Britain’s Next Reset Must Start with Credibility

It is the first weekend in May 1997 and Tony Blair’s new administration, barely unpacked, hands the Bank of England operational independence to set interest rates. This marked a major shift in UK economic policymaking and bought the government something more valuable than any single policy: credibility. That reset lasted a decade and it paid for a lot of subsequent ambition.

The UK is now at a similar inflection point. A new administration is going to be inheriting a country that has done many of the right things. Fiscal rules remain ironclad and the deficit is projected to fall below 3% by 2028, in contrast to many other developed market peers. Yet markets remain nervous. Gilt yields still trade with an excess yield relative to peer countries, which taxes every planned investment while the stock market trades at a hefty discount to G7 peers (Exhibit 1).

Exhibit 1

Gilt yields trade at a premium to peers while inflation and deficits are in-line with peers

The problem facing the UK is that monetary and fiscal policy are undermining each other.  An inflation shock lifts rates, swelling debt-service costs and forcing governments to spend more, feeding back into fresh rate-rise expectations. This negative loop has tempted politicians to tinker with the Bank's remit or its balance sheet losses, further eroding central bank credibility.  As a result, markets demand a higher risk premium on UK assets.

Burnham’s reset must begin by breaking that loop.

To do this, the new administration needs to reinforce the Bank of England’s independence. Granting goal independence for price stability and aligning its financial independence with that of the European Central Bank and Federal Reserve is a starting point. Markets read these subtleties and price them. The UK should look across the Atlantic for inspiration. Kevin Warsh, the newly appointed Fed Chairman, has signalled a hawkish policy bias, reinforcing central bank independence in the face of political pressure.

The new administration also needs to let the existing fiscal rules do their job. For all its flaws, the UK compares well to peers on this metric.  It needs to drop the national obsession with fiscal headroom – a concept no peer country agonises over – and stop treating every rate wobble as a mini crisis.

Bond markets do not treat all deficits equally. A credible government could borrow more if it also crossed political red lines to make genuine cuts, sending an unambiguous signal that tough decisions are possible.

The outgoing administration is widely seen to have done the opposite: its U-turns on winter fuel, for example, have entrenched a view that ministers flinch at every confrontation with their own backbenches, and gilt yields have moved to reflect it.

While markets have resigned themselves to the fact that taxes are likely to go up further, tax rises alone are unlikely to be enough to demonstrate fiscal resolve. For fiscal credibility, spending cuts are needed. 

Finally, the UK needs to invest in defence. The new administration should ring-fence increased defence spending by setting up a task force on how to finance it. An arm’s length task force could be a credible stepping stone to pave the way for the UK to adopt an EU-style temporary carve out. The benefit of this approach is to provide temporary fiscal space for a rapid ramp up in defence while still requiring strict adherence to the existing fiscal rule.

To be sure, none of this is sufficient to drive meaningful economic growth, but it is an essential prerequisite.

A credible reset leaches away the UK-specific risk premium, gives the government the precious fiscal space to enact the policies it wants and improves the risk-reward on gilts and sterling assets that have long screened cheap. The downside of not doing this while Burnham’s political capital remains high is either spooking markets and triggering a jump in interest rates or being so cautious that the opportunity slips away as it did for Starmer.