The writer is the author of “Two Hundred Years of Muddling Through: The Surprising Story of the British Economy”
The new Bank of England forecast gives an exceptionally bleak reading. In recent months, the bank’s governor, Andrew Bailey, has warned that the institution is walking “a narrow path” between the risks of high inflation and the possibility of a recession. The UK is now on the cusp of experiencing both, leaving the next prime minister with some uncomfortable choices.
The BoE forecasts that inflation will peak at an annual rate of over 13% and will remain above 10% for much of 2023. It forecasts that the economy will slide into recession in the next quarter and not return to the growth than in 2024. Even then, the eventual recovery will be anemic. Unemployment, in the bank’s central scenario, will increase for each of the next 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 impact on household income will be much deeper. Forecasts show the largest two-year drop in real household disposable income on record.
Yet despite recession forecasts, the Monetary Policy Committee recorded a 0.5% hike in interest rates – the biggest increase since the bank gained operational independence in 1997. While the UK is far from alone among advanced economies when it comes to suffering from high inflation, the nature of UK inflation is starting to look more worrying.
European inflation is primarily a story of soaring energy prices, while US inflation is now driven by a tight labor market that is driving up costs in the services sector. Britain has a dose of both.
The MPC was content to look past above-target inflation due to higher global commodity prices and pandemic-related supply chain disruptions, but now believes that Domestically generated price pressures require stronger action. Lowering these domestic pressures requires painful medicine, says the MPC: higher interest rates to slow hiring decisions and dampen some of the heat from the job market, even as high energy prices weigh already on consumer income and spending.
This view is certainly debatable. Cornwall Insight, a consultancy, estimates that the typical home energy bill for a household will be around £3,500 in 2023, up from almost £1,000 in 2021. With consumers forced to spend around 9% of their after-tax energy income in 2023, from 4.6% before the price hike, discretionary spending on other goods and services will fall sharply.
Labour-intensive, consumer-facing service companies could rethink their recruitment plans fairly quickly as demand dries up. Some of the 50- and 60-somethings who retired earlier than expected in 2020 and 2021 could find themselves drawn into work to make ends meet, pushing up labor supply. Soaring energy bills are inflationary in the short term. But in the medium term, they act as a deflationary tax hike on households and businesses.
But whether or not the BoE’s forecasts are correct on developments in the job market and domestic price pressures, they are almost certainly wrong when it comes to the Treasury’s reaction. The bank’s latest figures, as is always the case, are conditional on no change in fiscal policy. However, once Britain has a new prime minister in early September, some form of fiscal easing in the form of tax cuts, further rebates on energy bills or both will follow. It’s hard to imagine 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 the next British Prime Minister is, his relationship with the BoE will become increasingly strained. An MPC ready to raise interest rates in an expected recession signals that it will act to offset any fiscal easing coming from the government with tighter policy.
The bank concluded that a recession is necessary to bring inflation back to target. Liz Truss, the favorite to win the Tory leadership race according to polls and bookmakers, has chastised the BoE in recent weeks for its failure to control inflation. She is unlikely to be particularly pleased with a central bank willing to take action by raising rates in 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 suit Britain. Targeted fiscal support can support households most at risk from rising prices and prevent some otherwise viable businesses from going bankrupt. Higher rates could support the value of the pound and help ease pressures on imported prices.
But choosing the right policy mix for Britain today is like taking the least creased shirt out of the laundry basket: the best option isn’t necessarily the right one. The country is poorer than he thought. In the short term, it is inevitable. The real political debate is about how this pain is distributed among households, businesses and the government’s balance sheet, not how it is avoided.