It was enough to send a chill through any voter. Speaking to Sky News, Jeremy Hunt was asked if he would be comfortable with interest rates reaching such a height that the economy tips into recession.
“Yes,” he said. “Because in the end inflation is a source of instability. If we want to have prosperity, to grow the economy, to reduce the risk of recession, we have to support the Bank of England in the difficult decisions that they take.”
Such a bald statement is unlikely to play well with hard-pressed constituents in either the Shires or the Red Wall – and, with the Conservatives still more than 15 points adrift in the polls, it has unsurprisingly gone down badly with backbenchers too.
However, the comments make more sense if you realise that neither the voters nor the fractious Tory tribe are the intended target. Instead, Hunt is talking to an anxious City.
“There is a game here to just try and reassure the markets to make sure that we don’t get into a situation where they are disorderly,” says Andrew Goodwin, chief UK economist at Oxford Economics.
“We know from experience what sort of consequences that brings after what happened last year.”
The downfall of Liz Truss still casts a long shadow over Whitehall. Ministers and the Bank of England alike are fearful of the consequences if markets believe they want to make short-term, popular choices with no regard for borrowing costs or surging prices.
If Hunt can convince traders that the Government is willing to accept whatever it takes to bring inflation under control – even at the cost of an economic contraction – then it will pour oil on troubled waters, the thinking goes.
“Markets have become overly concerned by the inflation data this week. The extent to which market pricing is moving is significant,” says Goodwin.
Representatives from the Bank are likely to give speeches taking a similarly hard line in the coming weeks, he adds.
The latest turmoil started on Wednesday, when official data showed that prices rose by 8.7pc in April – significantly more than the 8.4pc expected by the Bank.
Worse still, core inflation – which strips out volatile components such as energy bills and food – is still rising, suggesting that pay growth is becoming embedded in the economy and driving prices up on its own.
This triggered a jump in borrowing costs and led to traders betting that the Bank will have to increase interest rates by a further full percentage point to 5.5pc in the coming months.
Such a steep increase in rates may be needed to prevent years of rising prices and falling living standards.
However, the risk is that it acts as a brake on growth, as consumer spending, investment and hiring slow as a result.
Economists now fear there is now a 66pc chance that Britain is heading for a recession as City traders make their biggest bets on a downturn since February.
Under normal circumstances, an economist would say there is a 30pc risk of recession, says Neil Shearing, group chief economist at Capital Economics. Now he thinks the risk is more than double that.
“It is more likely than not. I would say there is a two-thirds chance,” he says.
The British economy will likely fall into a downturn in the second half of this year and the start of 2024, says Shearing. The housing construction industry will be worst hit.
City traders have also started placing big bets on an economic downturn.
In normal circumstances, two-year gilt yields are lower than 10-year yields. But this week this balance flipped in what is known as an inverted yield curve, because a downturn is regarded as likely in the short term.
“It means that the market now expects there to be a recession at some point down the line,” says Thomas Pugh, a UK economist at RSM accountants.
The inversion gap is the largest recorded since February, when there were widespread forecasts of a major recession from the likes of the Bank and the International Monetary Fund.
The gap is roughly half the level recorded during the autumn mini-Budget crisis.
“Normally, you would expect that the longer you are locking your money away for, the higher the yield, to compensate for that extra risk and inconvenience of locking it away for a longer period,” says Pugh.
“When short-term yields are higher than long-term yields, it implies that interest rates or yields are going to fall pretty sharply at some point over that two-year horizon.
“And normally you would get falling yields because you are in a recession. So that is typically why it is used as an indicator.”
This is an independent variable which measures what City traders expect to happen, rather than a factor that will directly influence the trajectory of GDP.
“It is about the collective wisdom of the bond market anticipating a recession, rather than there actually being a pass through from that yield curve to the real economy that causes a recession,” says Shearing.
But it is clear that the outlook has rapidly become more bleak.
“In February, people were expecting there to be a recession, but then the economy was much more resilient than we had expected,” says Pugh.
Now, the strength of the economy is becoming a problem in itself. The resilience of the labour market and rising wages mean inflationary pressures may have become endemic.
Wage growth is currently at around 6pc – double the 3pc rate that the Bank of England says is consistent with 2pc inflation.
Althea Spinozzi, a senior fixed income strategist at Saxo Bank, says it may be impossible to put interest rates high enough to tame inflation without severely harming the banks and the economy.
A Bank rate at 5.5pc could trigger a fresh wave of financial turmoil, akin to that seen in the US in March, she says.
“The financial system has showed weakness far before we have got to 5pc,” she says.
“If rates continue to rise, then it is very likely that we might see something else breaking. There are a lot of issues not only with the pension funds but also issues that we have seen in the US might be very relevant not only to the UK but also for Europe. I believe that we will see more of that as rates rise.”
The financial system has adjusted to low interest rates in the 15 years since the financial crisis.
“The financial institutions have taken a lot of risks based on very low rates. The sensitivity to higher rates is much higher than it was 15 years ago,” Spinozzi adds.
But Bank of England governor Andrew Bailey is hamstrung.
“The problem is that the Bank will have to choose between either inflation or a very, very deep recession,” says Spinozzi.
“If the Bank of England doesn’t get a hold on inflation, there will be a recession anyway.”
For now, there is a false dawn. Recent economic data such as the purchasing managers’ indexes, suggest that economic performance will be OK over the next few months, says Shearing.
The real toll is coming in six months’ time. But for the Chancellor, it may be a price worth paying to avoid the same fate as Truss.
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Source: https://finance.yahoo.com/news/why-britain-may-doomed-itself-070000706.html