Unpalatable choices

The job of governing is difficult: It is a full-time occupation requiring the total focus of the person in charge to manage a vast range of complex economic and geopolitical issues. It would appear, however, that running the UK is a far less onerous task: After all, the Conservative Party currently has time to look for its fourth leader in six years as the contest to replace Boris Johnson gathers momentum. The lack of quality on offer does not bode well for a resolution to the mounting economic problems facing the UK.

After eight candidates threw their hat into the ring following Johnson’s enforced departure, the number of candidates has been whittled down to two, who are now in the process of trying to convince members of the Conservative Party that they are worthy successors to Johnson. This contest has pitted former Chancellor Rishi Sunak against current Foreign Secretary Liz Truss. Sunak is competent but regarded as untrustworthy by many in the party, due to his own personal dealings and the way he has clearly angled to edge out Johnson without explicitly appearing to do so. Truss is a former Liberal Democrat who supported Remain but who now sounds more Brexity than many of the anti-EU zealots. The debate has not been edifying. After all, both talk about the need for a fresh start despite the fact that they are both members of a party which has governed for 12 years and served as ministers in Johnson’s government. Truss is unashamedly copying Margaret Thatcher in terms of both rhetoric and policy and is now the bookmakers’ odds-on favourite, currently priced at 1-5 whilst Sunak is priced at 3-1 against (win probabilities of 77% and 23% respectively).

Given the magnitude of the economic problems in the months ahead, neither candidate gives the impression that they have much to offer. Truss has argued for tax cuts as a way of boosting economic growth, promising to freeze corporation tax; reverse the 1.25% rise in national insurance contributions and suspend the green energy levy added to energy bills. Sunak has also reluctantly been forced to concede that he would also reduce taxes, having previously accused Truss of promising unfunded tax cuts. One of his promises is to cut VAT on domestic energy bills to zero for 12 months if the price cap – currently just under £2,000 a year for the average home – exceeds £3,000 (as is now likely). Ironically, Sunak had previously ruled out such a move and told the House of Commons in February that “there would be no guarantee that suppliers would pass on the discounts to all customers.”

To the extent that economics plays a role in political thinking these days, the tax cut debate has dominated the debate so far. According to Truss, these tax cuts “are affordable within our current fiscal rules” – rules which envisage reducing the debt ratio and balancing the current budget on a three year horizon. According to the OBR, there is roughly £30bn of fiscal space but this is subject to a huge degree of uncertainty, especially since inflation could raise public sector outlays and eat up a large slice of the headroom. Truss argues that tax cuts which generate growth will pay for themselves. There is no evidence to suggest they will. She has also suggested that lowering taxes will help to curb inflation. It is unclear how this can happen. By putting more money in taxpayers’ pockets, in effect households will have more to spend which, at a time when supply constraints are biting hard, is more likely to raise prices than lower them. Moreover, the BoE would likely respond to a relaxation of the fiscal stance by tightening monetary policy more aggressively than it would otherwise, thus making households’ life worse rather than better.

Reducing taxes also has resource consequences for the public sector. The derisory 2% wage offer to public sector workers at a time when inflation is set to hit double figures implies a significant real wage cut for key workers who two years ago were being lauded for their sacrifices in keeping the economy afloat during lockdown. It will simply not be possible to deliver the levelling up programme, which both candidates aspire to, whilst reducing tax revenues. And as I have pointed out before, shrinking the size of the state at a time when an ageing population will place significant strains on an already overstretched NHS, has major implications for the nature of health provision.

What is striking is that both candidates are focusing on supply side reforms of the kind implemented by the Thatcher government in the 1980s. This is not necessarily the wrong focus – the UK does need supply side reform – but tinkering with taxes is not the right way to go about it. If the government is serious about tax issues, it should look at the recommendations of the Mirrlees Review which argued for root and branch reform. As it is, the economy’s potential annual growth rate has dropped from around 2.5% prior to 2008 to something below 1.5% today (chart above), whilst labour productivity remains weak. Boosting investment is thus vital if there is to be any sustainable pickup in growth. Whilst many of these problems are not unique to the UK – slower potential growth is evident across the industrialised world, partly due to demographic factors – the UK faces the unique problem of Brexit. 

Although the media has this week focused on the queues at Channel crossings, many Conservative politicians – including the leadership candidates – continue to deny that Brexit played any role in this. Still less do they acknowledge the fact that France now treats the UK as a third country precisely because that is what the UK requested. Eliminating, or at least reducing, some of these trade frictions would go a long way towards improving business conditions for export-oriented companies and provide some support to the economy. Anyone denying that Brexit is a problem for the economy is deluded.

