Talking about the issues in the 1992 US election campaign, James Carville, an adviser to the then presidential candidate Bill Clinton, famously said, “it’s the economy, stupid”. And on another occasion, he quipped that if there were reincarnation he wanted to come back as the bond market because then “you can intimidate everybody”.
How might the economy and bond markets influence UK electoral prospects over coming weeks?
Of course, despite Carville’s remark, elections are about a good deal more than the economy. After the UK’s ejection from the European Exchange Rate Mechanism (ERM) on September 16, 1992, the British economy was well managed by the Conservative chancellors Lamont and Clarke. And it responded well too. Economic growth was strong and inflation was low. The public finances were in good order. But none of this seemed to cut much ice with the electorate. In 1997 Labour won a landslide victory.
This didn’t necessarily prove Carville wrong, though, about the importance of the economy. For in large part this shattering defeat for the Conservatives originated from the earlier humiliating ERM exit, which saw interest rates increased twice in a day, first to 12pc and then to 15pc. On that one day the Conservatives lost their reputation for economic competence. Is there a parallel here with the Truss/Kwarteng mini-budget?
In contrast to the situation in 1997, there is no doubt that over the five years since the last election in 2019, economic performance has not been good. Whereas at the time of the 2019 election the economy had grown by 1.8pc over the previous year, and GDP per capita by 1.3pc, the equivalent figures now are 0.2pc and -0.7pc. At the time of the 2019 election, CPI inflation was 1.4pc whereas it now stands at 2.3pc. And Bank Rate was then at 0.75pc whereas it now stands at 5.25pc.
Admittedly, recent data have been more encouraging and have given some support to the Government’s case that we have turned a corner. Most importantly, GDP in Q1 was shown to have grown by a surprisingly strong 0.6pc, thereby putting an end to the short and shallow recession and showing the economy expanding at what used to be its normal rate, namely about 2.5pc per annum.
Then came the inflation figures for April. They were widely written up as disappointing because inflation didn’t fall as far as many analysts (including yours truly) had predicted. Nevertheless, they did show inflation down to 2.3pc, sharply down from the peak of 11.1pc and within a hair’s breadth of the 2pc inflation target.
There is scope for some more good news in the next few weeks. On June 12 the figures for April’s GDP could show that the first three months of the year’s decent recovery continued. Equally, it is possible that the May inflation figures, due out on June 19, will show inflation falling below the 2pc target.
These figures could influence the Bank of England’s decision on interest rates which is due on the June 20. I suspect, though, that it won’t cut rates then. Even so, the data could influence expectations of a rate cut in August and affect general consumer confidence.
Historical analysis shows that when the GfK measure of consumer confidence is above -15, the incumbent government has a decent chance of being re-elected. This measure recently rose from -19 in April to -17 in May, so within a whisker of that supposedly critical level. And a further improvement to -15 or better is certainly possible in coming weeks.
Beyond the election, though, it is far from plain sailing. Admittedly, inflation could carry on falling and interest rates could be reduced in August and perhaps again later. But, as things stand, the fiscal position looks far from rosy.
This may well have been a critical factor influencing the Prime Minister’s decision to call the election in July, rather than waiting until October or November as had been widely assumed. The attractions of the latter were largely based on the hope that another “fiscal event” could be staged then, allowing the Government to cut taxes, including, perhaps, a third reduction in employee National Insurance contributions.
But recently the fiscal outlook has become cloudier. Of course, government expenditure is under upward pressure from all the usual sources, including the NHS and defence. Recently, the tainted blood scandal threatens to be resolved only with the payment of about £10bn in compensation. In fact, that shouldn’t make things more difficult for the fiscal rules since it will be a one-off payment. The Government’s standing against the key fiscal rule, namely that the ratio of government debt to GDP must be falling in five years’ time, should be unaffected.
What has really made the difference to the fiscal outlook is the recent deterioration in interest rate expectations and bond yields, following the slower than expected fall in inflation. This phenomenon began in the United States but it continued over here.
The result is that, whereas at the time of the Budget, the OBR estimated that there was headroom above the fiscal rules of about £9bn, and at one point subsequently it looked that headroom could be much larger, it now looks as though the figure could be as low as £5bn. That would buy next to no handouts.
Of course, all this can change. Not the economic fundamentals, mind. Slow productivity growth cannot change radically by autumn. Similarly, the debt ratio is bound to still be uncomfortably high.
But, as Carville warned, the bond markets are both powerful and fickle. With the Prime Minister having gone for an early election partly because there will supposedly be no money in the kitty come autumn, if Labour were to win, it would be deeply ironic if a sharp fall in interest rate expectations and bond yields presented the new chancellor with a significant amount of fiscal headroom for Labour’s first “fiscal event”.
Roger Bootle is senior independent adviser to Capital Economics. roger.bootle@capitaleconomics.com
