The UK economy is suffering from severe stagflation and the outlook is bleak. That’s the conclusion financial markets drew this week from more disappointing data that underscored weakness in the post-COVID-19 economy and persistence of high inflation.
With output not growing since last July and inflationary pressures rising along with wages, few are happy with the way the economy is doing.
Bank of England Governor Andrew Bailey has begun a review of his own performance after accepting that inflation has been taking “much longer than we expected”. Financial market traders shunned UK government debt, pushing two-year borrowing costs above levels hit at the worst of Liz Truss’ short tenure in office. Facing households with average real wages no higher than they were in 2005 and soaring mortgage costs, ministers have given them little consolation by telling them the economy has avoided recession.
All of this is ahead of a general election expected next year. Lord Nick Macpherson, a former senior Treasury official, said this meant the government would face voters at a time of recent interest rate rises and the economic pain necessary to squeeze inflation out of the system. “I don’t recall an election where 18 months (after the vote) interest rates were still rising sharply,” he said.
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Adam Posen, head of the Peterson Institute think tank in Washington, went a step further, saying that compared with the US and the euro zone, the UK was suffering from the additional problems of Brexit, the loss of credibility in economic governance and the legacy of deficits. – Investment in public health and transport services.
“It’s not good,” Posen said, highlighting what he said were signs that inflation in Britain would remain in place for longer than in most other advanced economies on both sides of the Atlantic. “The mystery to me is not that the UK economy is doing worse than the eurozone or the US, but why it isn’t doing worse and why sterling remains strong.”
common problem
On Monday, UK chancellor Jeremy Hunt dismissed such comments as “declineists”. But later in the week he was forced to address inflationary pressures again, saying the government was aware of the pain in household budgets and the best he could do was to “support the Bank of England as they are reining in inflation”.
The chancellor may feel he has reason to be aggrieved by the market and media reaction. This week’s own economic difficulties in the US and the euro zone have shown that the UK is not alone. After keeping interest rates between 5% and 5.25%, Federal Reserve Chairman Jay Powell acknowledged on Wednesday that U.S. inflation had not been hit as he signaled the central bank would need to raise rates two more times. Powell said the Fed still needs to see “credible evidence that inflation is peaking and then starting to come down.”
ECB President Christine Lagarde also warned that inflation across the euro zone would remain “too high for too long” as she raised interest rates for the eighth time in a row and proposed new Forecasts, showing inflation was higher than previously expected, while growth slowed.
So general economic problems are common, but financial markets single out the UK because most people think the problems in the UK are more difficult than elsewhere.
Data over the past month showed that core inflation rose to 6.8% in April from 6.2% in March, a departure from more stable rates in the euro zone and the US. Wage data released this week showed average earnings rose at a near-record 7.2% annual rate between February and April. These have convinced traders that the Bank of England needs to tighten policy further, as rapidly rising wages are incompatible with the 2% target inflation rate.
By Friday, expectations for official U.K. interest rates had risen to a peak near 6%, from as low as 4.5% in early May.
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While many problems are common, there are differing views on what made things worse in Britain and how financial markets reacted more than most other economies.
One theory is that it was hit by the world’s worst on both sides of the Atlantic. It has seen the kind of strong demand in the United States that has led to labor shortages, while also experiencing high energy prices elsewhere in Europe due to the war in Ukraine.
Financial markets and many economists see more explanations for continued rapid wage growth and a gloomy outlook even as the energy price shock begins to fade.
Economists said the huge market reaction to this week’s data was partly 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 long-term growth and productivity.
Bailey was forced to admit in recent testimony to MPs that the BoE’s forecasting models have been failing of late, forcing MPC members to “target” when setting interest rates. Under pressure to explain the errors, the BoE hastily announced this week a broad review of its forecasting process, acknowledging the extent of concerns about how it communicates its policy decisions.
Simon French, chief economist at investment bank Panmure Gordon, said: “The Bank of England has managed to undercut its well-deserved reputation for competence in this area in recent quarters.” The BoE bases its forecasts on publicly announced government policy, he said. The deal raised a problem that sometimes “policy stances are widely viewed as lacking credibility” and the government may increase spending or reduce taxes.
severity of the challenge
There are two deeper problems. First, rapid wage growth suggests that the public believes inflation will remain high for longer and is seeking to defend its interests. Second, while Rishi Sunak’s government has succeeded in rebuilding market credibility after the fall’s turmoil, it has not convinced investors that it can lift the economy out of secular stagnation. This week’s renewed political drama within the Conservative Party will not help.
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Data this week showed that while Britain has so far avoided recession, output is no higher than it was in October 2019, while household income has been flat since 2005. This has resulted in “a large swath of the economy at a standstill and low productivity”, according to a think tank.
Hunt assured the audience at an event in London last week that the government was committed to boosting productivity in both the public and private sectors to escape the “low growth trap”.
But a trade report published by the Resolution Foundation on Thursday underscored the magnitude of the challenge facing the UK. It argues that unless ministers accept the need to radically rethink trading arrangements with the EU, the most productive part of the country’s manufacturing sector is doomed to decline.
Andrew Goodwin of Oxford Economics said that despite measures announced by Hunt in the March budget — including expanding state-funded childcare to help more parents work — investors “are still Awaiting a credible supply-side strategy”. Without it, as recent data show, “there’s not any growth at all . . . it’s pretty inflationary,” he said.
What this means is obvious. If the UK economy barely grows 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 – to keep inflation in check.
The first sign of the Bank of England’s thinking will come on Thursday when it sets rates for the first time after spooking financial markets. Almost all economists expect the Bank of England to raise rates by a quarter of a percentage point to 4.75%, as they see no doubt that economic data has cleared the hurdle for the central bank’s desire to see “more persistent price pressures” before raising rates.
Economists at BNP Paribas said that while rate-setters may have previously been wary of raising rates above 5% – because of the “huge” impact on homeowners – “we now think the MPC will be more willing to cross the Rubicon “.
Some economists reject the argument that Britain is inherently more inflationary, arguing that its deflation has only been delayed.
Swati Dhingra, one of the MPC members already opposed to further tightening, argued this week that the impact of rate hikes may take longer than in the past to be felt because fixed-rate mortgages are more common . Still, she said, higher interest rates “have begun to add to ongoing pressure on households renting or negotiating in the mortgage market,” and wage growth is expected to slow soon.
But over the past month, as evidence of Britain’s stagflation problems mounts, such warnings have grown less pronounced.
While data may spontaneously improve to make Britain’s problems look less serious, most MPC members are poised to send a tough message on Thursday: they need to keep putting the brakes on because they can’t let wages and prices push each other up .
As MPC member Jonathan Haskel recently said: “As difficult as we are now, embedded inflation would be worse.”