The writer is author of ‘Two Hundred Years of Muddling Through: The Surprising Story of the British Economy’
The Bank of England’s new forecasts make for exceptionally grim reading. In recent months the bank’s governor Andrew Bailey has warned that the institution is walking “a narrow path” between the risks of continuing high inflation and the chance of a recession. The UK is now set to experience both, leaving the next prime minister with some uncomfortable choices.
The BoE forecasts that inflation will peak at an annual rate of more than 13 per cent and remain above 10 per cent for much of 2023. It foresees the economy slipping into recession in the coming quarter and not returning to growth until 2024. Even then, the eventual recovery will be anaemic. Unemployment, in the bank’s central scenario, will rise for each of the coming three years.
The BoE expects the depth of the recession to be comparable to that of the early 1990s, and milder than that which followed either the financial crisis or the lockdowns associated with the pandemic, but the hit to household incomes will run far deeper. The forecasts show the largest two-year fall in real household disposable income on record.
Yet despite forecasting a recession, the Monetary Policy Committee delivered a 0.5 per cent rise in interest rates — the largest single increase since the bank gained operational independence in 1997. While the UK is far from unique among advanced economies when it comes to suffering from uncomfortably high inflation, the nature of Britain’s inflation is beginning to look more troubling.
European inflation is primarily a story of soaring energy prices while American inflation is now being driven by a tight jobs market pushing up costs in the service sector. Britain has a dose of both.
The MPC has been content to mostly look past above-target inflation driven by higher global commodity prices and pandemic-related supply chain disruptions, but now believes that domestically generated price pressures require firmer action. Bringing those domestic pressures down, in the MPC’s view, requires painful medicine: higher interest rates to slow hiring decisions and take some of the heat out of the jobs market even as high energy prices already put the squeeze on consumer incomes and spending.
That view is certainly open to question. Cornwall Insight, a consultancy, reckons that the typical household domestic energy bill will be about £3,500 in 2023 — up from closer to £1,000 in 2021. With consumers forced to spend about 9 per cent of their post-tax income on energy in 2023, up from 4.6 per cent before the price rise, discretionary spending on other goods and services will fall sharply.
Labour-intensive consumer-facing services firms may rethink recruitment plans relatively quickly as demand dries up. A proportion of the fifty and sixty-somethings who took an earlier than expected retirement in 2020 and 2021 may find themselves drawn back into work to make ends meet, pushing up labour supply. Soaring energy bills are inflationary in the short term. But in the medium term they act as a deflationary tax rise on households and firms.
But whether the BoE’s forecasts are correct or not on how the jobs market and domestic price pressures will develop, they are almost certainly wrong when it comes to how the Treasury will respond. The bank’s latest numbers, as is always the case, are conditional on there being no change in fiscal policy. Once Britain has a new prime minister in early September, however, some form of fiscal easing in the shape of tax cuts, further energy bill rebates or both will follow. It is hard to see any of these measures being enough to avert a recession at this point, but they could still ease some of the pressure on household income in the months ahead.
Whoever is Britain’s next premier, their relationship with the BoE will become increasingly fraught. An MPC prepared to raise interest rates into a forecast recession is signalling that it will move to offset any fiscal easing coming from the government with tighter policy.
The bank has concluded that a recession is necessary to return inflation to target. Liz Truss, the favourite to win the Conservative leadership contest according to both the polls and the bookmakers, has berated the BoE in recent weeks for its failure to control inflation. She is unlikely to be especially happy with a central bank prepared to take action by raising rates into a slowing economy and offsetting any policy easing by a government she leads.
Against a backdrop of global energy price inflation, a mix of looser fiscal policy and tighter monetary policy may well be appropriate for Britain. Targeted fiscal support can support the households most at risk from rising prices and prevent some otherwise viable firms from going under. Higher rates may support the value of sterling and help damp imported price pressures.
But choosing the right policy mix for Britain now is very much akin to picking out the least crumpled shirt from the laundry basket: the best option is not necessarily a good one. The country is poorer than it thought it would be. In the short term that is unavoidable. The real policy debate is about how that pain is divided between households, firms and the government’s balance sheet — not how it is avoided.