At a time when the UK is facing its most severe headwinds since the 1970s it is striking that neither candidate has much to say about the cost of living crisis. Unfortunately, this reflects a lack of ideas on the right of the political spectrum. This is not to say that the centre-left is a fund of ideas either, but a rehashing of old ideas to tackle the social problems which are themselves partly due to austerity and the inequalities resulting from the 1980s tax cuts, demonstrates a lack of joined-up thinking. Truss and Sunak appear to be engaged in the pursuit of power for its own sake rather than bringing forward ideas to make life better for voters. Such intellectual bankruptcy suggests that in the absence of a major turnaround, politicians will continue to ignore the UK’s mounting economic difficulties. It is likely to be a hard winter but the new PM would be wise to recall the 1978-79 Winter of Discontent which banished Labour to the political margins for a generation.

Going, going ...

“He's a most notable coward, an infinite and endless liar, an hourly promise-breaker, the owner of no one good quality worthy your lordship's entertainment”

All's Well That Ends Well, Act III, Scene VI

Nothing became his tenure like the leaving of it

Six years ago Boris Johnson made the fateful decision to back Brexit, giving a rocket-propelled surge to his career which eventually led to Downing Street. The rocket has now run out of fuel. His career, having reached its zenith, is plunging back to earth and the blond bombshell who has run roughshod over Britain’s constitutional niceties for three years finally exhausted the patience of his Tory Party supporters. All this was predictable. As I pointed out three years ago when Johnson took up residence in Downing Street, “sometimes you need adults guarding the liquor cabinet. Johnson is akin to the alcoholic who has just been given the keys to a brewery and I fear it will not end well.”

Johnson has now resigned as party leader but plans to remain in place as Prime Minister until a new leader is elected, which could take a couple of months. Given the magnitude of the economic problems Britain – indeed, the world – faces over the coming months, this is not a satisfactory arrangement and there is a large swathe of the party which finds it unacceptable. Contingency plans are required to deal with the prospect of recession and the impact that sky-high energy prices will have on living standards, not to mention the very real prospect that European economies will face serious gas shortages over the winter. The likelihood that the Conservative Party will be absorbed by the contest to choose a fourth leader in six years suggests it will be all too easy for the government to take its eye off the ball.

At least an end to the chaotic Johnson government is in sight. Like Silvio Berlusconi, who dominated Italian political life between 1994 and 2011, Johnson sucked all the air out of the room by being the centre of attention rather than the calm centre of competent government. Indeed, his resignation speech was, in the words of journalist Paul Waugh, “a study in reluctance bordering on petulance.” Unlike Berlusconi, it is difficult to imagine Johnson returning as PM. 

But the extent to which matters will improve once he is gone is an open question. A large proportion of moderate Tory MPs who urged a softer Brexit than Johnson’s government delivered were expelled from the party in 2019 and the current intake reflects a more ideological strand of Conservatism. We should also not forget that many Tory MPs aided and abetted Johnson as he lied his way through three years of “getting Brexit done”, mismanaging a pandemic and straining the very fabric of the United Kingdom. This excellent post by Philip Stephens reminds us that the next Prime Minister has a big job on their hands to restore some of the trust in government that Johnson managed to squander. Nonetheless, a disciplined government which is focused on the job at hand will be a great improvement on the car crash approach adopted by Johnson over the last three years.

A new start

Whoever the next PM is, whether Conservative or even a Labour representative following a snap election, the process of political and economic healing begins on Day One of their term. The first task should be to start repairing relationships with the EU. This may be easier said than done, depending who succeeds Johnson. Whilst some of the likely candidates continue to espouse hardline positions on relations with the EU, the easiest fix would be to call a halt to prospective unilateral changes to the Northern Ireland Protocol. Although a Bill proposing such changes is proceeding through parliament, there is nothing to stop a new administration pulling it from the agenda. At the very least, adopting a more conciliatory approach will make it slightly easier for the UK to achieve any changes it may wish to make.

Taxation is a big issue for many Conservative MPs and many were deeply concerned that former Chancellor Rishi Sunak raised taxes to their highest level since the 1940s. They are consequently desperate to see a return to a “traditional Tory” low tax regime. A responsible Chancellor should resist calls for radical tax cuts. The release yesterday of the OBR’s Fiscal Risks Report made it clear that a “riskier world and ageing population ultimately leave the public finances on an unsustainable path.” Demographics will prove to be a major long-term fiscal headwind as the population ages, whilst a fall in the birth rate and the expectation that Brexit will reduce immigration will combine in the long-term to raise the old-age dependency ratio. In addition, the commitment to net zero will result in lower hydrocarbon taxes (notably fuel duty and vehicle excise duty). Whatever the UK’s current economic ills, and there are many, as Chris Giles put it in his latest FT piece, “cutting taxes will not magically improve the UK’s economic performance. Any politician suggesting otherwise is lying to you."

