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24 August 2022

The coming economic storm

As inflation reaches a 40-year high and with Britain facing a punishing recession, the Conservative leadership contenders have failed to grasp the scale of the crisis.

By Duncan Weldon

Having endured one lost decade of stagnant growth and declining living standards, Britain is heading for a second. The economy shrank by 0.1 per cent in the second quarter of this year and the Bank of England has forecast that output will fall for five consecutive quarters.

Threadneedle Street now expects inflation, which already stands at a 40-year high of 10.1 per cent, to peak at over 13 per cent this year. Perhaps more alarmingly, the Bank forecasts that it will still be around 9.5 per cent next autumn. Unemployment is expected to increase for each of the next three years, rising from 3.8 per cent at present to 6.3 per cent.

While the coming recession, in the Bank’s view, will be comparable to that of the early 1990s, and less severe than those experienced after the 2008 financial crisis or during the Covid-19 pandemic, it will also hit households far harder. Real household disposable income – the income of households after accounting for changes in prices, taxes and benefits – is due to fall in both 2022 and 2023. The cumulative drop anticipated by the Bank’s baseline scenario is the largest two-year fall since at least the 1950s. While the poorest households – which spend the greatest share of their income on essentials such as food and fuel – will be the worst affected, almost no one will escape the pain.

[See also: Can interest rate rises reduce the UK’s “astronomical” inflation?]

That pain is mostly emanating from what economists rather prosaically call a “negative terms-of-trade shock”. In straightforward terms, the price of goods that the UK imports, such as energy and food, has soared, reducing our ability to pay for them. According to the World Bank, global energy prices have risen by 165 per cent since the beginning of 2021 and food prices by almost 30 per cent. In effect, the country finds itself poorer than it expected to be.

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The combination of a global energy spike, multi-decade inflation highs and industrial unrest has prompted more than the usual number of commentators to make analogies with the 1970s. But most of these comparisons are inaccurate. The structure of the UK jobs market was changed almost beyond recognition by the Thatcherite assault on the trade unions in the 1980s. The labour market today is far more flexible, and worker bargaining power is inherently weaker. Fretting about a wage-price spiral when wage growth is markedly lower than inflation feels almost perverse. The economy is more globalised and supply chains are far more international, and the inflation dynamics are different.

But there is one sense in which looking to the 1970s is instructive. It was a decade in which the British economy was hit by multiple, simultaneous shocks that often pushed politicians to respond in contradictory ways. And, even with the benefit of years of hindsight, it is tricky to say exactly how policymakers should have acted. Much like now, there was no easy way out of the mess.

The Bank of England, at the same time as unveiling its apocalyptic forecasts, increased interest rates by 0.5 percentage points, the largest single rise in 27 years. Since December 2021 it has hiked borrowing costs from just 0.1 per cent to 1.75 per cent. Financial markets expect the Bank’s base rate to reach 2.75 per cent by the end of next year.

This is the fastest tightening of British monetary policy in three decades and comes even as the UK falls into recession. Understanding why the Bank is acting to slow an already weak economy means delving into the nature of the UK’s high inflation.

Britain is far from unique in suffering from price surges. Inflation is at or near a 40-year high across the eurozone (8.6 per cent) and the US (8.5 per cent). But the main causes vary. In Europe the story is mostly one of high energy and food prices. In the US the decisive factor has been higher services price inflation, as a tight labour market (where workers are in short supply) pushes up wages and adds to the cost base of firms, which are trying to pass some of that cost to consumers.

The UK has a dose of both. While energy prices are the single largest factor, services price inflation is running at 5.7 per cent, its fastest pace since the early 1990s. The labour market – for now, at least – remains tight. There are more advertised job vacancies than unemployed workers, partially due to the supply of potential workers being lower than before the pandemic.

