Critics of UK economic policy and of Brexit make much of the fact that UK inflation at 8.7% (May) is higher than in the EU (6.1%) or in the US (4.0%). Former BoE Governor Mark Carney absurdly (and shamefully, because he must know it is nonsense) attributes this difference to Brexit. Increased costs of trading with the EU probably pushed UK inflation marginally higher in the months after the UK/EU FTA came into force, but that was two and a half years ago. Thereafter cuts in or abolition of import tariffs had the opposite effect, and as our new FTA’s come into force further downward pressure on prices will result. Brexit is a complete red herring in this context. The culprits behind the UK’s relatively poor inflation performance thus far in the cycle are energy pricing and monetary policy.
The UK is dependent on natural gas for 40% of its electricity, compared to less than 20% in the EU. The enormous jump in gas prices caused by the Ukraine war was therefore bound to have a bigger impact on inflation in the UK than in the EU, an effect compounded by a number of EU countries (most notably France) using tax cuts, subsidies and price freezes to hold energy prices down. In contrast UK policy allowed more of the rise in wholesale gas prices to flow through and concentrated on helping consumers to pay these higher bills. The UK’s convoluted energy pricing system also results in a longer lag between lower wholesale gas prices and reduced prices to the consumer. These factors largely account for the current gap between UK and EU inflation but, crucially, UK domestic energy prices will start falling from July onwards.
Inflation in the US has been markedly lower than in the UK for two key reasons. Firstly, the US’s status as a major natural gas producer and exporter meant their domestic gas prices rose much less than in the UK post the invasion of Ukraine*. Secondly, and most importantly the US Fed tightened monetary policy more decisively than the BoE. Although the BoE was the first major central bank to raise interest rates in this cycle – in Dec 2021- they squandered this advantage with a tentative follow through. In the subsequent six months UK Bank Rate had only increased from 0.25% to 1.25%. The US Fed only began raising rates in March 2022, but in six months had raised the Fed Funds Rate (FFR) from 0.25% to 3.25% and to 4.5% by year-end. These rate rises were accompanied by an aggressive switch from quantitative easing (QE) to quantitative tightening (QT) – in effect directly reducing money supply rather than creating it. The BoE also adopted a QT programme but a less aggressive one than the Fed.
Both the Fed and the BoE have succeeded in bringing the grossly excessive money supply growth of the Covid period under control, but more recent US money growth has been notably lower than in the UK. In line with Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” it is no surprise that US inflation has thus fallen more rapidly than in the UK. However, in reaction to recent poor inflation data the BoE has raised the pace of its tightening programme, while the Fed has slowed down and indeed “paused” its rate hikes with the FFR at 5.25%. The current large gap between US and UK inflation rates should close significantly in coming quarters.
How Low can UK Inflation Fall?
How low can UK inflation fall and over what time period? Milton Friedman emphasised that there are “long and variable” lags between trends in money growth and inflation. However, UK broad money growth has been at or below 5% for nearly two years now and rose by only 1.6% in the year to April. Although interest rates are not high by historical standards the pace of tightening has been very rapid compared to history. This is likely to keep money growth low, particularly as UK regulators have also imposed an increase from 1% to 2% in the “counter cyclical buffers” held by banks. Prolonged money growth in this range means that inflation can plausibly return to the 2% target level within the next year or so. The danger now is that the BoE overdoes the monetary tightening or has already done so. Unfortunately, the Bank arrogantly continues to ignore money data, despite the strong theoretical and empirical grounds testifying to its importance, and despite its own truly appalling forecasting and policy record over the last decade or more** (hence Mr Carney introducing his Brexit red herring).
The Bank is raising rates now because the current inflation rate is high and the labour market is tight, but these are lagging indicators. Economists that are still calling for further rate hikes worry about a possible wage price spiral. However, a notable feature of the recent upsurge in strike action is that even at a time of maximum union leverage wage settlements have generally ended up well below inflation. As inflation falls so will the average pay rise. Because monetary policy itself acts with a lag it should be set by looking forwards. Apart from persistent low money growth other indicators also suggest rates should not go any higher. Insolvencies are rising rapidly. Sterling has reversed all the weakness of the Truss/Kwarteng interlude and recently reached a post-Referendum high in trade weighted terms. The yield curve has become inverted, that is short term rates are notably higher than long term rates. This means markets think short term rates are unsustainably high. Consumer price inflation is still high, but producer price inflation has collapsed. Producer prices very reliably lead consumer prices by a few months, and producer input prices similarly lead producer output prices. Producer input price inflation has fallen from 24% to 0.5% % in the last 11 months while producer output inflation has fallen from 19.6% to 2.9% over the same period. China’s post-Covid recovery has been feeble and producer prices there are falling sharply, presaging a new wave of global disinflation.
