The future of the UK economy is uncertain

In the last 15 years, the UK economy has been affected by three major external shocks: the financial crisis, covid-19 and now the war between Russia and Ukraine, and one internally generated, Brexit. We are hit by surprises whose implications are unknown, even unknowable.

It took a long time, for example, to realize that the financial crisis marked a sharp turning point in the trend of productivity growth. However, as the Resolution Foundation Notes in his evaluation of the spring statement From Rishi Sunak, Minister of Finance, “Labor productivity grew by just 0.4 per cent a year between 2007 and 2019, one of the lowest rates among rich countries, and much slower than the rate of about 2 per cent. in the previous 12 years. .

This, in turn, explains the near stagnation in household real disposable income that has preceded the an exceptional squeeze is expected this year. But why this happened is still unknown. Again, it was predictable that Brexit would make the economy less open to trade. TThe extent to which it will end up making the economy permanently less productive is still unknown.

Similarly, we know that today’s shock has followed on the heels of a large and mostly unexpected rise in inflation post-COVID-19. We know that it will squeeze real income from the least well-off in particularly brutal ways. But the full economic ramifications of the war are unclear.

the Office of Budget Responsibility has, however, made a heroic guess. This helps us clarify some painful possibilities. The OBR forecasts that this new shock will push inflation to around 9% this year, which will be the highest rate in 40 years. Similar increases in inflation are occurring in other high-income countries. This increase is mainly due to higher gasoline and fuel prices, along with a global increase in the prices of manufactured goods. The OBR also expects that excess demand in the domestic economy will ensure that these higher costs are passed through to consumer prices. But it assumes that they will only be partially offset by higher nominal wage growth: in short, real wages will fall significantly.

Crucially, this rise in inflation is expected to be temporary. The OBR forecasts that inflation will fall sharply next year as today’s high prices become the baseline for future calculations. However, this result depends on the belief that nominal wages will remain well below inflation. However, this assumption is made despite confidence that the labor market will remain strong and unemployment low. In addition, the bank rate is forecast to peak below 2 percent, implying very negative real rates throughout. In short, we will see a combination of falling real wages with a strong labor market and accommodative monetary policy.

UK Unemployment Rate line chart, with OBR forecasts (%) showing Unemployment rate forecast to remain low

The economy could easily end up much weaker than the OBR forecasts. Monetary policy could be much tighter; for example, if inflation did not go down. Alternatively, the contraction in real incomes could substantially reduce demand and output, without the need for higher interest rates. Either option would mean a much weaker economy. An embargo on Russian gas exports would make that outcome more likely. The economy would then suffer from stagflation.

What role should politicians and policymakers play in all of this? The Bank of England’s job remains what it should be: to bring inflation back down to target and thus stabilize expectations. must do it. The chancellor’s job is much more complex. He is right to want to preserve his fiscal leeway. But, according to the Resolution Foundation, the policy changes so far have offset only a third of the income shock that would have hit the poorest half of the population in 2022-23. Given what is happening now and the pressures on real incomes that lie ahead, it will surely need to cushion short-term shocks to the poorest households more effectively than ever before.

Bank of England bank rate line chart, with OBR (%) forecasts showing Interest rate forecast is on the upside, but still peaks at a low rate

However, an even bigger point can be seen. In difficult times, a country needs trusted people in charge. Questions about the prime minister are evident. At the start of the pandemic, Sunak and Hacienda responded impressively. However, recently, notably in his Spring Statement, he has claimed that he is cutting taxes when he is raising them (in part by freezing tax thresholds in nominal terms). He has also been replacing bad taxes (national insurance) with better ones (income tax). Sunak, affirms Paul Johnson of the Institute for Fiscal Studies“He has proven himself to be something of a fiscal illusionist.”

Indeed, it has and not only “something” of one. People will notice the extent of illusions in their pay packages and actual disposable income. You’re burning your credibility. This will be bad for him and bad for the country.

martin.wolf@ft.com

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