The British government was right to describe the recent bout of market volatility in the UK as having been fuelled 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 (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 10-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.
The combination of higher yields and a weaker currency presents a particularly thorny challenge, because it impedes the government’s ability to mount a fiscal- and monetary-policy response. Higher debt costs eat up tax revenues, shrinking the government’s fiscal headroom and, potentially, raising the need for spending cuts, tax hikes, and/or increased borrowing. The inflationary effect of a weaker currency makes the Bank of England more hesitant to cut interest rates.
Beyond the immediate economic outlook looms a longstanding cause for concern. Though Keir Starmer’s government has been working to improve productivity, foster investment and promote durably faster growth, the British economy remains beset by long-term structural weaknesses that leave it exposed to external shocks. If anywhere in the world sneezes, the UK is at risk of catching a cold.
All this has fuelled a decidedly, and often excessively, unflattering image of the UK economy. The perception that it is a mire of sluggish growth, anaemic productivity and investment, deteriorating public services, high deficits and large debts will be difficult to dislodge.
In fact, as price movements and analyst commentary alike make clear, markets are not giving the government enough credit for its handling of the economic and budgetary mess it inherited.
Against this backdrop, Starmer’s government needs to do a better job of communicating what it is already doing to improve UK economic conditions – and it must do more. Messaging must be consistent, and it must address head-on the widespread, long-held, and excessive scepticism about the UK’s economic situation. And policy action must be timely and broad-based. While there is no magic bullet that would transform Britain’s economic outlook, a wide range of measures – extending beyond housing and planning to address more comprehensively infrastructure, research and development, innovation, skill accumulation, and labour retraining – can make a difference.
Strengthening trade linkages would also help. Current political and geopolitical realities suggest that these efforts might have to focus more on Europe and the US, and less on China.
Together, such policies can reach a kind of critical mass, at which point the UK could pull back decisively from the brink of a self-reinforcing vicious cycle of rising borrowing costs, currency depreciation, intensifying inflationary pressures, and slowing growth.
No country wants external developments to worsen its economic and financial outlook and, at the same time, erode its policy flexibility. That is especially true of the UK today, given the cyclical and structural challenges it faces. But rather than view recent market volatility exclusively negatively, the government has an opportunity to frame it as a moment to improve the public’s understanding of what it is already doing to improve the economic outlook and to accelerate and expand its efforts.
Mohamed El-Erian is the president of Queens’ College at the University of Cambridge and a professor at the Wharton School of the University of Pennsylvania.