More thought needed on the future of the political process

The Johnson era – and to some extent the previous May parliament – highlighted the extent to which political arrangements depend on convention rather than codified rules. What the constitutional historian Peter Hennessy called “the good chaps” theory of government is well and truly dead. Whilst not necessarily arguing for a written constitution – just look at the problems that have resulted in the United States – there is a strong case for imposing limits on the power of central government. The passing of the Election Act, for example, has brought the independent Electoral Commission’s strategy and policy under government control which can only be seen as a power grab. Governments must remain open to independent scrutiny.

There is also increasingly a case for reforming the House of Lords. The current system has worked well for hundreds of years but it has increasingly become a place of patronage and the award of a peerage to Evgeny Lebedev is particularly controversial. During Johnson’s term of office, his government elevated 86 members to the peerage accounting for 11% of the total (767). During David Cameron’s six year term, his government created 243 life peers. The case for an elected second chamber has been strengthened by recent research suggesting that political donations are a strong guarantee of a seat in the Lords.

Then there is the vexed question of how MPs should be rewarded – a subject I touched on some time ago. There is a strong case for paying MPs more and banning all outside sources of income in order to eliminate disputes over conflicts of interest that dogged Johnson’s term. The funding of political parties is another issue that perhaps ought to be looked at (but almost certainly won’t be). Many European countries permit systems of public funding and whilst it is fraught with difficulties, if such a system could limit the volume of dark money flowing into British politics, it is an issue that should at least be looked at.

Last word

Over the years I have been consistent in my view that Johnson is unsuited to high office and have pointed out that his tenure has coincided with a deterioration in the quality of governance. Yet despite the relief that Johnson is about to depart, we should be careful what we wish for. I have repeatedly made the point that he is a symptom, rather than the cause, of an erosion of standards in public life. Many prominent Conservatives have noted that the party currently reflects a nationalist, ideological streak that is at odds with the pragmatism for which it was noted. This does not bode well for a restoration of better relationships with the EU. Nor is there any sign that it will take seriously the needs of the economy. But take it seriously they must, for as The Economist noted this week, “Britain is in a dangerous state. The country is poorer than it imagines ... With Mr Johnson’s departure, politics must once more become anchored to reality.”

The sick man of Europe suffers a relapse

Politics gets in the way …

“When a regime has been in power too long, when it has fatally exhausted the patience of the people, and when oblivion finally beckons – I am afraid that across the world you can rely on the leaders of that regime to act solely in the interests of self-preservation, and not in the interests of the electorate.” It sounds like the sort of quote that Churchill, Thatcher or Blair might have offered up. In fact it was penned by none other than Boris Johnson in 2011 in an article in the Daily Telegraph. It is worth recalling this quote in a week when Johnson survived a motion of no-confidence amongst his own MPs by a margin of 211-148. With 41% of his own MPs voting against him, the general consensus is that Johnson’s days in office are numbered. I would not be so sure.

For one thing, Johnson’s polling share amongst MPs (58.8%) is higher than the average across the previous ten contests (54.2% - see chart above). It was a big parliamentary rebellion, to be sure, and it will make life difficult but as shows of support go this was not a bad one. Public opinion polling evidence does not suggest that his popular appeal has been damaged significantly more than most Prime Ministers at this point in their term. The long-running Ipsos poll, with data back to 1977, indicates that Johnson’s latest approval rating of 26% is slightly below the long-term average of 31% whilst the disapproval rating is at 66% versus the historical average of 60% (chart below). Past experience suggests that a disapproval rating above 70% would be a cause for concern, foreshadowing a change of government in 1979, 1997 and 2010. The latest poll reported in The Observer indicates that only 26% of respondents believe Labour leader Keir Starmer would make the best Prime Minister versus 28% for Johnson. Thus the current polling readings suggest the Tories should not be in too much of a hurry to ditch Johnson. After all, who would replace him? And would the electorate forgive the Conservatives if they ditched a third leader in six years?