Is a Recession Inevitable?
Assuming the forecast of a return of inflation to target in 2024 is correct, does this necessarily mean the UK economy will go into recession as many economists argue/assume? This is clearly a possibility – inverted yield curves and declining real money growth are classic leading indicators of recessions. While higher interest rates constrain economic activity in the short run, they also increase returns to savers, and in the long run the resumption of a ‘normal’ level of interest rates is an unalloyed blessing. The era of zero interest rates, leading to the misallocation of capital on a grand scale, has been a disaster for long run productivity growth in western economies. Nevertheless, if the BoE continues to raise interest rates from present levels in the face of compelling evidence that inflationary forces are in retreat, recession will become a certainty. The first condition for forecasting no UK recession is therefore for the Bank to “pause” its rate hikes. A cause for optimism on this score is that at the last BoE rate setting meeting two of the nine committee members voted to hold rates steady. At key turning points in the interest rate cycle minority votes often lead future policy direction.
A second condition is that the government must continue to use Brexit freedoms to carry out supply side reforms. Prominent Brexiteers have understandably been critical of government for being too slow in using those freedoms, criticism that has the unfortunate effect of downplaying the very real changes that have been and are being made – a point made strongly by former cabinet minister Lord Lilley in a recent article entitled “Brexit has already saved us Billions”. He points out that if we were still in the EU, we would have had to pay roughly £95bn into the EU Covid Recovery Fund (of which we would have got only a fraction back), plus our annual net contribution which by now would amount to hundreds of millions per week. Outside the EU we were able to have the fastest vaccine roll out in Europe, and more recently to raise our global standing by taking the lead in supporting Ukraine. Our farmers will now be able to plant gene-edited crops. We solved the HGV driver shortage during Covid in quick time by altering old EU rules on training and granting of permits. A £50 rise in motor insurance premiums was averted by reversing a European Court judgement. 100 tariffs on manufacturing components were abolished. Farmers are now subsidised for environmentally sound practises instead of for just owning land. VAT on energy products was reduced.
To Lord Lilley’s list I would add the following. We now have a points-based immigration system which prioritises skilled workers from all parts of the globe rather than allowing uncontrolled numbers of unskilled workers from the EU. We have begun to set up enterprise zones. Our FTA’s with Australia and NZ have just taken effect while negotiations continue with a number of other countries. Memorandums of Understanding (in effect partial FTA’s) have now been reached with five US states and negotiations with others are ongoing. Our historic Accession to the giant trading bloc CTPPP was recently concluded. While the USA and the EU have both initiated huge subsidy programmes for green energy and other technologies – much of which is likely to be wasteful – the UK has adopted a more nuanced approach which focusses resources on areas in which we have world leading potential. The Chancellor is pushing ahead with his Edinburgh Reforms to the financial sector.
Taken together this amounts to a significant reform package. It is true that many are very recent or are yet to be carried out in full. Yet even announcements or indications of future change can stimulate economic activity. Companies begin searching out future export markets or investment opportunities ahead of those changes coming legally into force and make initial investments to take advantage of them. In recent quarters the UK economy has been consistently more resilient than forecast. Many economists, including those at the BoE, have been expecting the UK go into recession but have so far been wrong. The EU officially went into recession (albeit shallow) in Q4 2022 and has remained there even though the ECB only began raising interest rates in July 2022 and has yet to initiate a QT programme. UK growth has been low but still positive thus far. Could it be that our Brexit freedoms explain why UK economic growth has outperformed the EU in recent quarters, despite widespread disruption to economic activity caused by strikes, a significant fall in public-sector productivity and a tighter fiscal and monetary policy than the EU? Although the difference thus far is marginal, if BoE can stop compounding its errors there is good reason to believe that the gap will widen considerably in coming years.
Robert Lee June 28th 2023
* In rough terms US domestic natural gas prices are an astounding 5 times lower than prices paid by the UK or EU for LNG (Liquid Natural Gas). A great deal of LNG export capacity is coming on stream in the US and Canada in the next 18 months, so this unsustainably large gap will close, almost certainly resulting in significantly higher US gas prices.
** It is remarkable that two UK PM’s have lost their jobs in the last twelve months, including one with a very strong electoral mandate, and yet BoE Governor Andrew Bailey continues in his post despite being responsible for policy errors that have caused immense damage to the UK economy. Urgent reform is required to ensure such powerful independent officials are made properly accountable for their actions.