Billionaire investor Ray Dalio says U.K.’s economic plan ‘suggests incompetence’
On September 22, 2022, The Bank of England, the U.K. central bank, raised its benchmark interest rates by 50 basis points setting off a cascade of events. The new rate now stood at 2.25%, the highest since 2008. The move was geared to offset rising inflation. The consumer price index in the U.K. rose to 9.9% in August, and it was clear that the central bank needed to act to stem the tide of higher inflation. The move coincided with an announcement by the government.
The new Prime Minister discussed the new budget, which included tax cuts. In conjunction with the tightening by the Bank of England, her statement created a wave of selling of U.K. Gilts, which led to a massive decline in the pound sterling. The Bank of England then needed to step into the markets and purchase bonds to settle investor fears. In the wake of these events, many, including billionaire Ray Dalio said that the government was incompetent.
Central Bank Policy
The British economy is in flux as rising prices are eroding consumer confidence. The August consumer price index rose by 9.9%, down slightly from July, which was the fastest pace in 40 years. Many factors led to the increase in inflation expectations. The pandemic destroyed supply chains as lockdowns disrupted businesses throughout the United Kingdom.
The demand for goods and services roared back to life, but the supply of goods lagged, pushing prices higher. Simultaneously, central banks globally cut interest rates and supply stimulus via bond purchase programs. Governments also created loose fiscal policies to help buoy economic growth. Unfortunately, the punch bowl was left out too long, pushing prices substantially higher.
With inflation at unsustainable levels, the Bank of England needed to tighten its monetary policy. In late 2021 the BoE raised its benchmark interest rates by 25 basis points for the first time in three years. In February 2022, the central bank increased interest rates by another 25 basis points, the first time the BoE raised rates consecutively since 2004. In May 2022, the Bank of England increased rates by 0.50 to 1%. In June, the central bank increased rates by another 25 basis points.
Another 50 basis points were added in August, and in September, the Bank of England voted to raise rates by another 50 basis points to 2.25%. The sharp rise in rates slightly reduced inflation but also reduced economic growth. Unfortunately, one of the only ways a central bank can reduce inflation is to create a recession. Wages are at the core of most inflation spirals. If people get more compensation, they are willing to pay higher prices. If you reduce wages, people are less inclined to pay for goods and services, and eventually, prices begin to fall.
The U.K. Budget
In the aftermath of the last Bank of England rate hike, the new U.K. leadership announced a mini-budget geared to enhance economic growth. The announcement of the mini-budget set off a fire sale of U.K. government bonds. The sell-off in U.K. bonds spilled over into the sterling pound, pushing the currency lower against most major currencies. Riskier assets, such as equities, also saw selling. The spiral of selling and the increase in government borrowing costs caused the Bank of England to step in and attempt to calm the markets. The BoE started to purchase bonds to allay fears that the gilt prices would continue to fall. The central bank pledged to buy up to 65 billion pounds of U.K government bonds.
The bond plunge causes concern as the country has more than 1.5 trillion liability-driven investments tied to U.K. gilts. These investments, called LDIs, are held by pension plans across the U.K. In the aftermath of the announcement by the Bank of England, U.K. gilt yields dropped more than 100 basis points calming investor fears. The U.K. Treasury is poised to set its medium-term fiscal plan on November 23, 2022.
Competence or Incompetence?
In the wake of her decision to try to buoy growth, the British Prime Minister defended her position and insisted that cutting taxes was the right thing to do. She argues that morally and economically, there is a need to lift some of the burdens from higher constituents by butting taxes.
The move by the government was not well received. Not only did the Bank of England have to come in and rescue the bond market, but waves of market pundits also said that her government was incompetent. One of the most prominent critics is Ray Dalio, the founder of Bridgewater associates, one of the world’s most significant hedge funds. Dalio said that the tax cuts would not stimulate the economy and that productivity is what generates economic growth. He commented that he believed that the government should understand this mechanism.
The Bottom Line
The upshot is that many believe that the U.K. government made a mistake in its mini-budget and created a situation where the Bank of England needed to rescue the bond and forex trading sectors. Trying to cut taxes as the central bank raises rates is not unusual. In 2018, while the Fed started to raise interest rates, the tax cuts enacted by former President Donald Trump took effect.
The issue was that the U.K. government sent a mixed signal to the markets. The goal of fighting inflation was compromised as the government said it needed to stimulate fiscal policy to fend off a recession. A recession is likely what the Bank of England needs to create in order to reduce wages and stem the tide of rising inflation expectations. Many investors have said that the mini-budget announced by the government was incompetent and that the announcement created a spiral that could have caused a financial disaster.
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