It is clear that Johnson believes that he has a mandate to continue. For a politician who believes a 52-48 majority in favour of Brexit represents the will of the people, a 59-41 margin represents a thumping majority. As far as Johnson is concerned, he is not going anywhere and under current Conservative Party rules he cannot be challenged as party leader for another 12 months which would confirm him in Downing Street beyond year-end. The rules can, of course, be changed and with the Prime Minister due to face the Parliamentary Privileges Committee in the autumn over whether he lied to parliament, the position could change considerably.

… but the economy is increasingly what matters for voters

The bigger problem is that the government is likely to become increasingly distracted by internal politics rather than the mounting headwinds facing the economy. Just this week, the media focused on the news that the latest OECD forecast suggests that the UK will be the slowest growing economy in the G20 after Russia in 2023 with a GDP growth rate of zero. This is driven by a number of factors including higher interest rates, higher taxes, reduced trade in the wake of Brexit and higher food and energy prices. The government has control over some of these factors; others it has not. The concern, however, is that competing factions in the Tory government will push to implement a range of potentially contradictory policies. It is an article of faith amongst many of them that taxes should be cut. Others have picked up on mounting public concern about the poor state of public service provision, most notably the NHS where workers have been rewarded for their sacrifices during the pandemic with pay rises well below the inflation rate. It is not possible to satisfy both of these competing demands. Then there is Brexit, where there are signs of unease on the backbenches that the policy is not delivering what was promised.

But the malaise goes deeper. As a recent article in The Economist noted, the “half-hearted vote to endorse Boris Johnson as prime minister, on June 6th, betrayed how deeply Britain’s ruling party fails to confront hard choices … Britain is stuck in a 15-year rut. It likes to think of itself as a dynamic, free-market place, but its economy lags behind much of the rich world. There is plenty of speechifying about growth, and no shortage of ideas about how to turn the country round. But the mettle and strategic thinking that reform requires are absent—another instance of Tories ducking hard choices.”

There is little new economic thinking coming from the government. One of the key policies announced in the March Budget was a cut in the basic rate of income tax in 2024 – a direct nod to the Thatcherite policies of the 1980s. Last week, the government announced plans to allow benefits to be put towards mortgages and permit social tenants to buy their homes, echoing the “right to buy” policy of the 1980s. Unfortunately, those with savings of more than £16,000 will not be eligible and those with savings below the threshold will struggle to fund a mortgage.

Housing policy is certainly one area where new thinking is required. The government’s approach over the years has amounted to raising demand in the face of a slowly expanding housing supply which has served to inflate prices relative to household incomes. Unlike the 1930s the government is not in the business of building houses but it is in a position to influence policy to increase housing supply which ought to alleviate some of the cost pressures on the poorest in society in the long run. The government’s stated target is for 300,000 new homes to be built per year by the mid-2020s (some estimates put the requirement at up to 340,000). Over the last five years housing completions have averaged 163,000. The Centre for Cities argues that the lack of available land in the right places is one of the key constraints on increasing supply, which could be remedied by (inter alia) making better use of Green Belt land and reforming property taxes, notably levying a tax of 20% on the selling price of new properties to develop local infrastructure and allow funding for more social housing. Whether or not these are the right policies, they are an improvement on efforts to stoke demand.

There are a host of other areas where reform is required and space considerations preclude a detailed look. However, in order to improve the economic circumstances of voters requires reform of areas such as NHS funding and the social care system. Efforts to reduce regional imbalances which could help to boost productivity, long the Achilles Heel of the UK economy, are also necessary which may require changes to regional governance. Reforms to the tax and benefits system are very clearly needed – Universal Credit is a good idea in principle but its implementation has been badly handled, as the National Audit Office pointed out in 2018 – whilst the Mirrlees Review noted more than a decade ago that “the tax and benefit system should have a coherent structure based on clearly defined economic principles.”

There are many other areas besides. But the main takeaway, as the article in The Economist made clear, is that the government has failed to take bold steps in recent years to tackle many of the underlying economic problems. It continues to rely too heavily on policies which were deemed successful in the past but which may not be appropriate today. Unfortunately since Johnson’s government will spend the next couple of years merely trying to survive and is unlikely to engage in much long-term strategic thinking, most of the UK’s economic ills will continue to fester. In the 1970s, Britain was known as “the sick man of Europe.” It appears to have relapsed.

A platinum performance

As Britain basks in a long weekend, it is a sobering thought that for those of us of a certain age the Platinum Jubilee marking the Queen’s 70 years on the throne may be the last major royal celebration in our lifetime. After all, Prince Charles will be older than the Queen is now if he ever celebrates his Silver Jubilee. It puts into perspective the fact that seven decades in the job really is a long time and the Britain over which Queen Elizabeth reigned in 1952 is in many respects barely recognisable today, especially with regard to the economy.

