Take it slow and steady

It has long been evident that we are heading for a bumpy economic landing but the BoE’s pessimistic outlook delivered in this week’s Monetary Policy Report nonetheless came as a shock. According to the BoE, CPI inflation is set for a peak of 13% by the fourth quarter of 2022 whilst real output growth more or less flatlines over 2023 and 2024 and unemployment is projected to rise. All this is taking place at the same time as the Conservative Party is set to choose a new leader – frankly, this would be a good contest to lose given that politicians are almost certain to be blamed for the cost of living crisis heading our way. 

It has become fashionable in recent months to lay the blame for the inflation surge on the BoE. Liz Truss, the current front runner to replace the hive of inactivity that is Boris Johnson, argued recently that “the best way of dealing with inflation is monetary policy and what I have said is I want to change the Bank of England’s mandate to make sure in the future it matches some of the most effective central banks in the world at controlling inflation.” I am not sure which central banks she is referring to. In the US, inflation is already above 9% and in the euro zone it is within a whisker of this rate (according to Eurostat, it is likely to have hit 8.9% in July). Admittedly Japanese inflation is at 2.2% but this is after years of disinflation with real GDP growth averaging just 0.5% per annum since the turn of the century. 

Prominent Tory politicians, such as current Attorney General Suella Braverman, have suggested that “interest rates should have been raised a long time ago and the Bank of England has been too slow in this regard.” But this is to conflate a number of issues in the monetary policy debate. In my view there are a number of questions which should be tackled separately: (i) did central banks become complacent in the wake of the GFC by holding rates too low for too long; (ii) was the policy response around the time of the Covid outbreak appropriate and (iii) would higher interest rates have prevented the current inflation spike? 

The answer to (i) is undoubtedly yes. The decline in inflation in the years prior to 2008 buttressed central bank credibility and their actions to inject liquidity in the wake of the GFC without triggering a surge in consumer prices gave rise to the view that they really had conquered inflation. Modern macroeconomics also has a lot to answer for, with the dominant paradigm in academia and central banks having little to say about the inflation process (I touch on this below but a more detailed look is a topic for another day). Thus the recent spike in prices blindsided central bankers who had, frankly, grown complacent. 

With regard to (ii) there is a valid argument to suggest that the Covid-induced collapse in output was a supply side shock to which central banks responded by stimulating demand, which was inevitably going to lead to inflation as demand outstripped supply. Admittedly, this view has only emerged with hindsight but there is a ring of truth to it (even if it is understandable why central banks reacted as they did in 2020). As to whether higher interest rates would have prevented the inflation spike, the answer is unequivocally no. Monetary policy cannot hope to impact on the type of supply shock posed by a huge rise in energy prices.

What does the empirical evidence suggest?

All of this raises an uncomfortable question for central banks which is far less clear cut than they think it is. The standard response to rising inflation is that the credibility of central bank policy requires higher interest rates to bear down on inflation expectations. The economist John Cochrane has been looking at this in a US context (a shorter overview of some of the key points can be found in this blog post). His starting point is the classic 1972 paper by Robert Lucas (even after 50 years it is still heavy going) which demonstrated that money is neutral with regard to the real economy. But as Cochrane pointed out, “our central banks set interest rates. The Fed does not even pretend to control money supply. There are no reserve requirements. We need a theory of inflation under interest rate targets.” At the current juncture, there isn’t one.

Modern macroeconomic models rely on the Phillips curve to propagate inflation dynamics (this postulates there is a negative relationship between unemployment and inflation). In Cochrane’s words, “the Phillips curve has been a disaster, especially lately” (a subject I looked at briefly here). Indeed, Roger Farmer has argued that we should replace the standard Phillips curve with a ‘belief’ function in which nominal output in the current period depends only on what happened in the previous period (see my blog post on this issue). Cochrane concludes on the basis of his analysis that there is no need for central banks to overreact to the surge in inflation: “If the Fed does nothing, inflation may surge for a while, but it will not explode. Inflation will eventually come back on its own, so long as fiscal policy does not create more inflation. The Fed’s inaction does not spur more inflation or set off an inflation spiral.”

I find this conclusion rather comforting since most of the models I have ever used demonstrated only a tenuous relationship between interest rates and inflation. The chart above illustrates the impact of a simulation exercise conducted using my structural macro model of the UK in which Bank Rate is raised by 100 bps relative to baseline and held there for four quarters. After 12 quarters, output is reduced by 1.4 percentage points relative to baseline but the level of consumer prices only declines by 0.1% (note that the impact on wages is far larger).

Another way of looking at the relationship between interest rates and the macroeconomy is to look at vector autoregression (VAR) models which capture the linear dependencies amongst time series by modelling each one in terms of past values of all series in the system. VARs are designed such that we do not need to know the structure of the economy but instead capture how changes in one variable affect other variables in the system. This makes them sub-optimal as forecasting models but very insightful as a method of assessing how shocks percolate through the economy. The model used here contains series for real GDP growth, CPI inflation, Bank Rate and the nominal sterling exchange rate index. The impulse response functions shown in the chart above suggest that the impact of higher BoE interest rates on UK inflation is limited (purists will quibble about the specification of the model and the analysis may come across as a bit back-of the-envelope).

Key takeaway

Based on the evidence, those who argue that the BoE is too far behind the curve (the same applies to other central banks) and that huge interest rate rises are needed to curb the current inflation spike are misguided. The most likely impact of such action will be to crimp economic activity thereby making life harder for those already being hit by the cost of living crisis.

As Cochrane notes: “Why do we not know answers to such basic questions? I think we have been a bit guilty of studying the world as we wish it to be rather than the world we are in.” He goes on to point out: “How is it that we’ve been playing with interest-rate based models for 50 years, yet such basic questions are still unanswered? … As I look at the effort to build monetary models based on interest rate targets, we have been guilty of playing with far too complex models that we don’t really understand.” This is not an argument for central banks taking their foot off the pedal. However, it is an argument for due care in the monetary tightening process. If the economic downturn is as nasty as the BoE predicts, the calls for rate cuts in a year’s time will start to become louder.

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.”