One of the UK’s core selling points has always been its commercial geography — between North America and continental Europe. But, at the moment, it is getting the worst of both worlds. As Andrew Bailey, the Bank of England governor, warned last week, the UK economy is “weakening rather earlier and somewhat more than others”. The country will face “a further step-up” in inflation later this year — and its prices problem will have “more persistence”.
Like the US, Britain had a strong post-Covid surge. But two years of pent-up demand and changed tastes were unleashed on an economy that proved unable to satisfy them. This fuelled rapid growth, but the mismatch between supply and demand also generated inflationary heat.
From Europe, the UK has imported exposure to a particularly nasty energy price shock, largely caused by Russia’s war in Ukraine. Consumer price inflation rose by 9.1 per cent in the year to May. Much of that was driven by a surge in household costs and transport — or, put another way: gas, electricity and petrol. But high UK inflation has been broadening to most goods and services. The BoE thinks inflation has now taken root in corporate psychology.
There are also some specifically British phenomena: the energy regulation system — which includes caps on consumer tariffs — means the full impact of energy price rises is not yet actually being felt by households. The same system will inject a further dose of price increases in October, prolonging the period of inflationary pressure.
The UK is also suffering a particular squeeze on the labour force. Around 380,000 additional working-age people over 25 have left the labour market since the pandemic — and many will be very difficult to bring back. Most of the net rise has come from people over 50 leaving the labour market: they may believe they have clocked out for the last time.
This is, to a limited extent, also about Brexit. While non-EU workers continue to arrive in big numbers, Brexit has reduced the ability to draw in workers from abroad quickly. The deterioration in Britain’s trading position continues to weigh on growth. The weakness of sterling has made the recent price shocks more painful, too. The pound has lost more than 10 per cent of its value against the US dollar this year.
There is no elegant solution. The UK needs to brace itself for the possibility that inflation will still be rising — possibly into double digits — months after it has started falling back elsewhere. The cost of energy, a deterioration in trade, the loss of a tranche of workers — all have the same consequence: the country is poorer than it thought it would be.
That means Britain needs to share out the pain of adjusting. The key question is how. For the UK government, this also means thinking through what it means if prices rise by as much as one-fifth within three years. It will have implications for everything from the application of its fiscal rules through to tax thresholds and public sector pay settlements as well as how safety nets for the neediest should work.
The task for monetary policymakers at the BoE is tough, but in some regards less complex. The central bank needs to tighten policy further to show its determination to re-anchor inflation expectations closer to 2 per cent. It is possible that the BoE will do too much and go too far: calibrating the right level of tightening is going to require more luck than judgment. It may squeeze too much life out of Britain’s struggling economy. But that should not be a critical concern — it would be possible to loosen policy rapidly, if needed. In the medium term, the situation will be much worse if the UK has become a place where people do not trust the currency to hold value.
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