The economy now and then

There was a sense of expectation and excitement at the dawn of the second Elizabethan era as it was popularly known in 1952. After all, the UK was the world's third largest economy in the early-1950s, behind the US and USSR and, hard though it may be to imagine today, was Europe's industrial powerhouse. But beneath the surface, all was not well. The UK was, to all intents and purposes, bankrupt in 1945 and had been the biggest recipient of US aid under the auspices of the Marshall Plan. One of the key elements of economic policy in the early 1950s was thus to generate as much export income as possible in a bid to stay afloat.

Britain’s economy was still dominated by heavy industry in the 1950s but the rapid pace of economic reconstruction in Germany, which resulted in output exceeding UK levels by 1955, meant that the UK faced increasingly stiff competition for its manufactured goods. The next twenty years were characterised by 'stop-go' policies in a bid to relieve pressure on sterling, which was fixed to the dollar under the Bretton Woods agreement whilst the 1970s and 1980s were dominated by industrial strife as the government and unions locked horns in a bid to restructure the economy.

Such were the economic difficulties which the UK faced in 1952 that consumption of a number of goods was still rationed. The rationing of tea did not end until October 1952; sugar consumption was rationed until February 1953 and only in 1954 did cheese and meat rationing end. These were definitely not the “good old days.” Despite nostalgia for the 1950s, life is in many ways a lot sweeter today (sugar rationing notwithstanding). On average, people today are materially much better off than in 1952. Real GDP per head, for example, has quadrupled over the past 70 years (chart below) whilst the real cost of what were once luxury items has fallen. Take the example of cars, where the best-selling Morris Minor would have cost £631 in 1952 (£14,004 in 2022 prices) compared to £15,485 for the cheapest Vauxhall Corsa, the UK's best-selling car in 2022. However, an average car at the start of the Queen’s reign cost two years’ salary compared to six months in 2022. The relative fall in the price of cars has contributed to a huge surge in the number of vehicles on the road, from 2.5 million in 1952 (50 per 1000 head of population) to 37.5 million today (556 per 1000 head of population).

Perhaps one of the most notable changes since 1952 has been the technological revolution in communications, with the advent of the computer and the mobile phone changing the way in which people interact with the wider world. Less than two million households owned a TV in the black and white world of 1952, whilst households had to wait for the GPO to connect them to a system in which telephonists manually operated the exchanges. Today, anyone can walk into a shop to pick up a mobile phone from which they can immediately watch all sorts of media content and communicate with people anywhere in the world. As for computers, they were the stuff of science fiction. In 1952, IBM introduced its first fully electric system with 1Kb of RAM at a monthly leasing rate of $15,000 (£5,350 at 1952 exchange rates). A machine with 8000 times as much RAM can be bought today for around £200.

Radical social change

It is interesting to reflect on political change over the past 70 years. Winston Churchill was Prime Minister in 1952, heading a government which was very much rooted in Britain’s imperial past. In 1953, Churchill suffered a stroke which was kept secret from the public and he largely remained out of the public eye for five months. Imagine being able to get away with that in today’s world dominated by social media. The contrast between the government of Churchill and that of Boris Johnson is immense and embodies the extent to which the relationship between the rulers and the ruled has changed over the years.

Many aspects of British life in the early 1950s are very difficult to capture in terms of the data alone. For a portrayal of the hardships experienced by a large proportion of UK residents, interested readers are referred to the social history of post-war Britain by David Kynaston[1]. This paints a picture of cramped housing, dirty cities (the Great London Smog of December 1952 is believed to have contributed to the deaths of 4,000 people), lack of educational opportunity and a very steep path to the better economic times which lay ahead. Life in the UK (and indeed in many other European countries) was no picnic in 1952.

Seventy years of asset returns

Whilst the economic environment in 1952 was far from comfortable, financial markets were less volatile than they are today. An estimate of the rolling 10-year coefficient of variation for UK equity prices was at multi-year lows in 1952, although despite recent equity movements the degree of volatility on this measure is at its lowest since the mid-1950s. Over the last 70 years, UK equity prices have soared by over 10,000% (an average annual gain of 6.9%), though once we account for inflation this translates into a more modest 353% (annual average of 2.2%).