The Bank’s rate-setting Monetary Policy Committee is charged by the government with meeting an inflation target of 2 per cent. Its members accept their relative powerlessness when confronted by globally generated energy prices, but they have become convinced that domestically generated price pressures are now a concern. The best way to understand their new strategy is to realise that they have decided a recession is necessary to bring inflation back to target. For the first time since it was granted operational independence by Gordon Brown in 1997, the Bank finds itself playing the role of “bad cop”, introducing harsh monetary policy that it hopes is in the long-term interests of the economy.

Ironically, the politicians who have castigated the Bank in recent months for “failing to control inflation”, such as the Conservative leadership front-runner Liz Truss, are unlikely to be especially happy with a Bank now acting to bring down inflation.

It is worth stepping back and reminding ourselves exactly how the Bank “controls” inflation. The mechanism is increasing borrowing costs in order to raise mortgage bills, make corporate investment harder, and slow hiring and wage growth.

[See also: How much will it soon cost to boil a kettle?]

All of this makes the job of government ministers more difficult. The clear signal from the Bank is that, as politicians intervene to prop up the economy through household support payments or tax cuts, it will raise interest rates faster to bear down on inflation.

But whatever the Bank’s intentions, there is no doubt that households need more support. The typical annual energy bill is forecast to rise from £1,971 at present to around £3,600 by October and perhaps as much as £4,400 in April 2023. Just 18 months ago the typical bill was closer to £1,000. According to one estimate by the University of York, two thirds of UK households will be in fuel poverty (defined as spending more than 10 per cent of net total income on energy) by January. Even relatively high earners will struggle to cope with price rises of this magnitude. The median income for households in the top fifth of earners in Britain is around £63,000 after tax – affluent, but not rich enough to comfortably absorb a £2,500 rise in utility bills without cutting back elsewhere. As even the wealthiest reduce their discretionary spending, the wider economy will suffer a secondary blow.

Contemplating such colossal and potentially ruinous hikes in energy bills, the consumer finance expert Martin Lewis has been transferred into an increasingly radical campaigner on fuel poverty and has warned of “civil disobedience, civil unrest” if politicians do not act. A growing number of households are threatening to simply stop paying their energy bills. Don’t Pay UK, a campaign urging people to cancel their direct debits, claims to have more than 100,000 supporters.

Few politicians seem to have grasped the sheer scale or likely duration of the coming crisis. Truss is still prioritising tax cuts above all else, through reversing the recent 1.25 percentage point increase in National Insurance, suspending green levies, and the potential removal of VAT from fuel bills. Yet even taken together, this amounts to a giveaway of hundreds of pounds to households as their energy bills rise by thousands. Worse still, a cut in National Insurance would be remarkably badly targeted: the poorest 10 per cent of would accrue a monthly benefit of just 76p, while the richest tenth would be £93.19 better off.

Both the Liberal Democrats and, belatedly, Labour have gone further and pledged to freeze energy bills at their current level. Under their plans, Ofgem, the energy regulator, would be ordered to keep the current price cap in place and the government would meet the difference between the wholesale energy prices paid by the utility firms and the subsidised price for consumers.

While some have attacked the universalist approach of freezing bills and argued for means-tested support, the case for wide-ranging help is clear. The problem with Labour and the Liberal Democrats’ approach is not that the packages are too broad but rather that they are too narrow.

The policy focus on households is understandable: households vote, and elected politicians have to pay them attention. But while domestic energy bills are subject to a cap, business ones are not. The bills for small and medium-sized firms are rising by three to five times as their fixed-rate deals end. The British Institute of Innkeeping estimates that pubs will need to trade 20 per cent above 2019 levels to meet rising energy costs, but more than four-fifths of them already report that business is slower than before the Covid-19 pandemic. High energy costs may well cause thousands of otherwise viable businesses to fail over the coming months.

Then there are public services. Schools and hospitals are also exposed to rising energy prices and their budgets have not been increased to cope. Money spent on electricity is money not spent on teaching or care. The Institute for Fiscal Studies has calculated that public services need an additional £8bn this year and extra £18bn next year if their budgets are to be protected from inflation.

