LONDON — New British Prime Minister Liz Truss faces a confluence of economic challenges, but will need to balance her own ideals with the immediate needs of the country.

Last week, Truss announced an emergency fiscal package involving the capping of annual household energy bills at £2,500 (£2,891) for the next two years, with an equivalent guarantee for businesses over the next six months and further support in the pipeline for vulnerable sectors. 

The plan is expected to cost the public purse more than £130 billion, with new Finance Minister Kwasi Kwarteng expected to outline how it will be funded later this month, but is broadly seen by economists as a positive step to limit inflation and reduce the immediate risk of recession.

Former Finance Minister Rishi Sunak's energy rebate package for households will remain in force, while the Bank of England will establish a liquidity facility to aid firms in the wholesale energy market to weather extreme price volatility.

Energy plan

The fiscal package remains "pivotal"; to the U.K.'s growth outlook, according to Modupe Adegbembo, G-7 economist at AXA Investment Managers, who suggested in a research note Monday that the support to real incomes and growth boost will "likely be enough to prevent the economy slipping into a prolonged recession."

U.K. GDP grew by 0.2% month-on-month in July, official figures revealed on Monday, below consensus expectations for a 0.4% expansion. GDP contracted by 0.1% in the second quarter of 2022, and Adegbembo suggested that the additional public holiday this month for the funeral of Queen Elizabeth II may tip the U.K. into a technical recession this quarter.

The announcement has led major banks to rapidly reappraise their inflation projections. Barclays now expects inflation to close out 2022 at slightly below 9%, well below the Bank of England's 13.3% projected peak, and the British lender cut its forecast for 2023 CPI inflation from 9% to 5.5%.

U.K. inflation unexpectedly cooled in August, new data showed on Wednesday, so the Bank of England Monetary Policy Committee may be revisiting its outlook. However, economists were cautious of calling the peak, with some speculating that last month's reading may have been a "fluke" on a broader upward trajectory. 

Food and non-alcoholic beverage inflation rose to 13.1%, further compounding the day-to-day struggles facing household finances.

"Although the first-order impact of 'Trussonomics' will be to lower inflation over the next twelve months, the sheer scale of stimulus is likely to add to inflation in the medium term, pointing to a higher terminal rate than the (Bank of England's) MPC had previously embedded," said BNP Paribas Chief European Economist Paul Hollingsworth.

"Indeed, we note that the MPC is even further behind the market-implied terminal rate than when it began its tightening cycle."

Although details are set to be announced later this month, the government is expected to fund the difference arising from the price cap through borrowing, rather than a windfall tax on energy companies proposed by opposition parties.

"A package funded through public debt issuance would not be consequence-free for markets and would need to be factored in by the BoE when deciding on the operational details of its QT [quantitative tightening] programme, in particular the size of active sales and the start date," Barclays Chief U.K. Economist Fabrice Montagne said in a note last week.

Inflation and a tight labor market

The Bank of England has deferred its next monetary policy decision until Thursday Sept. 22 due to the death of the British queen. The Bank launched its biggest interest rate hike for 27 years in August and is broadly expected to opt for another 75 basis point rise this month.

"Following the announcement of the energy bills support package, we increased our Bank Rate forecasts; we now expect rates to reach 3.5% by year end," AXA's Adegbembo said. 

"Whilst the package is set to reduce headline inflation, the boost to growth it will provide leaves the Bank of England with more to do to ensure inflation returns to target."

AXA expects a 75 basis point hike this week, in line with market expectations, with further 50 basis point increases anticipated in November and December.

Truss was highly critical of what she considered the Bank of England's failure to nip inflation in the bud during her campaign for the Conservative Party leadership, and is reportedly considering a review of its mandate. 

Governor Andrew Bailey has repeatedly affirmed the Bank's imperviousness to political pressure, but BNP's Hollingsworth suggested that with inflation so high, "the optics of under-delivery are different against the current backdrop."

Truss's government and the central bank also have to contend with a historically tight labor market, with U.K. unemployment at a 48-year low and the economic inactivity rate at a five-year high, fueling further fears that inflation will be entrenched in the British economy.

Real wages — taking into account inflation — excluding bonuses fell by 2.8% in the three months to the end of July.

Tax reform

During her campaign, Truss argued in favor of tax cuts to boost growth and advocated for the controversial theory of "trickle-down" economics. 

She promised to cancel Sunak's hikes to corporate tax and National Insurance — a tax on earnings — which had been deployed to bolster the public purse in order to address the cost-of-living crisis directly.

The scrapping of both policies is expected to cost the public purse around £30 billion, with Kwarteng to set out details in his mini-budget later this month.

The energy price freeze and broad tax cuts have drawn criticism for disproportionately aiding the country's wealthiest households.

The Resolution Foundation, an independent think tank focused on living standards for low- and middle-income households, projected that the overall support package would benefit the highest-income decile of the population by £4,700 per year on average, while the poorest decile would receive £2,200.

Although Kwarteng's mini-budget will offer more details on how the tax cuts and energy package will be funded, many commentators and political opponents have suggested that Truss's opposition to levying windfall taxes on oil and gas companies — which have enjoyed record profits due to soaring energy prices — means the costs may well be recouped from taxpayers and cuts to investment in public services.

Truss repeatedly rejected the idea of direct government intervention to cap household energy bills while on the campaign trail, only to announce the new bumper fiscal package a week later.

Economists will be watching for any hints of further U-turns coming down the pike as the new prime minister weighs her economic principles against the country's precarious position.