they would prefer higher interest rates or higher inflation and the public want higher interest rates to higher prices by 61 per cent to 16 per cent.
Among older voters, the core Tory vote, opposition to higher prices is eye-watering – a puny 3 per cent choose higher prices among the over 65s and just 8 per cent among 55-65 year olds, while 81 per cent and 70 per cent choose higher interest rates. Continuing Sunak’s flagship policy of lower interest rates and higher inflation would be suicidal, given by 10:1 the elderly Tory core vote disagrees with it.
This approach will also insulate Truss from being called a Prime Minister of the rich. House prices declining will make it easier for younger people to own. It will be harder to show that “the wealthy” are not taking their share of the pain. This is preferable to the dangerous and damaging talk of wealth taxes to rebalance generational inequality or the political impossibility of scrapping the triple lock.
Most people want house prices to fall. Just 4 per cent want house price rises. Only around 1 in four now have a mortgage. Most people either want to buy, trade up, or fret about their children. Only reckless borrowers or speculators would lose out.
The idea that the Bank of England cannot be directed is absurd. Andrew Bailey’s inflationary record means the financial markets are unlikely to be concerned if the next exchanges of letters from Chancellor to Governor explicitly pushes for rate rises or even if direct action is taken That would include changing the law to allow the dismissal of the Governor by the Chancellor after a prolonged failure to hit their inflation target.
Of course, longer term the deficit will have to come down. But in 2024 Truss will be able to frame the choice as savings and growth with her versus Labour spending and inflation returning. But she will only be trusted by the public – as with Thatcher was by 1983 – if she can tame inflation beforehand.
Liz Truss has one key area and one chance to get this right
Within the next 12 months one issue will dominate politics: the cost-of-living crisis and inflation. By the middle of next year inflation will be under control or not, giving Truss authority or seeing it drain away. Partly luck, it also comes down to this immediate choice. Truss must pursue fiscal loosening and monetary tightening now or inflation risks undoing her wider reforms agenda before she even starts.