Another asset which has performed well over the course of the Queen's reign is housing. Back in 1952, the average house cost just shy of £1,900 but since the average gross annual wage in 1952 was a mere £314 (£6352 at today's prices), the price of a house was six times the annual wage. Today, an “average” house costs eight times the annual average wage. Over the Queen’s reign  house prices have risen at an average annual rate of 7.3% or 2.2% per annum in real terms which serves to support the old investment adage of "safe as houses."

Lessons for the future

Given the difficulties in forecasting trends even over the coming months, I am certainly not going to try and forecast how the UK economy will look in 70 years’ time, particularly since the problems we face today are unique in the post-1945 era. But it is interesting to reflect on past trends and assess whether there are any takeaways for the future. One feature of the UK over the period has been the relative stability of UK GDP growth (the post pandemic collapse notwithstanding). Real GDP growth has averaged 2.4% per annum since 1952 but this has slowed to an annual average of just 0.9% since 2008 (biased downwards, of course, by the 2020 collapse). But productivity growth remains one of the UK’s biggest challenges, with multifactor productivity barely growing, and with the population growing more slowly now than in the early years of the Queen’s reign (the baby boom came to an end many years ago) it is difficult to imagine the economic speed limit rising above 2% anytime soon.

One of the UK's economic success stories over the first 40 years of the Queen’s reign was the reduction in the huge debt overhang, which peaked at almost 238% of GDP in 1947. In 1952 the debt-to-GDP ratio was still at 162% and it continued falling to bottom out below 30% in the early-1990s. Economic events over the past 15 years have pushed it back to around 95%. The decline in the debt ratio was driven in part by rapid growth although as noted above, this is likely to be relatively sluggish over the coming years. Inflation also helped to erode the debt burden. Over the past 70 years, the UK has recorded an average CPI inflation rate of 4.6% which is more than double the BoE’s target rate. Stripping out the period 1971-81 results in an average of 3.3%. This may be close to the rate that the BoE will have to live with in the medium-term in order to help reduce the debt burden and may be an argument for raising the inflation target band from 1%-3% to 2%-4% (that is a debate for another time). Either way, the debt ratio is unlikely to fall rapidly in the coming years in the face of sluggish growth and big demands on government finances.

Whatever one’s views on the role of monarchy, it is nonetheless fascinating to reflect on the changes over the past 70 years. It serves as a reminder that for all the concerns about the current direction of travel, nothing is set in stone.

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[1] David Kynaston (2009) ‘Family Britain, 1951-57’, Bloomsbury Publishing

Not a pretty picture

This week’s decision by the BoE to raise interest rates another 25 bps to 1% takes Bank Rate to its highest since 2009 and in the process managed to please nobody. Consumers certainly do not welcome it, nor do the markets if pressure on the pound is any guide. Following on from the Fed’s 50 bps rise on Wednesday, central banks are now acting on their rhetoric to take action against the big rise in inflation which is running at 40-year highs in the US and 30-year highs in the UK. This puts the spotlight on the ECB which has yet to follow up its recent more hawkish message with action. But maybe the ECB, like many of us, has significant reservations about countering an adverse economic shock with a tightening of policy which in the short-term will squeeze the economy and make life harder for consumers and businesses which are already reeling under the strain.

The BoE’s economic forecast grabbed a lot of headlines with its prediction that CPI inflation will hit 10.2% by the fourth quarter of 2022, which would be the highest ever CPI inflation reading on data back to 1989 (the RPI series, by contrast, can be extended back to 1914). It also forecast that GDP will contract slightly in 2023, though the quarterly profile suggests that the technical definition of recession, in which there are two consecutive quarterly contractions, is not fulfilled. Looking out over the next three years, the forecast is consistent with annual average growth of just 0.3% which is a grim picture and not one in which a central bank would normally be expected to raise interest rates. So why do it? Aside from the surge in headline CPI inflation, the minutes of the MPC meeting made it clear that the Committee is concerned about the tightness of the labour market and the potential for a spillover to wages. We should thus view this week’s rate increase as a precautionary measure.

When looking ahead it is important to be aware of the interest rate assumptions underpinning the forecast. The baseline (modal) forecast is conditional on market interest rate expectations in which Bank Rate is expected to hit around 2½% by mid-2023 before falling to 2% by mid-2025. Under this assumption, GDP contracts by around 0.25% next year and the output gap widens to 1¼% on a twelve month horizon which under normal circumstances would be considered disinflationary. The central case projection also foresees rising unemployment, with the jobless rate rising by two percentage points to 5.5% on a three year view. These forces combine to produce a sharp slowdown in CPI inflation over the forecast horizon, with inflation close to target on a two year view (2.1%) and well below it by Q2  2025 (1.3%). In the alternative scenario, in which interest rates hold at 1%, the fall in output is less dramatic, with GDP growth next year averaging +0.8%. The rise in unemployment (jobless rate at 4.2% by mid-2025) and fall in inflation (still above target at 2.2% by mid-2025) are correspondingly slower. On the basis of these two forecast paths one conclusion we might draw is that in order to hit the inflation target on a three year view, rates will rise further but perhaps by less than the market is currently pricing in.

