UK's 'economic credibility now being questioned' after sterling's fall

"The Institute of Fiscal Studies has estimated that freezing energy bills could cost £100bn," said Conall Mac Coille chief economist at Davy

Conall Mac Coille: UK spending will worryingly not be accompanied by new forecasts from the Office for Budget Responsibility       

The sharp fall in sterling against the dollar and the euro has put the credibility of the new government led by Liz Truss under the spotlight and the Bank of England may respond by pushing British interest rates sharply higher to get to grips with inflation, the chief economist at broker Davy has said. 

Conall Mac Coille said in a research note that sterling remains under pressure as the new chancellor of the exchequer Kwasi Kwarteng prepares to provide more details on Friday of the mooted large increase in spending.

"Worryingly, this will not be accompanied by new forecasts from the Office for Budget Responsibility, or official costings of policy measures, on top of expected borrowing of 4% of GDP this budget year," said Mr Mac Coille. 

"The Institute of Fiscal Studies has estimated that freezing energy bills could cost £100bn, 4% of GDP, in the first 12 months. Reversing the 1.5% increase in national insurance contributions and the planned rise in the corporation tax rate to 25% could cost up to £30bn, 1.2% of GDP," he said.  

Last week, sterling fell sharply after a sharp drop in UK retail sales figures suggested that Britain was heading for a recession as consumers rein in spending in response to the cost-of-living crisis. 

On Monday, the UK currency continued to hover around its 37-year low against the dollar. It weakened further against the euro to 87.77 pence, reflecting the darkening of the economy facing Britain. 

"However, sterling’s depreciation has also been attributed to doubts regarding the UK government’s economic credibility, with Liz Truss promising fiscal stimulus that will substantially raise borrowing and threatening to review the Bank of England’s mandate to target CPI (consumer price) inflation," Mr Mac Coille said in his research.  

He said that the Bank of England "will be mindful that Liz Truss’s income tax commitments will add to inflationary pressure and may be inclined to bolster its own credibility by acting aggressively". 

It comes as the Bank of England this week will consider whether to push through the biggest interest rate increase in 33 years to respond to surging inflation and weakening confidence in British assets.

With prices rising five times faster than the UK central bank’s 2% target and sterling falling almost daily, policy makers led by governor Andrew Bailey are under pressure to step up the pace of monetary tightening. 

This month’s meeting for the Bank of England, delayed a week by the death of Queen Elizabeth, has split the debate among economists and policy makers about how to respond to conflicting forces buffeting the UK economy.

Inflation is forecast to rise further, and companies are struggling to find the staff they need to fill open jobs, pushing up wages and providing a constraint on how quickly they can grow. At the same time, the tightest cost-of-living squeeze in a generation is darkening the outlook.

Additional reporting Bloomberg