Inflation, Interest Rates, Net Debt: Why Is The UK’s Economy Such A Mess?

The UK economy seems to have been flailing for some time now – and it doesn’t look like that’s going to change any time soon.

In fact, new figures from the Office for National Statistics, released on Wednesday,  suggest things are really starting to stagnate as the cost of living crisis rumbles on.

So what’s behind all of this bad news, and what can we expect to happen next?

Three main figures paint a pretty bleak picture of our national finances:

1. Consumer price index (CPI) inflation remained the same as April in May – 8.7% instead of continuing its steady decline to 8.4% as previously hoped.

2. Core CPI inflation increased to 7.1%, the highest rate since 1992, instead of declining to the expected rate of 6.8%.

3. UK net debt passed 100% of GDP for the first time since 1961, as state borrowing more than doubled to £2.6 trillion – suggesting taxes probably won’t decline any time soon either. 

Inflation is the rate at which goods and services produced in one country increased over the last 12 months.

The Bank of England’s job is to keep this level at 2%, so the economy can grow but not too quickly that people can’t afford things.

Unfortunately, inflation soared up to double digits (11.1%) last autumn, and although it has come down to 8.7% (as of April) it is proving to be more stubborn than expected.

So the Bank’s Monetary Policy Committee will probably use the same lever it’s used before: increasing interest rates to bring down inflation.

This makes borrowing, such as buying credit or taking out a mortgage, more expensive – meaning people are less likely to spend.

That would then (in theory) make the economy balance out.

This is seriously affecting the cost of living, and it doesn’t bode well for any kind of change in the imminent future including other forms of government relief like tax cuts, mortgage relief or bill assistance.

So, another rise in interest rates is expected from the Bank on Thursday.

This is going to have knock-on impact for mortgage repayments – and the average five-year fixed rate has already climbed to 5.67%.

The Institute for Fiscal Studies has warned that higher rates would mean 1.4 million mortgage holders could lose more than 20% of their disposable income.

And rent now accounts for 28.3% of the average income, up from 27% on average for the last decade, according to numbers seen by the BBC.

Elsewhere, food inflation fell from 19.1% to 18.4%, which seemed positive on the surface – but services inflation has taken up the lead instead.

Rather than dropping from 6.9% to 6.8%, as forecast by the Bank of England, it was up to 7.4%.

Torsten Bell of the Resolution Foundation explained on Twitter that this is because goods which are meant to be driving down inflation are doing so – but leisure and hospitality are taking over instead.

He said this is due to “less demand surge” and the bigger than hoped for trickle-down of higher energy and goods costs into consumers – and high food prices continue to mean inflation is tougher on poorer households. 

It’s a mixed picture. 

Government minister Mel Stride said UK food prices are rising at a slower rate than other countries, saying: “In Germany, Portugal and Sweden, it’s running at about 20%, so higher than it is here.”

As of this month, however, the UK’s food inflation is higher than those three other countries as their rates have fallen significantly since March, unlike the UK’s.

Oxford Economics compared the UK to the whole of the EU, and found food costs here were about 7% below the EU average – but that was in relation to a whole range of economies.

Ananda Roy at consumer analysts Circana told the BBC earlier this month: “Whilst in the UK we’re experiencing higher prices for certain everyday items, at the same [time] we’re paying less than our European counterparts for others.”

The current inflation is global, but the UK seems to be feeling it a lot for a few reasons:

Former Bank of England governor Mark Carney told The Telegraph last week that he knew Brexit would create a “negative supply shock for a period of time and the consequence of that will be a weaker pound, higher inflation and weaker growth”.

He added: “It’s happened in coincidence with other factors but it is a unique aspect of the economic adjustment that’s going on here.”

The amount of red tape, especially importing animal produce, that came with Brexit meant importing food became more costly.

Academics at the London School Economics think Brexit added £250 in total to the typical household’s grocery shopping bills between December 2019 and March 2023 – an increase which mostly happened before the cost of living crisis hit.

Investment in UK services has stalled since the referendum too, but this could change when Sunak’s Windsor Framework – to address the problems with the Irish border – comes in.

However, just blaming Brexit overlooks the consequences of the pandemic and the war.

Ukraine’s export industry, previously described as the world’s bread basket, was hit by the Russian invasion last year, meaning a shortage of grains, fertiliser and fuel. And with less supply, prices were able to rise.

However, global food prices have been falling recently as markets look to other countries to meet the demand for products – it just takes a while for that impact to reach the consumer.

Bad weather from supply countries caused empty shelves earlier this year, because of the impact on crops and harvesting.

While this affected several nations, European countries which can grow their own food saw less significant price changes than the UK.

The ONS said the UK’s prices have been rising faster for longer because of the dependence on food imports.

Leaving the EU meant 330,000 fewer workers in the UK, according to the Centre for European Reform – that’s less than 1% of the UK workforce, but it still hit the transport, hospitality and retail sectors.

Employers now have to pay workers more to keep them, and these costs get passed onto consumers. 

There will almost certainly be another hike to interest rates, but it is concerning that the current high rate of 4.5% is not effective enough.

It means Rishi Sunak’s promise to halve inflation by December is now looking even more ambitious.

One of chancellor Jeremy Hunt’s advisors, Karen Ward, even called for the Bank to trigger a recession to fix the current crisis – which she claims would stop a wage-price spiral.

She said: ″The difficulty for the Bank of England is… they have to therefore create a recession. They have to create uncertainty and fragility.”

She said it’s only when workers and companies feel less confident that they don’t push for higher pay – “it’s that weakness which eventually gets rid of inflation.”