The cost-of-living crisis has been fueled by runaway energy prices and poor monetary policy, which has contributed to high inflation and higher taxes.
I expect the new Prime Minister to present clear, credible policies backed by immediate action. The first thing to do is tackle energy prices head-on.
Some argue that prices are still allowed to rise as such market signals will influence behavior. However, the reality is that prices have increased so much that people and businesses are already changing their behavior to save energy. There is no point in letting prices continue to rise.
The dislocations in energy prices are now so great that it makes sense for the government to step in and protect people and businesses by setting wholesale energy prices. That takes the pressure off. It will also allow the government to focus on ensuring future supplies. It is a simple measure that can be implemented in a way that keeps government costs low.
Such a move would remove uncertainty and have a positive impact on business and consumer confidence.
Of course, the measures should not stop there. The orthodox thinking in the Treasury has failed. As trend growth is low, the policy approach is that more of the fiscal deficit is structural rather than cyclical. This thinking led to austerity a decade ago and has now led to higher taxes. It’s like being in a hole and digging deeper.
That needs to be turned on its head. Capping gas prices will improve the inflation outlook. The same applies to cutting energy and fuel taxes. Liz Truss will suspend the environmental levy. The suspension of the 5% VAT on household energy also makes sense. Due to the weaker global economy, oil prices have fallen significantly, so that a reduction in petrol tariffs is not necessary.
A two pence cut in income tax is already planned for 2024. She should be preferred. Also, inflation has pushed many people into higher tax brackets, necessitating an increase in income tax thresholds and allowances, although this may take time.
Planned tax increases such as social security and corporation tax must be reversed and trade taxes lowered.
What matters is how the financial markets will see all of this. Importantly, in recent weeks market expectations of where UK interest rates will peak have risen sharply, but the pound has weakened. Markets are nervous about the economy and about policy options.
The management of the energy crisis is viewed positively due to its impact on growth. However, it is still unclear how the markets will react to a comprehensive fiscal package. This creates the need for government to change the narrative and expectations.
The message is that monetary policy must deal with future inflation, while the role of fiscal policy is to stabilize the economy. Fiscal action is now necessary, affordable and non-inflationary. Although lending rates have risen, the UK can still borrow at very negative real rates. Such borrowing must help us avoid an unnecessarily deep recession – it’s sound planning.
The prime minister must rip up current fiscal rules that constrain politics with no apparent benefit. Fiscal rules sound reasonable, but since Gordon Brown introduced them, there have been eight different versions.
Budgetary discipline is essential. That is not debatable. The only rule we need is to reduce the debt-to-GDP ratio over time, ensure solvency and curb public spending. Crucially, the effective use of fiscal policy makes macroeconomic policy more credible. It should also enable the Bank of England to focus on fighting inflation.
Financial markets expect inflation to peak this winter and slow down next year. Government measures to limit gas prices will improve the outlook. The Bank of England has a credibility gap and a communication problem. You need to address both to get inflation under control.
dr Gerard Lyons is Chief Economic Strategist at Netwealth
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