Sep 2022 — Observing the UK Economy

Originally published on Medium, 12 October 2022.

It is early October 2022 and the market sentiment towards the UK economy is negative. This writeup aims to chronicle the events that has led to this market outlook.

These observations are meant to study various tools used to stabilise the economy. The intention of sharing these observations is not to provide a political commentary.

The Snapshot of the economy section provides key metrics that highlight why the market outlook on the economy is bearish.

The Chronology of Events highlights measures used by the authorities to stabilise the economy and how the market reacted to those changes.

The Analysis for Dummies provides my analysis and poses a question if there is an elegant alternative to handle the monetary policy.

Alert: Web3 and DeFi is mentioned in this article

Snapshot of the economy as of Sep’2022

The technical indicators highlighted in this section provide some data points to outline why the market outlook is negative. Feel free to skip this section if you are not interested in technical metrics.

• Inflation has increased from 4.8% in 2021 to 9.9%
• Bank rates have increased from 0.25% in Dec’2021 to 2.25%
• Yield on Gilts (10 Year Bonds) has increased from 0.8% in Dec’2021 to 4.3%
• Sterling(£) compared to USD($) has fallen from 1.3 in Mar’2022 to 1.07

Chronology of Events

Since Dec’2018, inflation has been sitting at or below 2%. It rose above 2% in May’2021 and rapidly increased to 4.8% in Dec’2021 and almost touching 10% by end of Sep’2022.

The Central Bank says reduce expenses

To reign in the inflation, the Central Bank (Bank of England “BoE”) raised the interest rates for the first time since Mar’2020 and followed that by six successive increases for the bank rate to be 2.25% by Sep’2022. In short, BoE is telling the market to reduce expenses.

Even with the increasing interest rate, inflation in Aug 2022 was 8.6% against a target of 2%

Government says spend

On 23rd of Sep’2022, the new UK Government released a mini budget with significant tax cuts. It is assumed that the Government would fund these programs via debt instruments (typically by issuing Treasury Bonds). The yield on gilts is 4.3% and has more than tripled since the start of 2022.

Trouble for pension funds and lenders

By 28th of Sep’2022 the cost of government borrowing was rising to alarming levels. This raised the risk of collapse of pension funds, 900+ lending products being discontinued, economist predicting house prices to drop by 10–15%.

Bank of England to the rescue

This forced BoE into an emergency action to avert a financial crisis by pledging to buy £65billion of government bonds.

The Government u-turn

By 3rd of Oct’2022, the Government has gone back by on the mini budget and conceded that top tax bracket of 45% won’t be reduced per the original mini-budget.

Analysis for Dummies

A key tenant for an open free market within a country is that while setting the monetary policy, the Central Bank should act independently from the elected Government.

Typically Central Bank would raise interest rates to try and reduce inflation.

And Treasury, which represents the Government would print money by issuing bonds. This would obviously increase the supply of money in the economy, which in turn increases inflation.

So the market anticipates and positions itself to deal with either increasing interest rates and a reduced supply of money, or decreasing interest rates and increasing supply of money in the market. Technically this positioning is known as hedging.

And miscalculating this hedging position can prove to be disastrous in the economy. Like collapse of pension funds, which has follow on impact on Government expenditure as it has to set aside more money to look after ageing population.

In the case of UK, the Government wanted to stimulate economic growth in the short term. And realistically printing money (or issuing bonds) is the only way to do this.

So in the mini budget, the new UK Government proposed increased expenditure by issuing bonds, while the BoE was raising interest rates to get on top of inflation. These mixed signals caused the market to panic and BoE had to stabilise the market by purchasing bonds. This was followed by the Government backing away from some expenditure.

This poses following two questions.

Is this the best way for Government to test waters?

It is worth considering if the UK Government was pushing the envelope with the mini-budget, with the full knowledge that Bank of England will come to the rescue if required. Would an open system be more reasonable where the Government can observe the current market positioning in realtime and stress test various scenarios with real data, before proposing appropriate fiscal policies?

Technology has matured to the point where fund managers should be able to provide this information in real time, in a secure manner to the interested parties. Blockchain could be used as the system of record by all the participants and still secure the data without needing to inherently trust all the other participants.

Why should Governments get to decide when and how much money to print?

This is really the crux of the issue. Is there a merit to having a monetary policy which is truely independent of the elected Government’s fiscal policy? Like an algorithm that calculates how much money should be created. Meaning that the elected Government has to spend within known limits, which hopefully means they can’t create money to the keep election promises.

DeFi movement proposes removing these central authorities and making the financial system open, observable and actionable.

In closing, technology is only part of the solution. What is more important is a realisation that a change is required. If we are not experimenting, we are not evolving. Don’t love the solution, enjoy solving the problem.