Any forecast relies on assumptions about the future, and those regarding energy prices are particularly uncertain but will have major implications for the inflation projection. As it currently stands, the BoE assumes household energy bills will rise by another 40% in October when the domestic price cap is up for its biannual review, following the 54% rise in April (5 percentage points of which were accounted for by the costs resulting from those suppliers that went bust in recent months). Yet the BoE admits that if energy prices “fall back to the levels implied by futures curves …  the level of GDP would be nearly 1% higher by the end of the forecast period and excess supply and unemployment around ¾ percentage points lower. CPI inflation would fall back towards the target more rapidly than in the central projection and would be around ½ and over 1 percentage points below the target in two and three years’ time respectively.” Bottom line: Things may not turn out quite as bad as this forecast suggests.

There are some other elements of the forecast which don’t necessarily stack up. First, if energy prices do rise by 40% in the fourth quarter, the slowdown in inflation in 2023 looks quite ambitious – the BoE estimates that energy will add only 0.25 percentage points to inflation versus 4 points in 2022. Average earnings inflation is expected to slow from 5¾% this year to 4¾% in 2023 despite the fact that if the labour market is as tight as the BoE believes, surely there will be greater upward pressure on wages rather than less as workers try to recoup some of the real wage losses suffered in 2022. This would point to upside risks to the inflation forecast and it is noteworthy that the BoE sees risks to the inflation outlook as tilted marginally to the upside.

If inflation does turn out higher, should the BoE be more aggressive in raising rates compared to current market expectations? In my view, no. Higher inflation will continue to act as a brake on real incomes and activity rates, and in an environment where the UK is struggling to come to terms with a post-Brexit world the headwinds are strong enough without an additional monetary burden (the BoE’s forecast looks for net trade to subtract 1.5 percentage points from growth next year).

Not everyone agrees. Former MPC member Adam Posen is quoted as saying that “The central bank has no choice but to cause a recession when a broad range of prices are rising at such a strong pace … It is duty bound to bring inflation down after more than a year when it has been more than 2 percentage points above its 2% target level during a period of full employment.” This is both irresponsible and wrong from an economist whose work I admire and is the kind of thinking which gets economists a bad name. It also ignores the fact that the BoE’s mandate is to maintain price stability subject to “the Government’s economic policy, including its objectives on growth and employment.” Given the Conservatives’ poor showing in this week’s local elections, I cannot imagine anyone in government believes that exacerbating the cost of living crisis is going to make them any more popular at the ballot box.

Another issue which perhaps did not get as much prominence as it deserved was that in lifting Bank Rate to 1%, the BoE has reached the threshold at which it will consider actively running down its balance sheet. We can expect more guidance as to how this might happen in the August Monetary Policy Report. Suffice to say that if the BoE is raising interest rates whilst simultaneously engaging in quantitative tightening, it is likely to make a bad situation worse.

Pleasing nobody

In its assessment of Chancellor Rishi Sunak’s Spring Statement (as the March fiscal set piece event is now known), the OBR pointed out that the first quarter of the 21^st century has seen the economy subject to a number of unprecedented shocks of which the war in Ukraine is just the latest. Each shock appears to be worse than the last but with inflation expected to head towards 40-year highs, the economic fallout from the Covid pandemic and the Ukraine war have combined to produce a hit to living standards, the likes of which many people have not seen in their working lifetime. In the course of March 2020, Sunak unveiled a package of measures appropriate to the scale of the problems facing the economy. His efforts in March 2022 were a woefully inadequate response to current problems, managing to be both ineffectual and badly targeted.

The nature of the cost of living squeeze

Last year Sunak announced that he was freezing income tax thresholds at 2021-22 levels until 2025-26. This would be bad enough if inflation was running at or slightly above the 2% target but with CPI inflation set to average more than 7% this year – the fastest pace in almost 40 years – a lot more people are likely to find themselves dragged into the higher income tax bracket if wages follow suit. Last September, Sunak also announced that he planned to raise National Insurance Contributions from April 2022 which I argued at the time was an unnecessary risk when the economy was only just recovering from a severe recession. Most worryingly, domestic energy bills are set to rise by over 50% from next month with the prospect of further big hikes in October. Altogether this combination of events is helping to stoke what many commentators are calling the UK’s biggest cost of living crisis in decades, with low paid workers set to pay the biggest price.

