The UK economy is suffering a nasty bout of stagflation and the prospects appear poor. That is the conclusion financial markets drew this week from yet more disappointing data, highlighting the weakness of the post-Covid economy and the persistence of high inflation.
With no growth in output since last July and inflationary pressures intensifying as wage growth increases, almost no one is satisfied with the way the economy is working.
Andrew Bailey, governor of the Bank of England, launched a review into its own performance after accepting inflation was “taking a lot longer than we expected” to fall away. Traders in financial markets shunned UK government debt, sending two-year borrowing costs above the levels hit in the worst moments of Liz Truss’s shortlived tenure as prime minister. And households, facing average real pay no higher than in 2005 and soaring mortgage costs, drew little comfort from ministers telling them that the economy had avoided a recession.
All of this is taking place ahead of a general election that is expected next year. Lord Nick Macpherson, a former top official at the Treasury, says this means the government would face voters at a time of recently rising interest rates and necessary economic pain to squeeze inflation out of the system. “I can’t remember an election when, 18 months out [from the vote], interest rates were still rising steeply,” he says.
Adam Posen, head of the Peterson Institute think-tank in Washington, goes even further, saying that in comparison to the US and eurozone, the UK is suffering the additional problems of Brexit, a loss of credibility of economic governance and the legacy of under-investment in public health and transport services.
“It’s not good,” says Posen, highlighting what he says are signs that inflation would stay higher for longer in the UK than in most other advanced economies on both sides of the Atlantic. “The mystery to me is not so much the UK economy doing worse than the eurozone or the US, but why it’s not doing even worse and why sterling remains as strong as it is.”
Common problems
Chancellor Jeremy Hunt dismissed such talk as “declinist” on Monday. But later in the week he was forced again to address inflationary pressures, saying the government was aware of the pain on families’ budgets and the best he could do was “support the Bank of England as they bear down on inflation”.
The chancellor might feel he has cause to be aggrieved by the market and media reaction. Both the US and the eurozone’s own economic difficulties this week show that the UK is not alone. After holding interest rates at between 5 and 5.25 per cent, Federal Reserve chair Jay Powell accepted on Wednesday that US inflation had not been beaten as he signalled the central bank would need to raise interest rates another two times. The Fed still needed to see “credible evidence that inflation is topping out and then beginning to come down”, Powell said.
Christine Lagarde, European Central Bank president, also warned that inflation would stay “too high for too long” across the eurozone as she raised interest rates for the eighth consecutive time and presented new forecasts showing higher inflation and slower growth than previously expected.
The general economic problems are therefore common, but financial markets have singled the UK out because most believe the issues are more difficult in the UK than elsewhere.
Over the past month data has showed core inflation rising from 6.2 per cent in March to 6.8 per cent in April, unlike the more stable rates in the eurozone and US. Wage figures published this week showed average earnings grew at a near-record pace of 7.2 per cent on an annual basis between February and April. These convinced traders that the BoE would need to tighten the screws further because rapidly rising wages were not compatible with a target rate of 2 per cent inflation.
By Friday, expectations of UK official interest rates had risen to a peak of close to 6 per cent, having been at as low as 4.5 per cent in early May.
Views differ on what makes the UK’s situation worse and financial market reaction larger than most other economies when many of the problems are shared.
One theory is that it has suffered the worst of all worlds on both sides of the Atlantic. It has had the sort of strong demand seen in the US that has led to labour shortages while also experiencing the blow from high energy prices that the rest of Europe has faced from the Ukraine war.
Financial markets and many economists think it will take more than this to explain the continued rapid growth of wages and the downbeat outlook even as the energy price shock starts to dissipate.
The outsized market reaction to this week’s data, economists say, is in part due to growing doubts about the wage setting process, the Bank of England’s handling of inflation and the lack of a convincing government strategy to boost growth and productivity in the longer term.
Bailey was forced to admit, in recent testimony to MPs, that the BoE’s forecasting models had been misfiring recently, forcing monetary policy committee members to “aim off” in setting interest rates. Under pressure to explain these errors, the BoE this week rushed forward an announcement of a wide-ranging review of its forecasting processes, acknowledging the extent of concerns about its communication of policy decisions.
“The Bank of England has managed to dent a well-deserved reputation for competence in this arena over recent quarters,” says Simon French, chief economist at the investment bank Panmure Gordon. One problem arose from the BoE’s protocol of basing forecasts on publicly announced government policy, he says, at times when it was “widely accepted that the policy position lacks credibility” and the government was likely to spend more or tax less.
The severity of the challenges
There are two deeper problems. First, that the rapid growth of wages suggests that the public think inflation will stay higher for longer and are seeking to defend their interests. And second, that although Rishi Sunak’s government has managed to rebuild credibility with markets after the autumn’s turmoil, it has not convinced investors it can lift the economy out of its long-term stagnation. This week’s renewed political drama within the Conservative party will not have helped.
The data this week showed that while the UK has so far avoided recession, output is no higher now than in October 2019 while households’ earnings have been flat since 2005. With more people in work, James Smith, research director at the Resolution Foundation, a think-tank, says this left “much of the economy flatlining and productivity tanking”.
Hunt assured an audience at an event in London last week of the government’s commitment to boosting productivity in both the public and private sectors to escape a “low growth trap”.
But a report on trade published on Thursday by the Resolution Foundation underlined the severity of the challenges the UK faces. It argued that the most productive parts of the country’s manufacturing sector would be doomed to decline unless ministers embraced the need for a radical rethink of trade arrangements with the EU.
Andrew Goodwin, at the consultancy Oxford Economics, says that despite the measures announced in Hunt’s March Budget — including the expansion of state-funded childcare to help more parents work — investors are “still waiting for a credible supply side strategy”. In its absence, as the recent data shows, “any growth at all . . . is quite inflationary”, he says.
The implications of this are stark. If the UK economy can barely grow without overheating, the Bank of England will be forced to inflict more pain on households — in the form of job losses and higher mortgage costs — in order to bring inflation under control.
The first indication of the BoE’s thinking will come on Thursday, when it sets interest rates for the first time since financial markets have taken fright. Almost all economists expect the BoE to raise rates by 0.25 percentage points to 4.75 per cent because they think there is little doubt the economic data has cleared the central bank’s hurdle of wanting to see “more persistent pressures” on prices before it raised rates.
Economists at BNP Paribas said that while rate setters might previously have worried about raising interest rates above 5 per cent — because of the “outsized” effect on homeowners — “we now think the monetary policy committee will be more willing to cross the Rubicon”.
There are economists who reject the argument that the UK is inherently more inflationary and think its disinflation is merely delayed.
Swati Dhingra, one of the MPC members who has already opposed any further tightening in policy, argued this week that the effects of interest rate rises could take longer to show up than in the past, because fixed rate mortgages were more prevalent. Despite this, higher rates were “already starting to add to ongoing pressures for families that are renting or negotiating in the mortgage market”, she said, and wage growth could also be expected to slow soon.
But cautionary voices such as this have become rarer over the past month as the evidence of the UK’s stagflationary problems have mounted.
Although the data might improve spontaneously, making the UK’s problems appear less severe, most MPC members are poised to deliver a tough message on Thursday: that they need to keep pressing harder on the brakes because they cannot allow wages and prices to drive each other higher.
As Jonathan Haskel, an MPC member, recently said: “As difficult as our current circumstances are, embedded inflation would be worse.”
