The drumbeat of ‘stagflation’ – the dreaded combination of a stagnant economy and elevated inflation – is getting louder in the UK. Headline inflation, already running at a 30-year high of 7% in March, is on course to rise towards 10% by the end of the year according to the latest projections from the Bank of England1.
At the same time, with consumer confidence falling to its lowest level since the 2008 financial crisis2, the risk of outright recession is growing.
Although the economy expanded 0.8% q/q in Q1, the economy lost momentum during the course of the quarter, with monthly GDP contracting 0.1% m/m in March3. Looking forward, the combination of squeezed household incomes (due to April’s rise in energy bills and increase in National Insurance contributions), less public spending on healthcare (due to reduced covid testing) and fewer working days (due to the Queen’s jubilee celebrations) raise the prospect of an outright decline in GDP during the second quarter.
While the Bank’s own projections see the economy avoiding a technical recession (defined as two consecutive quarters of negative growth), they speak to an environment of prolonged stagnation; real GDP at the end of 2023 is forecast to be broadly unchanged from the level prevailing at the start of 20224.
Policy dilemma
This ‘stagflationary’ outlook clearly raises a dilemma for policymakers. Above-target inflation argues for a marked rise in interest rates, while a stagnating economy and the growing risk of recession might suggest the need for looser policy. This conundrum is reflected in divisions on the Bank of England’s Monetary Policy Committee (MPC).
Although the 9-member MPC voted to raise rates by 0.25 percentage points to 1.0% earlier this month, three members preferred a 0.5 point increase, arguing that greater tightening was needed to counter the risk of inflation becoming more entrenched.
However, there was also dissent on the dovish side. While most members of the MPC judged “some degree of further tightening in monetary policy might still be appropriate in the coming months”, some members of the Committee judged that such guidance was not appropriate at this juncture, the suggestion being that policy has been tightened enough already.
This dovish view is understandable. Most of the recent pick-up in inflation has been the result of global factors, such as higher food and energy costs, along with supply chain disruptions which have been exacerbated by the war in Ukraine and covid restrictions in China. As the factors driving these price increases stabilize, inflation will, to some extent at least, fall back naturally, aided by favourable base effects and reduced discretionary demand as more household expenditure is diverted to food and energy.
Domestic price pressures
However, the argument for more aggressive tightening highlights the risk of inflation expectations becoming de-anchored and growing domestic price pressures, most notably from the tightness of the labour market. Due to a combination of post-Brexit curbs on immigration and the fallout from the pandemic (early retirement, long covid, longer NHS waiting lists etc.) the UK workforce has shrunk by around 440,000 since the end of 20196.
This has created widespread labour shortages which have put upward pressure on wages and domestic costs. Core services inflation – a subset of the CPI basket that is largely domestically produced – has picked up more quickly than the Bank expected and is currently running at about 4% y/y7.
These developments speak to a nagging suspicion that the speed at which the post-pandemic UK economy can grow without generating inflation is lower than it once was. Although policymakers will be reluctant to admit it in public, more slack is needed in the labour market (i.e., higher unemployment) in order to curb pay demands and reduce the chances of a wage-price spiral developing. Under such circumstances, a mild recession starts to look less like a ‘policy mistake’, and more like a ‘necessary evil’.
This is obviously a difficult message for the public to hear, and there are growing doubts as to whether the Bank of England has the nerve to implement the required tightening in monetary conditions.
Sterling weakness
Indeed, the gloomy growth outlook, along with the BoE’s prediction that inflation will ultimately fall below its 2% inflation target towards the end of the forecast period in 20258, have caused investors to revise down expectations for future rate hikes. Prior to the Bank’s May meeting, market expectations (as measured by the OIS forward curve) were for Bank Rate to top out at around 2.7% by the end of next year.
This expected peak has subsequently come down to around 2.3%9.
Against this backdrop, it is not surprising that the pound has tumbled in recent weeks. With the Bank of England’s more cautious narrative of late contrasting with an aggressively hawkish US Federal Reserve, Sterling has fallen by around 7% over the last month and currently trades at a near 2-year low of US$1.2210. Moreover, this is not just about the strength of the US dollar; the pound has also weakened against the euro in recent weeks11.
