UK political stalemate unlikely to be "all in the price"
Simon Ward
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None of the three main parties has been honest with the electorate about the scale of fiscal retrenchment needed to stabilise the public finances but the Conservatives have been most vocal about the dangers of failing to make an early start on reducing the deficit. Their inability to achieve a clear mandate indicates that the new government, whatever its composition, will face strong public resistance to the required actions.
The stability of the pound and gilt yields for most of the campaign had led some to suggest that markets were comfortable with the prospect of an inconclusive result. This stability, however, partly reflected a “safe-haven” influx of capital fleeing peripheral Eurozone economies. The risks that could be downplayed while the polls fluctuated have now crystallised. The initial negative market reaction is more likely to extend rather than be reversed on further reflection.
The “best-case” scenario for markets is a minority Conservative government that presses ahead with an early emergency budget setting out a credible deficit-reduction programme. The need, however, to appease collaborators suggests that this would be less ambitious than required. The alternative scenario of a Lab-Lib coalition, in theory, would delay any new fiscal announcements until an autumn Pre-Budget Report. In either case, the credibility of medium-term proposals would be low given the likelihood of another election within a year or so.
The notion that delaying fiscal tightening will boost near-term growth prospects is a fallacy. Policy uncertainty will cause businesses to delay plans to expand investment and hiring while consumer caution will similarly increase. A likely rise in the “risk premium” in UK market interest rates will act as a further drag on the recovery. Inflation expectations, meanwhile, may firm, with markets suspicious that the Bank of England will restart gilt-buying in the event of deficit-financing difficulties, even if this conflicts with its inflation-targeting remit.
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