The winner of the Conservative leadership contest will inherit an economy that resembles a poorly structured bond: tempting yields but a worrying risk of default. The fiscal credibility that the UK painstakingly rebuilt after the 2008 crisis has been eroded by a combination of pandemic spending, energy subsidies, and, most recently, the mini-Budget debacle. The question is not whether the new Prime Minister will face economic challenges, but how quickly the bond markets will test their resolve.
First, let's talk about inflation. The Bank of England's forecast of inflation peaking around 11% this winter is, in my view, optimistic. Core inflation continues to surprise to the upside, driven by domestic services and wage pressures. The labour market remains tight despite rising unemployment claims, suggesting that the 'Great Resignation' is a misnomer; it is more a 'Great Reallocation' where workers are switching jobs for better pay, putting upward pressure on wages. The Bank's Monetary Policy Committee will be forced to raise rates more aggressively, perhaps reaching 5% by mid-2023, a level not seen since before the 2008 crisis. This will crush the housing market and squeeze business investment, but it is necessary to prevent a wage-price spiral.
Second, the gilt market. The so-called 'Liz Truss premium' has all but disappeared, but the scars remain. The new Prime Minister must understand that the market's tolerance for unfunded tax cuts is zero. The PM must signal fiscal discipline from day one. That means credible medium-term fiscal plans that bring down debt-to-GDP over the cycle, not just pledges to 'grow the economy'. The Office for Budget Responsibility must be given a greater role in policing fiscal rules, perhaps with a mandate to publish binding ceilings on departmental spending. If the new PM fails to do this, the market will do it for them, as we saw with the emergency bond purchases by the Bank of England in September. The spectre of capital flight is real: foreign investors hold nearly a quarter of UK gilts, and they are becoming increasingly skittish. A loss of confidence could send sterling tumbling and import-driven inflation even higher.
Third, the tax burden. It is already at a 70-year high, and spending pressures from the NHS, social care, defence, and net zero are only growing. The new PM will have to take the unpopular decision to either raise taxes further or cut spending. I suspect they will try to muddle through with a mix of cosmetic cuts and stealth taxes, but the markets will see through that. The only sustainable path is to cut government spending as a share of GDP, which means tackling the structural deficits in health and pension spending. That will require a level of political bravery that has been lacking since the austerity years.
Finally, the energy crisis. The Energy Price Guarantee will cost an estimated £150 billion over two years. While necessary to prevent a humanitarian crisis, it is ultimately a fiscal transfer from taxpayers to energy companies. The new PM should consider a windfall tax on renewable energy producers (who are currently reaping mega profits due to the high marginal gas price in the UK's market) and use that revenue to fund the price cap, rather than borrowing. This would be seen as fiscally responsible and politically savvy.
To sum up, the next PM will face a cruel economic paradox: to beat inflation, they must implement austerity; but austerity will kill growth, which is the only way to reduce debt. The only way out is through supply-side reform: planning liberalisation, tax reforms that encourage investment, and trade deals that boost productivity. But these are long-term bets in a short-term crisis. The market will be watching, and it will be unforgiving. The new PM's first test is not a vote of confidence in the House of Commons. It is a test of confidence in the bond market. And that exam is already in session.
