The writer is the author of ‘Two Hundred Years of Immersion: The Surprising Story of the British Economy’
The Bank of England’s new forecasts are particularly bad. In recent months, the bank’s governor Andrew Bailey has warned that the institution is walking “a narrow path” between the risks of continued high inflation and the chance of a recession. The UK is currently going through both of these, leaving the next prime minister subject to some uncomfortable choices.
BoE forecast that inflation will peak at an annual rate of more than 13% and remain above 10% for much of 2023. It forecasts the economy will slip into a recession next quarter and won’t return to growth until next year. 2024. Even then, the eventual recovery will be anemic. According to the bank’s central scenario, the unemployment rate will increase over the next three years.
The BoE expects the depth of the recession to be comparable to that of the early 1990s, and milder than after the financial crisis or pandemic-related shutdowns, but affect household incomes. will be much more profound. The forecast shows the biggest drop in real household disposable income in two years.
However, despite forecasts of a recession, the Monetary Policy Committee delivered a 0.5% increase in interest rates – the biggest increase since the bank achieved independence in 1997. While the UK is not alone among advanced economies in suffering uncomfortably high inflation, the nature of inflation in the UK is starting to look more worrisome.
European inflation is primarily a story of soaring energy prices while US inflation is currently being driven by a tight job market that pushes up costs in the services sector. England has a dose of both.
MPC has largely been content to view inflation above target due to higher global commodity prices and pandemic-related supply chain disruptions, but now believes that domestic-generated price pressures require must take more decisive action. In the MPC’s view, easing those domestic pressures requires a painful panacea: higher interest rates to slow hiring decisions and ease the heat of the job market even as the job market heats up. High energy prices have put pressure on consumer income and spending.
That view is certainly open-ended. Cornwall Insight, a consulting firm, calculates that a typical household’s domestic energy bill will be around £3,500 in 2023 – up from almost £1,000 in 2021. With consumers moving forced to spend about 9% of its after-tax income on energy by 2023, up from 4.6% before the price hike, discretionary spending on other goods and services would plummet.
Labor-intensive consumer-facing service companies can rethink hiring plans relatively quickly when demand dries up. A proportion of those in their 50s and 60s who retire earlier than expected in 2020 and 2021 could return to work for a living, boosting the labor supply. Rising energy bills cause short-term inflation. But in the medium term, they act as a deflationary tax boost for households and businesses.
But whether or not the BoE’s projections are correct about how the job market and domestic price pressures will develop, they are almost certainly wrong when it comes to how the Treasury will react. The bank’s latest numbers are, as always, conditional on no change in fiscal policy. However, when Britain gets a new prime minister in early September, some form of fiscal easing in the form of tax cuts, further reductions in energy bills or both will follow. It’s unlikely any of these measures will be enough to stave off a recession at this point, but they could still ease some pressure on household incomes in the coming months.
Whoever is Britain’s next prime minister, their relationship with the BoE will become increasingly strained. An MPC set to raise rates during a forecast recession is signaling that it will move to offset any fiscal easing coming from the government with tighter policy.
The bank has concluded that a recession is needed to bring inflation back on target. Liz Truss, the favorite to win the Conservative Party leadership contest by both polls and bookmakers, has praised the BoE in recent weeks for its failure to keep inflation in check. She is unlikely to be particularly pleased with a central bank that is prepared to act by raising interest rates amid a slowing economy and offsetting any easing of government policy that she he leads.
Against the backdrop of global energy price inflation, a combination of looser fiscal policy and tighter monetary policy could work for the UK. Targeted fiscal support could support households most at risk from rising prices and prevent some other viable businesses from taking over. A higher exchange rate could support the value of the pound and help ease import price pressures.
But choosing the right matching policy for Britain today is a lot like picking the least wrinkled shirt from the laundry basket: the best choice is not necessarily the best choice. The country is poorer than people think. In the short term that is inevitable. The real policy debate is about how that pain is divided among households, businesses and government balance sheets – not how to avoid that pain.