There could be worse to come, as both economic and geopolitical factors leave Sterling looking vulnerable. With Brexit weighing on export performance and higher fuel costs boosting energy imports, the UK’s trade deficit for goods and services widened to a record £25.2bn during the first quarter12. Furthermore, a possible trade war with the EU over the disputed Northern Ireland Protocol carries the potential to further compound downward pressure on the pound, which would further boost inflation via the impact on import prices. The prospect of Sterling trading at parity versus the US dollar is now being openly debated.
Taking all of this into consideration, there are doubts that the path of interest rates currently priced in by the market will be sufficient to rein in underlying domestic price pressures and prop up a hobbled currency. Indeed, if Bank Rate does peak at just 2.3% by the end of next year, it is likely to be below the prevailing rate of inflation, i.e., still negative in real terms13.
Moreover, the Bank itself has noted that lower levels of household debt, along with excess savings built up during the pandemic and a lower share of households on variable rate mortgages (around 80% of outstanding mortgages by value are fixed for an initial period, usually 2-5 years) could mean that the effect of rate hikes on the household sector is smaller than it was before the financial crisis14.
The Bank’s caution is perhaps understandable given that the current monetary tightening involves not just interest rate hikes, but also a reduction in its balance sheet (so-called quantitative tightening, or QT). The Bank started shrinking its balance sheet in March by not reinvesting maturing bonds and is currently looking into the possibility of outright bond sales. As the Bank has not overseen a sustained shrinkage of its balance sheet before, there is a degree of uncertainty as to how this will impact the economy and financial markets.
A test of independence
Even so, with elevated household inflation expectations indicative of growing doubts about the Bank’s commitment to the 2% inflation target15, policymakers need to act more forcefully to re-establish credibility. Interestingly, several former MPC members, including Adam Posen and Charles Goodhart, recently told the UK parliament’s Treasury Committee that rates might ultimately need to rise above 4% to tame inflation16.
If rates were to rise to such levels, it would cause considerable pain for the public finances, given the heightened sensitivity of debt servicing costs to increases in Bank Rate (see our commentary of November 202117). As a result, there is likely to be clandestine pressure from the government to keep borrowing costs low.
The Bank should resist. Following a period when inflationary pressures have been consistently underestimated, it is time for policymakers to refocus on their mandate of achieving price stability.
16th May 2022
1 https://www.reuters.com/world/uk/bank-england-set-4th-straight-rate-hike-fight-inflation-2022-05-04/
2 https://tradingeconomics.com/united-kingdom/consumer-confidence
3 https://www.ons.gov.uk/economy/grossdomesticproductgdp/bulletins/gdpmonthlyestimateuk/march2022
4 Bank of England Monetary Policy Report, May 2022.
5 https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2022/may-2022
6https://www.bankofengland.co.uk/speech/2022/may/michael-saunders-speech-at-the-resolution-foundation-event1
7 Bank of England Monetary Policy Report, May 2022
8 Bank of England Monetary Policy Report, May 2022
9 https://www.bankofengland.co.uk/statistics/yield-curves
10 https://tradingeconomics.com/gbpusd:cur
11 https://tradingeconomics.com/gbpeur:cur
12 https://www.ons.gov.uk/economy/nationalaccounts/balanceofpayments/bulletins/uktrade/march2022
13 Bank of England Monetary Policy Report, May 2022
14 Bank of England Monetary Policy Report, February 2022
15 https://www.reuters.com/world/uk/uk-public-inflation-expectations-fall-april-citiyougov-2022-04-28/
16 https://www.reuters.com/world/uk/bank-england-interest-rate-could-hit-4-or-more-ex-policymakers-warn-2022-05-11/
17 https://www.afhwm.co.uk/resources/commentaries/economic-commentary-4-key-considerations-as-the-bank-of-england-looks-to-hike-interest-rates