One of the points we mentioned regularly then is worth noting now. That is, when there is a shift in the inflation landscape, economists, markets and policymakers can sometimes be slow to adjust. This was the case in the early 1970s when there was a move from low to high inflation and in the early 1990s, too, when we shifted from high to low inflation.
This is worth bearing in mind now, as there is a temptation in the markets to think inflation will return towards the 2% level that markets and central banks had accepted as the norm pre-pandemic.
Inflation risks have shifted
At the start of the year, in The Times survey of economists, I was one of only two economists who said inflation would peak above 7%. At that time our thinking was that inflation would peak in April, stay elevated and then decelerate next year, settling at around 3%-4%. Admittedly, we did say inflation risks were on the upside, and since then the inflation risks have shifted.
The war in Ukraine has exacerbated these risks. Now inflation may peak around 10.5% or above, and will likely stay elevated. While this is a global phenomenon, the way our energy cap works, with the next increase in the autumn, the UK’s inflation at year-end may be higher than elsewhere. But the reality is, up to now at least, that it is pretty much the same inflation dynamics that we are seeing in many western economies.
The Bank of England has now hiked rates at five successive meetings. Policy rates are 1.25%. This is still low and rates will head considerably higher. Our view is that so-called “r-star” – the neutral level of policy rates – will have to settle at a far higher level. It is still difficult to say where this will be; possibly 4% to 5%, but it certainly won’t be the far lower level of policy rates we have become used to in recent years.
Yet that view is not widely shared and also it would be unwise to think of policy being on autopilot with rates rising until they reach a desired level. As we have noted before, while the direction of monetary policy is set for it to tighten, the speed, scale and the sequencing of this tightening between higher rates and reversing quantitative easing through quantitative tightening (QT) needs to be sensitive to how the economy is performing. The economy may prove highly sensitive to monetary tightening.
The challenge is that the UK economy faces two immediate economic challenges: rising inflation and an inevitable economic slowdown. Each requires a different policy solution: fighting inflation needs a tighter policy, a slowing economy requires a helping help from the policy side.
Much depends upon the nature of the inflation shock and also upon how much the economy could weaken. I favour a tighter monetary policy to help curb inflation, a looser fiscal stance centred on targeted tax cuts on the fiscal side. But within policy circles in the UK there is also a reluctance to ease fiscal policy in case it stimulates demand; the fear being that in itself will trigger inflation.
While understandable, this overlooks the current slowdown and weakening that is already underway. It also overlooks the fact that a tighter monetary policy is best suited to curb inflation.
Understanding the inflation challenge
Let’s consider the inflation problem. The main trigger has been supply-side pressures linked to the pandemic and exacerbated by the war in Ukraine and Russian sanctions. This often leads to the question, “How can the Bank hiking rates change the price of oil?” Well, it can’t on the supply side. Policy works by squeezing the economy, which in this case curbs demand and may also dampen inflation expectations. But importantly, this supply-side shock was not the only cause of inflation. Lax monetary conditions played a big part, too.
One might think of this as the first-round inflation impact, fed by supply-side pressures and loose monetary conditions. The rebound from the pandemic may have also fed this last year, as inflation rose from a low of 0.2% in August 2020. On the eve of the pandemic in February 2020 – and when the economy was already weak – inflation stood at 1.7%.
It should have been obvious as we emerged from the pandemic last year that inflation would rise, and indeed the data showed this at the time. At the very least the data suggested not easing any further as was the case through QE.
The trouble is – and this is a challenge not just in the UK but in the US and euro area, too – we are now into second-round inflation effects. This is when firms pass on higher costs, to maintain or boost margins, and when large wage increases are sought as people try to keep up with higher prices. Inflation expectations therefore rise. It is for this reason that inflation cycles can have various phases, not just peaking, remaining elevated and falling. That is a danger now.
In the US the more hawkish stance from the Federal Reserve (the Fed) has been to get on top of this. Hence, they have enacted the most aggressive phase of monetary tightening seen in any three-monthly period of Fed meetings: three hikes for a combined 1.5%. Another 0.75% hike is likely at the next Federal Open Market Committee (FOMC) meeting. Hence the dollar is strong.
Also, perhaps prematurely, the market is anticipating the Fed to ease next year as higher oil prices and higher rates trigger a recession. Such easing is not inevitable, pausing in the hiking cycle is, but the Fed seems in no mood to go slow at the moment.
In contrast, here in the UK the Bank of England has been far slower to act. This, plus its poor and sometimes misleading communication has not helped. Admittedly, now there is a clearer message. Recent speeches have been hawkish, the message clearer. Thus, more aggressive rate hikes seem inevitable. The Bank, though, can also tighten considerably, if it chooses, via more QT, which would push longer-term yields higher.
The economic slowdown, though, is a concern. Here the picture is mixed. There is a sharp divergence between consumer confidence, which has fallen to an all-time low and the jobs market, which is still very healthy. Higher inflation is squeezing spending power, and people may be worried about what lies ahead.
For instance, the volume of retail sales in May was 2.6% above pre-pandemic levels but they fell 0.5% that month and in the three months to May were 1.3% below the previous three months to February. Credit card borrowing is up. The household savings ratio was 6.8% in the first quarter, having reached 23.9% in the second quarter of 2020, when the economy was in its first lockdown. With inflation outstripping wage growth, this helps explain the deteriorating industrial relations climate, including sporadic strikes, that is now being seen.
In addition to this, the backdrop for financial markets is exacerbated by the recent political turmoil. A new prime minister will be in place after the summer. It is unclear whether there will be a new policy direction. This political vacuum could lead to a slightly higher risk premium being attached to UK assets, but there is not a general election looming and thus a major policy shift is unlikely.
If anything, there may be renewed pressure to help provide help to those impacted by the cost-of-living crisis and to cut taxes to help the economy. Such policy measures would make sense.
Fiscal and monetary policy should not be seen as opposite ends of the same seesaw, in that any easing of fiscal policy through tax cuts, does not automatically imply interest rates will rise further. But, as noted, interest rates are already set to rise anyway.
Sterling, meanwhile, remains vulnerable. News recently of a record current account deficit in the first quarter of the year did not help. The main story, though, is that of a strong dollar, as the euro, as well as sterling, are weak. The euro area could face looming problems as inflation rises sharply in Germany, too, and as a sovereign debt crisis may be taking shape. This adds to the complex global backdrop facing the UK.
Rising inflation points to a tighter monetary policy. Economic slowdown and a possible recession point to the need for a looser fiscal stance through targeted tax cuts. The political crisis, with a few months before a new prime minister is chosen, should not result in any policy vacuum but may add to the present uncertain mood overhanging sterling.
Please note, the value of your investments can go down as well as up.