The Labour party have won the general election with a massive majority (currently forecast to be 179 seats).
Labour's victory has come as little surprise to the financial markets, though their majority is bigger than anyone expected. During the election campaign, they took a keener interest in economic developments in the United States than in UK politics. This was understandable given the strength of support for Labour in the opinion polls throughout.
This morning sterling is weaker - down just over 2 pfennigs against the DM to DM2.77 and down 1.5 cents against the $ to $1.61. The gilt market is also a little weaker and the FT-SE 100 index of leading shares has fallen by 13 points (0.3%) to 4432. There is some nervousness that the size of the Labour majority will allow Tony Blair to be more radical (ie left-wing) than appeared likely during the election campaign. But most market participants seem to believe that 'New' Labour policies will be implemented, at least for the next couple of years, and that, on the whole, these will not be bad for the economy or for financial markets.
The continued strength of consumer demand - fuelled by rising earnings and falling unemployment - will lead Eddie George to persist, and rightly so, in calling for at least a 25 basis points rise in interest rates. However, the Governor may take advantage of Gordon Brown's probable desire to make a positive initial impact on the markets, and request a 50 basis points hike. Should he agree, Gordon Brown would have the opportunity to blame this on a 'politically motivated' Kenneth Clarke who 'should have tightened rates prior to the election'. This would bolster his image with the markets, though at the cost of some unpopularity with the electorate in the short term.
The new chancellor will produce a mini-budget within six to eight weeks (as the Tories did in 1979). The treasury might offer him some good reasons for adopting a tighter fiscal stance:
Higher taxes would assist an immediate 25 basis points rise in interest rates in checking demand growth, thus avoiding the need for even higher rate rises. This would be desirable because higher base rates will add further upward pressure on sterling and hit exporters' competitiveness even more.
The PSBR is still far too high for this stage of the economic cycle and with the economy growing strongly tackling the deficit immediately is the most appropriate action.
A reduced fiscal deficit is essential to apply for membership of EMU.
Gordon Brown is known to be pro-EMU. He may well be tempted to take the treasury's advice and be seen to be taking 'positive steps' towards putting fiscal policy on a sustainable path.
So what are Labour going to do on the fiscal front? In their mini-budget, they will introduce the much talked-about 'windfall tax' on the privatised utilities to finance their 'welfare-to-work' programmes. This will be a one-off tax, probably raising between£3bn-£5bn. As part of a manifesto commitment, Labour will also reduce VAT on fuel from 8% to 5%. However, the likelihood of a more radical budget, dwindled following a speech by Gordon Brown on 20th January, in which he stated that 'blanket commitments' would not be made until 'all the economic circumstances ...including the true state of public finances' facing a Labour government were known.
Looking further ahead, Labour have openly acknowledged the damaging effects of tax and spend policies and intend to maintain current public spending plans for two years. They plan to abide by the Golden Rule - holding state borrowing below capital spending - by 1999/2000. The necessary spending plans are quite tough, allowing only a 0.5% real rise in the spending over the next three years.
On the taxation front, however, they have some leeway. Labour have pledged no increases in income tax rates for five years, no return to penal taxation and a longer term objective of a 10p starting rate for income tax. This leaves a variety of other measures available to add to the coffers, however, such as the phasing out of MIRAS, reduction of personal allowances, a wider VAT base and higher National Insurance contributions. Given relatively low business taxes in the UK compared with the rest of the EU, Gordon Brown may also be tempted to raise corporation tax. These measures will not have broken pre-election promises and the chancellor will have the opportunity to blame them on 'Tory mis-management'.
Summing up, in his first few months, we think Gordon Brown will:
-- Raise base rates by 25 basis points after his first meeting with Eddie George
-- Present a mini-budget in six to eight weeks which will introduce the 'windfall tax' - raising£3-£5bn - and reduce VAT on fuel to 5% from 8%
In his first full Budget he will:
-- Announce no additional spending cuts
-- Increase taxation revenue, possibly through the abolition of MIRAS, a wider VAT base, reduced personal allowances or higher national insurance contributions
We feel that these would be the actions of a prudent chancellor given the urgent need for an improvement in the state of public finances, and efforts to slow economic activity.