Topsy-Turvy UK Markets Reveal Risks in Policy Responses to the Energy Crisis

The rate and currency shocks in the United Kingdom this week have caused some market participants to compare the UK to an emerging market economy. I think it’s a poor comparison. In my view, an important root of the problem was a market mispricing of Bank of England (BoE) messaging and a reversal of government intentions stemming from the energy price shock.

Flip-flopping fiscal policy
Back in August, the BoE forecasted a recession. The recession headline grabbed the market’s attention. However, in my opinion, many missed two key conditions the BoE attached to its recession forecast:

• Lack of fiscal response (at the time, the two Conservative candidates for prime minister had shown little appetite for fiscal policy)
• Potential for surging utility prices to trigger a demand shock and disinflation

Gilt yields remained at levels that did not account for the conditional risks, the UK’s entrenched inflation dynamics and the potential path for bank rates, in my view.

A Steady Decline in UK Real Rates

Source: Bloomberg, as of 30 September 2022. Used with permission from Bloomberg Finance L.P.
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When UK prime minister Liz Truss announced measures to limit energy bill increases, the BoE could no longer rely on a demand shock from surging energy prices as a mechanism for disinflation. The market had to adjust to a more aggressive rate path. These developments happened against a backdrop of concerns about the efficacy of UK policy, given the broader growth package announced on 23 September, and broader moves in currency markets.

No magic bullets
The shocks to the UK markets this week revealed how policy responses to the energy crisis can have disruptive effects on market activity and financial infrastructure. Europe has been dealing with similar issues.

There have been a lot of policy ideas floating around the UK and Europe, including some that aim to cap retail prices and switch benchmarks. My concern with these measures is that actions may cause unintended reactions in hard-to-address areas of the energy financial market system. Government interest in shielding households from rising prices may impede demand responses and runs the risk of harming confidence in fiscal policy if not well calibrated. What’s more, scarce energy inputs could lead to supply chain and production disruptions. More administrative rationing-like measures may come. As the BoE did with its August placeholder forecast, I believe central banks will need to await and assess fiscal actions as they come—and do this in an environment of very high inflation and the need to act within their inflation-targeting mandates.