It was clear from Rishi Sunak’s five priorities, as laid out in his New Year’s speech, how he saw the political situation and how he was going to respond.
After the tumultuous events of 2022, the Conservative Party faced a daunting challenge. What remained of its reputation for economic competence had been destroyed by Liz Truss and Kwasi Kwarteng’s mini-Budget. With living standards forecast to fall by the largest amount since records began, 2023 was going to be a dismal year.
Sunak was not going to expend political capital in seeking to avoid the inevitable. His strategy was to avoid big promises and bluster (those had been tried before), to set out achievable objectives and then demonstrate – in time – that he had achieved them. Everything said and done in 2023 was intended to later prove to the public in 2024 that Sunak is a prime minister who delivers. With the electorate decidedly cynical about Tory promises, his government had to show, not tell.
This remains the strategy and was reiterated to Conservative MPs at their away day in Windsor last week by Sunak’s election guru, Isaac Levido. There is no expectation of an imminent recovery in the Tories’ polling, the local election results will be terrible, and MPs were told that 2023 will be a year to forget. But by not over-promising, accumulating a record of achievement, and presiding over an economic recovery, the Conservatives will have a case to take to the British people.
There are many reasons why this strategy could fail but there is a distinctive threat emerging. Paradoxically, it is that the British economy is performing better than expected.
The UK has so far avoided a formal recession; unemployment is only rising slowly; energy prices have fallen; tax receipts are more buoyant and welfare spending is lower than forecast. Most businesses were braced for a disastrous year and have been pleasantly surprised by nothing worse than a flatlining economy.
This should be good news but it is a problem for the government for two reasons.
The first, which is attracting much attention in advance of next week’s Budget, is that expectations have risen of tax cuts or spending increases from Jeremy Hunt. This is true to the extent that he has more fiscal flexibility this year than last. But for permanent tax cuts or spending increases, we need evidence that the economy is likely to be stronger in future years. A stronger performance in 2023 does not necessarily mean a bigger economy than forecast in 2026 and 2027. This creates a party management issue, but once the Office for Budget Responsibility publishes its forecasts the fiscal reality will be apparent, even if the Trussites remain unsatisfied at the lack of tax cuts.
The second, bigger problem may be that 2023 turns out not to be the year in which we defeat inflation.
Looked at from a purely political perspective, what the Tories needed was a short, sharp contraction from which the British economy could recover with interest rates (currently 4 per cent) starting to fall. But a stronger economic performance in 2023 than expected means that 2024 may not see an upswing, and continued inflationary pressures mean that interest rates might still be at elevated levels by the time of the next election.
This is not to say that inflation won’t fall from its present level (10.1 per cent). Many of the price increases caused by Russia’s invasion of Ukraine, China’s lockdown and the general readjustment to a post-pandemic world will have passed through the indices in the second half of 2023. Sunak’s target of halving inflation will almost certainly be met. But the Bank of England’s inflation target is 2 per cent, not 5 per cent, and achieving that level may require yet higher interest rates.
The principal issue is that the labour market remains tight. In nominal terms, wage growth is high and the national living wage will rise by 9.7 per cent. This also has a wider impact on earnings if pay differentials are maintained. To give an illustration of what this means for businesses, one chief executive of an employer of 5,000 people has told me that the direct consequence of the national living wage increase for his business will be £2.8m, but the consequent cost of maintaining differentials would be £9.7m. These additional costs will be mostly passed on to customers.
With labour costs continuing to rise, inflation may persist well into 2024. It is uncertain how much more the Bank of England will need to raise interest rates by to meet its 2 per cent inflation target, but it is plausible that it will have to rise in an election year. This may test the institutional relationship between the Bank and the government.
The inflation risk could also provide a constraint on Hunt not just in next week’s Budget but also in an Autumn Statement or a Budget in March 2024. A tax cut that provokes an interest rate hike would not be the pre-election sweetener desired by the Chancellor.
There is a sense of relief that the UK economy has out-performed last autumn’s forecasts. But for Conservative electoral strategists, this is a mixed blessing. Inflation could still be a problem when the country next goes to the polls.