With winter coming, the debate has shrunk to a simple question: how does the country get through it? But energy analysts fear high prices will persist for at least another two years. While Labour and the Liberal Democrats’ plans have been costed at around £30bn and £36bn respectively, this would only delay the pain by six months. Extending relief beyond that point will be costly.

Other European countries, suffering the same wholesale rise in energy costs, have taken different approaches. To date, the British response has been to mostly pass on price rises to consumers – albeit in a delayed manner, as the price cap is reset each quarter – and to support them through cash rebates. But most of Europe has taken the route favoured by the UK’s opposition parties: capping bill rises at source and not passing on the full increase to consumers.

In France, for example, the government has imposed a 4 per cent limit on rises in EDF energy bills – meaning that the French state is effectively subsiding a loss of tens of billions of euros by state-owned EDF (one of the UK’s “Big Five” energy suppliers). In Spain wholesale prices have been capped to protect both households and firms, with the shortfall covered by government-backed borrowing by the energy companies. The intention is to increase bills (or taxes) to repay the debt in later years, reducing the intensity of the pain by spreading it out.

[See also: Boris Johnson was a catastrophe for Britain]

In the longer run, heavy investment in nuclear and renewable energy to lessen Britain’s dependence on imported energy is vital. Electricity imports have risen from seven terawatt hours in 2010 to almost 30 terawatt hours in 2021. A much greater focus on home insulation and energy conservation is also essential. The cuts made to subsidies for insulation by the Tory-Lib Dem coalition government always appeared short-sighted but they feel especially acute a decade on. A recently resurfaced video from 2010 of Nick Clegg, in which the then deputy prime minister dismisses investing in new nuclear energy capacity because it will not “come on-stream until about 2021 or 2022”, demonstrates how short-termist energy policymaking has become.

But projects such as new nuclear plants always take time to pay off. In the next six to 18 months, the pain of higher global energy prices is unavoidable. The real debate is about how that pain is divided up between different households, different firms and the government’s own finances.

The answer will doubtless be more government borrowing. And as the state acts to shield households – and eventually firms – from the full measure of higher global energy costs, the Bank may well increase interest rates at a faster pace than it currently plans. A mix of looser fiscal policy and tighter monetary policy may not make a large difference to the overall size of the economy, but it will affect the distribution of the suffering and in ways that risk fracturing the Conservative electoral coalition.

Watch why Duncan Weldon thinks that the UK is the new “sick man of Europe.”

Over the past 12 years, even as real wages have stagnated, the Tories have grown their vote share at four successive general elections. While the party’s core demographic has been the over-65s, it has won a significant chunk of the working-age population. Ultra-low interest rates have played an important role: cheap car finance and even cheaper mortgages have meant that, for some, the past decade has not felt lost at all. But while working-age homeowners may welcome tax cuts and new energy support payments, they will also see their monthly mortgage costs rise by £200 to £400. It is hard to see exactly what the Conservatives have to offer to working-age voters if they are experiencing rising unemployment, falling real incomes and higher borrowing costs.

No government can sit by as households and businesses are consumed by a tidal wave of energy price rises. But with inflation high and the Bank of England determined to reduce it, there is no easy route out of the crisis. Truss, highly likely to become Britain’s prime minister on 5 September, is keen to reward loyal Tory members by slashing taxes by £30bn. But a can-do attitude and reheated Thatcherite rhetoric cannot compensate for the impact of a trade shock. In the short run, the pain is unavoidable: politicians can influence who feels it most but they cannot make it go away.

Liz Truss has spent the summer rebuking the Bank of England for not tackling inflation. This winter, as it continues to raise rates and mortgage bills surge to deal with that very problem, she may learn that sometimes one should be careful what one wishes for.

Duncan Weldon is the author of “Two Hundred Years of Muddling Through” (Abacus) and writes the “Value Added” Substack newsletter

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This article appears in the 24 Aug 2022 issue of the New Statesman, The Inflation Wars