We are in a double bind right now.
Prices are going through the roof but all the signs suggest that the economy is weakening. The answer to higher prices is normally to raise interest rates, but this also induces people and firms to spend less money. The challenge for central banks is to try and deal with both problems at the same time.
We asked three UK economists whether they saw a way of bringing down inflation without causing a severe recession. Here’s what they said:
Jonathan Perraton
The Bank of England’s decision to raise interest rates by a relatively modest 0.25 percentage points to 1.25% contrasts with the US Federal Reserve’s 0.75 points hike the day before to a range of 1.5% to 1.75%. This reflects concerns in the UK that economic growth will be weaker than previously forecast.
It follows the unexpected news that the UK economy shrank by 0.3% in April, plus sobering forecasts from the Organization for Economic Co-operation and Development (OECD) that the UK will be the worst performing major economy in 2023 apart from Russia. GDP is now only fractionally above its pre-COVID level and all major sectors are shrinking.
Inflation is a worldwide problem thanks to pressures on supply chains after Covid and higher energy and other commodity prices following Russia’s invasion of Ukraine. However, US economist Adam Posen has pointed to Brexit as a key factor in explaining Britain’s relatively high inflation. This has meant higher trading costs, weak sterling and labour shortages.
Brigitte Granville
“Stagflation” is upon us, so a natural focus for any “where next?” discussion must be whether we are on course for an episode as bad as the 1970s or even worse. My answer would be that recession is likely, but the 1970s experience of high inflation persisting despite repeated recessions should be avoidable. That said, even a relatively milder dose of stagflation will be painful for living standards.
The mildest way out of the present situation would be inflation promptly curing itself: By making people poorer in real terms so they can’t afford to buy so much. In this scenario, inflation would ease and central banks could help with the downturn in the economy by reversing their present interest-rate hikes.
There are several obstacles to such a fast turnaround, however, the context of the post-Covid recovery and the labour market.
The main inflationary impulse has come from two factors on the global supply side. First, supply chains have struggled to cope with demand collapsing and resurging during and after Covid, made worse by China’s zero-Covid policy. Second, energy and other natural resource supplies have been constrained by Russia’s war in Ukraine and the west’s sanctions.
The inflationary effects of these issues are being prolonged by pent-up demand from Western firms and consumers due to Covid stimulus packages in the UK and especially the US, as well as unspent income accumulated during lockdowns. In the UK, for example, household deposit balances were still well above pre-Covid levels as recently as April.
It doesn’t help that the financial markets have been driven to such heights by loose monetary policy. Although the bubbles have been popping recently, valuations will have to fall some way further before people feel poorer and less willing to go out and buy things.
It seems to me that this will be more decisive in determining the course of inflation since it is a long-term structural issue, whereas the post-Covid issues should eventually straighten out. So overall, I expect that the UK economy’s present stagnation, quite likely dipping into mild recession, will bring inflation back down towards the 2% target. In the US, where underlying demand and credit is stronger, sharper interest hikes may be needed to achieve the same goal.
Chris Martin
The UK labour market is going to be key to how the UK economy performs in the coming months, and its prospects are finely balanced. On one hand, it proved resilient during the pandemic. The furlough schemes were a success, protecting the labour market from the worst effects of the crisis. The fall in employment was around three times lower than in the 1970s, even though the economic contraction was much greater.
Employment also recovered more quickly than in previous recessions. Vacancies are over 50% higher than before the pandemic. Average wages excluding bonuses are rising by about 4% a year, with even higher growth for drivers and workers in construction, software development and warehousing.
On the other hand, employment is still lower than before the pandemic by close to 250,000 workers. Real wages are still no higher than in 2008. And the macroeconomic context is gloomy: it is hard to see how the labour market will thrive if growth is weak or non-existent.
Several factors make the next few months hard to assess. First, unemployment is no longer a useful labour market indicator. Workers are nowadays categorized as employed, unemployed or inactive. Unemployed workers are actively seeking work but the inactive are not. Of the circa 250,000 drop in employed workers since 2019, 80% are inactive; only 20% are now unemployed.
Economists have a much weaker understanding of the inactive than the unemployed. This matters because most people getting hired are from the inactive rather than the unemployed category.
Second, perhaps surprisingly, Brexit has not reduced migration, but it has changed it. There are fewer EU citizens employed in the UK, but more workers from Nigeria, India, and similar countries. They tend to be more highly skilled and to work in health and social care, rather than in hospitality.
More skilled workers should be good for productivity and fill vital roles in health and social care, but hospitality is struggling at the same time. However, it is not yet clear if these changes are permanent, and this too makes the labour market more difficult to forecast.
So what is the outlook for UK employment? Above all, firms are likely to be looking for fewer workers as chronic weak investment and slowing consumer expenditure points to stagnant or falling GDP.
These negative forces will be offset by the large number of vacancies currently being offered by firms and by relatively large wage rises in some parts of the private sector. This may induce some of those workers back into the labour market who have withdrawn following the pandemic.
Jonathan Perraton is Senior Lecturer in Economics at the University of Sheffield. Brigitte Granville is Professor of International Economics and Economic Policy at the Queen Mary University of London. Chris Martin is Professor of Economics at the University of Bath. A version of this article first appeared in The Conversation UK and has been reprinted under special arrangement.
