The next Prime Minister will be announced on Monday September 5th. Whoever it is will face a daunting set of economic challenges, including a public sector debt burden at 96.1% of GDP. The UK is at full employment and the government should arguably be running a budget surplus. PAYE income tax receipts remain strong, but there is little control on spending. As the data begin to turn down, so will the outlook for the public finances. Already, the 12-month moving total for PSNB ex widened in June for the first time since March 2021, to £136.1bn. The positive fiscal surprises may be coming to an end.
Debt interest spending has surged, hitting record highs both for the single month of June (£19.4bn) and fiscal YTD (£33.7bn). The immediate pressure on the government net cash requirement is not so large. But the sensitivity of the public debt burden to higher inflation and higher interest rates is clear.
Natural gas prices soared again in Europe this week. UK natural gas futures for January delivery have now risen by over 1000% over the past two years. This is not just a winter shock. Futures curves show that gas prices will remain elevated for years to come.
The Bank of England will probably hike 50 basis points next week. Its credibility is damaged in some circles. It will want to send a message to the incoming Prime Minister that there is no free lunch. A Liz Truss victory with the promise of tax cuts certainly raises the risks of an even more hawkish BoE.
Some would argue that the combination of looser fiscal, tighter monetary policy is exactly what is required after a decade or so at, or near, the ZLB. Be that as it may, any adjustment that involves materially higher interest rates will come at a severe short-term economic cost.
A Liz Truss election could exacerbate the risks if the government is seen as losing control of the public finances. This could lead to a further rise in real yields. The climb in inflation-linked gilt yields is exposing vulnerabilities in some areas of the economy already: pension schemes without appropriate liquidity provisions are feeling the strain.
