Shock-Proofing the UK Economy

CAMBRIDGE – The British government was right to describe the recent bout of market volatility in the United Kingdom as having been fueled principally by “global factors” – in particular, a sharp rise in US bond yields. It was also right in touting how well UK markets have coped with the turmoil. But no one should downplay the additional challenges the UK economy will confront in the months ahead, the structural weaknesses that are compounding its vulnerability, or the policy action that is urgently needed.

The recent surge in US yields has three main causes: a string of data releases indicating that actual and potential economic growth are outpacing consensus estimates, higher-than-projected inflation (together with a meaningful rise in consumers’ inflation expectations), and increased market sensitivity to the bond issuance that comes with large deficits and debt. Given that advanced economies compete for funding from global investors, it should be no surprise that higher US yields caused borrowing costs in most other countries to rise as well.

This effect was particularly pronounced in the UK, with ten-year government bond yields rising faster than yields in the US and, by a much larger margin, those in the eurozone. They will not fall significantly anytime soon; they could even rise further. The result will be higher borrowing costs for companies, households (including through mortgages), and the government – a development that will undermine GDP growth.

But there is more: despite these higher yields, the British pound has endured a pronounced depreciation. This development – which one is more likely to see in developing countries than in advanced economies – can intensify inflationary pressures. As a result, fears of stagflation are growing, even though the moves in foreign-exchange markets were relatively orderly.

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© Project Syndicate

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