With recession threat looming, UK has no good options

Author is the author of Two Hundred Years of Mudding: The Amazing Story of the British Economy

The Bank of England’s new forecast is unusually pessimistic. In recent months, the bank’s governor, Andrew Bailey, has warned that the institution is walking “a narrow path” between the risk of persistently high inflation and the possibility of a recession. Britain will now experience both scenarios, leaving the next prime minister with some uncomfortable choices.

Bank of England predict Inflation will peak at an annual rate of over 13% and remain above 10% for most of 2023. It expects the economy to slip into recession in the next quarter and not return to growth until 2024. Even so, the eventual resuscitation will be anemic. In the bank’s core scenario, the unemployment rate will rise each year for the next three years.

The BoE expects the recession to be as deep as the early 1990s and milder than after the financial crisis or pandemic-related lockdowns, but with a deeper hit to household incomes. Forecasts show the biggest two-year drop in real household disposable income on record.

Yet despite forecasting a recession, the Monetary Policy Committee raised rates by 0.5% — the largest single increase since the bank gained operational independence in 1997. While the UK is far from uniquely high inflation among advanced economies, the nature of UK inflation is starting to look more troubling.

Inflation in Europe is mostly a story of soaring energy prices, while inflation in the U.S. is now being driven by a tight job market pushing up the cost of services. The UK has both.

MPC has mostly been content with 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 firmer action. In MPC’s view, reducing these domestic pressures will require painful drugs: raising interest rates to slow hiring decisions and easing some of the heat in the job market at a time when high energy prices are already weighing on consumer income and spending.

This view is certainly debatable. Consultancy Cornwall Insight estimates that a typical household’s domestic energy bill will be around £3,500 by 2023 – up from close to £1,000 in 2021. Consumers are forced to spend about 9% of their after-tax income on energy by 2023, up from 4.6% before price increases, and discretionary spending on other goods and services will fall sharply.

Consumer-facing labor-intensive service companies may reconsider hiring plans relatively quickly as demand dries up. A subset of those in their 50s and 60s who retire early in 2020 and 2021 may find themselves forced to return to work to make ends meet, pushing up the labor supply. Soaring energy bills can lead to inflation in the short term. But in the medium term, they act as a deflationary tax increase for households and businesses.

But whether the BoE’s predictions about how the job market and domestic price pressures will develop are correct or not, they are almost certainly wrong when it comes to how the Treasury will respond. As usual, the bank’s latest figures are conditional on unchanged fiscal policy. However, once the UK has a new prime minister in early September, there will be some form of fiscal easing, such as tax cuts, further energy bill rebates or both. It’s hard to see any of these measures being enough to stave off a recession right now, but they could still ease some of the pressure on household incomes in the coming months.

Whoever is Britain’s next prime minister will have increasingly strained relations with the Bank of England. The Monetary Policy Committee, poised to raise interest rates in a forecast recession, has signaled that it will act to tighten policy to offset any fiscal easing the government brings.

The bank concluded that a recession was necessary to bring inflation back to target. Liz Truss, the favourite to win the Conservative Party leadership race, has accused the Bank of England of failing to control inflation in recent weeks, according to opinion polls and bookmakers. She is unlikely to be particularly pleased that the central bank is poised to act to raise interest rates in a slowing economy and offset any policy easing by her administration.

In the context of rising global energy prices, looser fiscal policy and tighter monetary policy could be a good fit for the UK. Targeted financial support could support households most at risk of rising prices and prevent some otherwise viable companies from failing. Higher interest rates are likely to support the value of the pound and help dampen import price pressures.

But choosing the right mix of policies for the UK right now is a lot like picking the least wrinkled shirt from the laundry basket: the best choice is not necessarily the best. The country is poorer than imagined. This is inevitable in the short term. The real policy debate is about how to distribute this pain among the balance sheets of households, businesses and governments — not how to avoid it.

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