Sunak’s response was risible. He announced a temporary 5p per litre cut in motor fuel duty which (a) sends the wrong signal for a government which likes to talk up its green credentials and (b) does nothing to help the least well off who are more likely to spend money heating their homes than running a car. If the Chancellor was serious about helping this group he could have announced a temporary suspension of VAT on domestic fuel bills and thereby use one of the few additional policy levers derived from Brexit (EU rules require setting VAT on domestic fuel at a minimum of 5%).

To add insult to injury, Sunak announced that from April 2024 he intends to reduce the basic rate of income tax from 20% to 19%, thereby increasing the wedge between the taxation of earned and unearned income. The economic rationale for this is questionable and such is the uncertainty surrounding the economic outlook it may not even be affordable. It was also a blatantly political move, designed to burnish Sunak’s leadership credentials and his party’s standing ahead of an election in 2024, allowing him to continue making the claim that his is the party of low taxation. This is, of course, not true. According to the OBR, the overall tax burden is set to rise from 33% of GDP in 2019-20 to 36.3% by 2026-27 – its highest level since the late 1940s.

The OBR goes on to point out that “net tax cuts announced in this Spring Statement offset around a sixth of the net tax rises introduced by this Chancellor since he took over the role in February 2020, and just over a quarter of the personal tax rises he announced last year.” The FT’s putdown of Sunak’s credentials was funny, damning and accurate: “Sunak is a low-tax Chancellor, in the same way that people who play air guitar in their bedrooms are rock stars. He tried his best. He cut fuel taxes by 5p per litre, which means that, when your house is flooded by climate change, it’ll be cheaper to drive far away from it.”

The bigger economic picture

There is a lot of very good analysis on the state of the economy and what the spring statement implies and I will not repeat it here. The OBR’s mighty tome is the original source for a lot of the analysis (here) and the Resolution Foundation also produces an excellent synthesis (here). However a few issues do bear highlighting. The OBR’s analysis makes the point that “real household disposable incomes per person fall by 2.2 per cent in 2022-23, the largest fall in a single financial year since ONS records began in 1956-57.” It also highlights that in the wake of the decision to leave the EU, the UK “appears to have become a less trade intensive economy, with trade as a share of GDP falling 12 per cent since 2019, two and a half times more than in any other G7 country” (chart below).

Obviously governments cannot be held responsible for exogenous shocks which hit the economy but they do bear responsibility for the manner in which they deal with them. In this regard Sunak’s package of measures falls far short of what is required. Those on benefits face a particularly savage cut in real incomes, with benefits rising by 3.1% as inflation heads above 8%, compared with expected average weekly wage increases of 5.3%. As the IFS has pointed out, the current method for uprating benefits does not work when inflation is high and variable (chart below). A wider point made by the commentator Chris Dillow is that our current system derives its legitimacy from supporting all members of society. Ignoring the poorest undermines that legitimacy. That said, the Tories have hit the poorest voters hardest for more than a decade without any adverse consequences at the ballot box.

When it comes to trade, the government bears full responsibility for the adverse impact. By leaving the EU Single Market, the OBR maintains that the UK will suffer an output loss more than double that of the pandemic. At a time when living standards are under enough strain, the boiled frog problem of Brexit will place a significant additional burden on the economy. This matters because in a little-publicised report, the Government Actuary’s department has calculated that from the 2040s, the National Insurance Fund will be insufficient to maintain projected state pension payouts. Therefore we will either need faster growth, higher tax rates or lower pension payouts to ensure that the fund remains in balance. As an aside, it was notable that one of the measures announced yesterday was an alignment of the starting thresholds for income tax and NICs. How long before the government phases out employee NICs and folds them into income taxes (a subject I covered here)?

Last word

Sunak prides himself on his Thatcherite approach to fiscal management believing in an “ethical” mission to halt the expansion of the state, minimise taxes and restore fiscal self-discipline. I have long criticised politicians who treat state budgets like household finances and Sunak, who is an otherwise intelligent man, appears to have fallen into this trap. Within two years, the current budget balance is projected to return to surplus and overall public borrowing to fall below 2% of GDP. It may well be that the Chancellor will have to use some of these resources to provide extra help to the poorest in society. When even traditional supporters such as the Daily Telegraph balk at the lack of support, you had better believe more needs to be done.