The outlook for the UK economy

Our essay two weeks ago on the issues facing central banks as they struggle to contain inflation without sending economies into recession (“Whither Inflation? Whether Recession”, 24.07.22) concluded that the challenges were indeed daunting, but there was still a chance that they would be able to avoid the worst scenario of both persistent inflation and full-blown recession, a most unpleasant combination known as stagflation.

For the UK at least, avoiding this fate looks a lot less likely following the Bank of England’s statement last week. The Bank made three statements, each of which was at the more serious and negative end of expectations, and together they portray an economy which the Bank thinks is facing a very hard 12 to 18 months indeed.

The first part of the Bank’s statement was a rise in interest rates, by 0.5% to 1.75%. As just about every financial commentator has pointed out, this is the biggest single rate rise this century; one has to go back to 1995 to find the last ½ point rise, and (ignoring the swiftly cancelled rises when sterling fell out of the ERM in 1992) to 1989 to find one bigger than that.

This rise was actually quite well telegraphed; in a number of public statements since the last rate rise senior Bank officials have warned that they would take firm action, and in the week or so before last Thursday’s announcement, almost all the financial press were confidently predicting a ½ point rise. But it is nevertheless a serious blow to the economy, and especially to people with mortgages who are already finding their disposable income squeezed hard by food and energy price rises.

But it was the two forward-looking assessments that accompanied the rate rise announcement that caught the headlines. The first of these was on the future path of inflation, where the Bank revised upwards (yet again) its expectations for the peak that the inflation rate will reach. The new “peak rate before inflation starts to subside” is expected to be 13.3% – but one has to ask what the point of giving this figure is, or whether it has any residual credibility at all.

Since the Bank first started expressing their views on the future path of inflation and what level it might peak at about 2 years ago, there have been well over a dozen MPC meetings and well over a dozen forecasts of where inflation will peak. And every single figure they have produced in that 2 years has been higher than the previous one – indeed than all their previous ones.

All the Bank are proving by these successive upward revisions is that they are a long way from controlling inflation and perhaps even from understanding it.

Accompanying this latest forecast of inflation being “higher for longer”, the Bank for the first time last Thursday forecast that the UK economy would move into recession. And not just a mild or short one while inflation is tamed, but both a long recession (the Bank think over a year) and a deep one, perhaps approaching the scale of the recession after the 2008 Global Financial Crisis.

This is an awful combination. Older Britons may remember a much-loved TV series “Dad’s Army”, which was broadcast between 1968-1977, and the character Private Frazer. His catchphrase was “We’re all doomed, doomed I tell you”; short of quoting those exact words there was very little more the Bank could have said to paint the darkest of pictures and cause the media to predict the most difficult of winters ahead of us.

Which raises a number of questions. What is it that has tipped the Bank into full-scale doom and gloom like this (their statement after the June MPC was nothing like so pessimistic)? And even if they think this path for the economy is likely, was it wise to spell it out in such detail?

The Bank would certainly reply to the latter point that they have a duty to say what they see, and that if that is what their forecasts show it would be irresponsible of them not to make that fact public. And no doubt there is an element of “managing expectations” in the forecasts – the Bank do desperately need to be able to say at some point in the future “things are not quite as grim as we feared and told you last time”. It would not quite be “Happy days are here again”, but it would be a start.

But the Bank’s statement does also lay them open to the accusation of “talking Britain down” and “engineering the very recession they are predicting” through their negativity. And lo and behold, politicians of all stripes, but especially the two contenders for the Tory Party leadership, have been quick to do just that.

And here I think lies at least part of the explanation for the Bank’s statement and its very sombre, almost apocalyptic tone. The Bank, along with virtually the entire economics profession, is viewing the Tory Party leadership contest with mounting concern. Both candidates are involved in an auction of ever more expansive and expensive promises – tax cuts here, extra support for families there – which seem increasingly unconnected to the real world and increasingly unaffordable even if the economy was growing strongly.

But whereas private sector economic commentators can point this out, and indeed have been trying to do so with increasing vehemence as the mad auction escalates, the Bank is rather more restricted in what it can say publicly. It could therefore be that the Bank is trying to scare the two candidates back to reason by in effect saying “look, the economy is in a much worse state than you realise, and your promises are impractical, unaffordable and dangerous”.

Neither candidate is listening, both are playing to the electorate for this contest, ie the Conservative Party membership, rather than the nation. Rishi Sunak seems to have completely forgotten the orthodoxy he espoused at the Treasury when suggesting tax rises to pay for some of the pandemic-induced largesse, while Liz Truss appears to believe the mantra “we need to do something different, aggressive tax cuts are something different, so we need to have aggressive tax cuts”. Different her policy proposals certainly are, but that does not automatically make them sensible or wise.

Actually, for any student of economic history, there is a clear precedent for Truss’s approach. 50 years ago, the then Chancellor of the Exchequer Tony Barber faced a similar situation of a slowing economy and stubborn inflation, and in his 1972 budget he too decided on a very expansionary policy, replete with income tax cuts, relaxed controls on bank lending and increased public expenditure.

The economy responded as one might expect to this “dash for growth”, as it was called. Growth did indeed accelerate at first, and in the second half of 1972 and first half of 1973 GDP posted annualised figures of around 5% – figures Truss can only dream of. But inflation also accelerated, reaching 9% in 1973, 16% in 1974 and 27% in 1975. Unemployment soared, sterling was extremely weak on the international exchanges and by winter 1973-74 there was an energy crisis which forced the government to ration electricity, first to industry and then latterly even extending blackouts to domestic homes under the “three day week” policy.

For any chancellor, there are probably four main indicators they would like to have a positive impact on: growth, inflation, unemployment and the value of sterling. Very few chancellors have been able to hit the bull’s eye on all four for any prolonged period of time – one might have a short moment of all of them going in the right direction but if so that is largely luck and almost certainly transitory. Good chancellors faced with favourable conditions can hope to hit 3 out of the four, most would settle for 2 out of the four, and even poor chancellors would strive to hit at least 1 out of the four, if only to have something to parade as a success story. But Barber failed, spectacularly, on all four.

In Barber’s defence, he did not expect to be chancellor, and was only appointed when prime minister Ted Heath’s first choice, Ian Macleod, died suddenly after only one month in office. As a result he felt very much subservient to Heath, who dominated the discussion of economic policy between No 10 and No 11, and felt unable to resist Heath’s demands for an expansionary policy.

It was ever thus – prime ministers do tend to hold the more powerful cards, and they do have different and wider objectives than chancellors, and usually shorter time horizons too. But the read‑across from the early 1970s and the Barber Boom to the UK’s current political landscape, where we have a weak and unknown chancellor (whether Zahawi or whoever) and a probable PM in Truss who is proposing to take an aggressive fiscal stance and has short-term populist objectives not long-term economic ones, is particularly close.

It is this that many economists find so concerning, and, we think, may be behind the Bank’s dire warnings and doomsaying. It is to be hoped that the Bank’s forecasts are proved wrong – but with the economy in a weaker position than it was in 1972 (inflation already worse than 50 years ago, growth already slower, sterling already weaker, energy supplies already more uncertain), and the politicians ever more strident in their populist approach to the economy, the outlook does not look promising.

And the next time the Bank has to forecast what the peak of inflation will be, after the MPC meeting on 15 September, we would not be surprised at all if the headline number has once again, for the 15th time in a row, moved even higher.