Inflation blame game: UK economic woes set government and central bank on a collision course
Sunak has reiterated his “total support” for the Bank of England and under fire Governor Andrew Bailey.
STEFAN ROUSSEAU/POOL/AFP via Getty Images
LONDON — In January, with one eye on a critical general election in 2024, U.K. Prime Minister Rishi Sunak vowed to halve inflation by the end of the year.
At the time, headline consumer price inflation was running at an annual 10.1%. Given that most economists were projecting that this would halve naturally as the shock of soaring energy prices fell away, the pledge seemed like an open goal for Sunak’s Conservative government.
Yet headline CPI in May came in at 8.7%, unchanged from the previous month, while core inflation — which excludes volatile energy, food, alcohol and tobacco prices — increased to 7.1%, its highest rate for 31 years.
Annual average wage growth excluding bonuses also accelerated from 6.7% to 7.2% in the February-April quarter, the fastest rate on record, while the labor market remains hotter-than-expected and the U.K. has faced a unique spike in long-term sickness that has hammered its labor force participation rate.
Meanwhile, economic growth has all but stagnated and public debt has surpassed 100% of gross domestic product for the first time since March 1961.
The Bank of England re-accelerated the pace of interest rate hikes in June, raising the Bank rate by 50 basis points to 5%, further compounding domestic fears of a mortgage crisis and diverging from other major central banks that have been able to either slow or pause rate hikes.
Shaan Raithatha, senior economist at Vanguard, told CNBC’s “Squawk Box Europe” on Monday that the U.K. is suffering from the “worst of both worlds.”
“We’ve had a U.S.-style labor market shock, particularly the large number of long term sickness that has really impacted the supply of labor there, and they’ve also had a European-style energy shock emanating from the war in Ukraine,” he said.
“What is perhaps surprising is that the energy shock in the U.K. was larger than in most of mainland Europe.”
Raithatha suggested this could partly be a result of government policymakers being too slow to step in during the early stages of the energy crisis, and when they did step in, capping energy prices at a higher level than many peers.
“There’s an issue here because the economy is very resilient, we know that the transmission towards mortgages is a bit slower and a bit less effective than we’ve had in the past as well, and so clearly the Bank has to do a bit more to get inflation under control,” he added.
Problem ‘principally made in Moscow’
In the aftermath of the most recent inflation print, Sunak reiterated his “total support” for the Bank of England and under fire Governor Andrew Bailey.
In his January speech, the prime minister said the pledge to halve inflation was his personal responsibility, but should U.K. CPI remain stubbornly high through the end of the year, many expect the Bank of England to return to the crosshairs of government ministers looking to redirect blame.
“The economic and political cycles also appear mismatched for the government, especially as the case for pre-election tax cuts in 2024 is becoming harder to commit to at this point given public debt has surpassed GDP for the first time since March 1961,” said Richard Flax, chief investment officer at Moneyfarm.
“The chancellor reiterating his pledge to halve inflation this year while also promising to grow the economy and reduce debt appears to be a steep commitment given the challenges the U.K. faces.”
Following the high inflation print last month, Panmure Gordon Chief Economist Simon French said the U.K.’s problems were “principally made in Moscow but not exclusively made in Moscow,” adding that there is a “Brexit element” at play.
“There is a 4.5% increase in working age inactivity since the Brexit transition where all other G7 countries with perhaps the exception of the U.S. have seen inactivity falling, so we do look like an outlier in terms of impairments to the supply side of the economy which is driving core inflation higher,” French said.
“But Mr. Sunak has a narrative there as well which is fair, which is global factors. The U.K. is disproportionately impacted by the gas price because it’s a large part of the heating bill, but also the swing supply for electricity, and that has driven up the CPI component — headline — by 120% compared to about 40% in mainland Europe.”
In a recent CNBC-moderated panel at a monetary policy forum in Sintra, Portugal, Bailey noted that the U.K. labor force is unique in remaining below its pre-Covid levels.
“I see this when I go around the country talking to firms. What they say to me very frequently is that their plan is to retain labor as much as they can, even in the event of a downturn, because they’ve been concerned and it’s been difficult to recruit labor,” he said.
However, Bailey denied that Brexit was the key component in the labor market tightness and sticky inflationary pressures, instead citing the country’s response to the Covid pandemic.
The Bank has estimated a long-run downshift in the level of U.K. productivity of just over 3% as a result of Brexit, while fellow Monetary Policy Committee member Catherine Mann recently told a parliamentary committee that additional paperwork had damaged small firms and added to inflationary pressures.
“It’s not just small firms in the U.K. who want to export but it is also small firms in Europe who were suppliers and provided competition in the U.K. market, so there is an inflationary effect coming through the competition channel,” she added.
Bank of England ‘impotence’ and the ‘British disease’
U.K. inflation is still expected to fall sharply through the remainder of the year, in light of a 20% reduction in the energy price cap from July 1 and as the existing rate hikes feed through into the economy, compressing demand and employment.
The Bank of England has retained its data-dependent, meeting-by-meeting approach to monetary policy tightening, and members of the Monetary Policy Committee have openly challenged the market’s pricing for a peak rate of just over 6% through the winter of 2023 and into next year.
A major source of concern for economists is the central bank’s credibility, and Bailey recently offered a mea culpa on the MPC’s wayward forecasting of inflation over the last 18 months.
Panmure Gordon’s French suggested that if the Bank of England had “unimpeachable credibility,” policymakers could say the blunt tool of interest rates will take 18 months to two years to pass through the economy and retain the faith of markets and the public. However, its recent proclamations have not gained traction.
“The U.K. as an economy — 3% of global GDP, less than that in terms of population — is largely a price taker in terms of monetary conditions, and whether Andrew Bailey or indeed his predecessors want to admit to it, there is a degree of impotence in terms of the degree to which domestic monetary conditions can influence the domestic economic picture,” he said.
French likened the current economic picture to the “British disease” period of economic stagnation and high inflation in the 1970s, also noting that the U.K. hit double-digit inflation in the 1990s and was the only developed country with inflation significantly above target in the aftermath of the global financial crisis.
Thanos Papasavvas, founder of ABP Invest, also alluded to the unique susceptibility of the U.K. to high inflation, but said the Bank of England should have been alive to this far earlier.
“I put a lot of the blame on what’s been happening on the comments that he was making a couple of years ago, talking down inflation, the risk of inflation, and smiling about it at a time when there were inflationary pressures coming through and for a country which has had inflationary-prone tendencies,” he told CNBC.
“You don’t do that in the U.K. Even a few months ago, the expectations of inflation coming down to 2%, 3% were very unrealistic, so I think they’ve managed the communication very badly and they have a very hard decision.”
The Bank of England is undertaking a review of its inflation forecasting mechanisms, and Bailey recently told a parliamentary committee that the central bank had “lessons to learn” from the process, though it still sees inflation coming down rapidly this year, albeit at a slower rate.
Ahead of the coronavirus pandemic and the transition out of the EU in 2020, French highlighted that the Bank of England had managed 22 years of inflation averaging its 2% target, but that it had underestimated the supply side effects of Brexit.
He suggested there are “further frictions to come” in terms of food inflation and second-order effects as further checks on EU animal and plant imports are introduced later this year.
“Looking at some of the failings it’s made, some of the stuff was unforecastable, in terms of the futures and energy markets, some of the stuff actually bluntly they were asleep at the wheel in understanding the growth of U.K. imported labor supply,” French said.