Between the 2008 recession, the 2012 double-dip and the bleak period where Russell Brand was considered a serious political commentator, the last 14 years haven’t been a great period to live in Britain. To this litany of ills we can now add the Bank of England’s prediction of the longest recession in a century. Sadly for us, the Bank and the Treasury are looking to make things even worse.
To understand how to respond to a recession, it’s important to understand what’s causing it. The UK’s current woes are not the result of a sudden slackening of demand, driven by the sort of financial crash we’ve previously experienced. Instead, the economy is experiencing a supply-side shock. There are still snarls in global supply chains left by the disruption of the Covid pandemic, and Putin’s gas cut-off is driving energy costs up across Europe.
Adding to this, the US Federal Reserve is raising interest rates to deal with its own domestic inflation problem – which arose in part thanks to stimulus spending into an already constrained economy. This is a problem for the Bank. When interest rates go up in the US, so does the dollar. And when the dollar goes up, inflation rises here; it becomes more expensive to import goods from overseas, and this drives up prices.
The net effect is that inflation is rising even while economic activity is slackening – a particularly toxic combination that leaves the Government and the central bank without obvious policy tools to respond. If inflation is rising because demand is strong, the central bank acts to soak up demand, raising interest rates and bringing prices back under control. If the economy is falling because demand is weak, the central bank lowers interest rates, making borrowing cheaper. If the central bank finds itself trapped by the zero lower bound on interest rates, the Government can step in with fiscal support – increasing the efficacy of monetary policy.
Dealing with stagflation is much harder. Interest rate cuts send inflation spiralling higher, and don’t address the lack of supply. Interest rate increases, on the other hand, won’t do a great deal to bring down inflation driven by global factors affecting energy supplies or shipping. This doesn’t mean that some combinations of policy aren’t more painful than others. And the UK is set for a particularly wince-inducing mixture.
Even while the Bank is raising interest rates, Downing Street is captured by the need to minimise the total level of their rise. This is partly structural – the sudden panic sell-off of bonds by leveraged pension funds in response to the mini-budget illustrated that parts of the economy have built low interest rates expectations into their near and mid-term plans, and may be poorly positioned for a sudden and unexpected rise – but it is mostly political.
British politics is based around the interests of homeowners. Higher rates mean higher mortgage repayments and lower house prices, a politically hazardous combination which a party at a low ebb in the polls can hardly afford. Add to that a general need to avoid being seen to tip firms over the brink – even if this does create massive moral hazard – and the priority for the Government is now to be seen to be bringing borrowing under control.
That means that even as the economy is tipping into recession, Rishi Sunak and Jeremy Hunt are pencilling in tax increases and spending cuts in roughly equal proportion, with the aim being to shed £50bn in borrowing.
The Bank of England, meanwhile, is fixated on reducing inflation. This is, to be fair, in the Bank’s mandate. But it is not the only thing; the Bank has what is known as a flexible inflation target, where a period of above-trend inflation may be accepted in order to minimise the damage done by bringing it down. A period of supply-induced inflation is exactly when that flexibility is called for. Instead, the Bank plans to bring inflation down through interest rate increases. Their central projection is that – thanks to higher interest rates – ‘domestic inflationary pressures subside given the increasing amount of economic slack’. In plain English, this means that raising interest rates will reduce economic activity to the point where inflation starts to subside.
The overall impression is of a government and Bank willing to drive the recession deeper through contractionary fiscal and monetary policy rather than see inflation continue, or watch interest rates rise too high. Nominal GDP targeting – the policy backed by the Bank of Japan – would have seen the Bank given an all but explicit instruction not to raise rates too high in a supply-driven recession. As Sam Bowman has pointed out, it’s the sort of policy that would have made America’s 2008 recession substantially less damaging. It looks like the UK is about to learn that lesson for itself.
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