Unemployment rising. Inflation above 10%. Energy prices soaring. Living standards squeezed. The message from the Bank of England was crystal clear: the 1970s are back.
The word stagflation was not to be found in the 100-plus pages of Threadneedle Street’s monetary policy report. Yet a period of weak growth and rapidly rising prices is precisely what the Bank says is in store for the UK. The current post-lockdown bounce will be short-lived and, in a real blast from the past, the economy will be driven into recession to bring inflation under control.
Nor is the pain likely to be over quickly. The economy is expected to contract by 0.25% in 2023 and remain weak in the next two years. Unless things take a marked turn for the better, the next general election will take place against a backdrop of weak growth and lengthening dole queues.
Just as in the 1970s, the Bank says external factors are mainly to blame. In 1973, it was the Yom Kippur war that led to 25% inflation by mid-1975. This time it is the war in Ukraine. The Bank is pencilling in another 40% increase in the energy price cap in October, taking the average annual household bill to £2,800.
There may be arguments about whether the UK is technically heading for recession because the Bank is not forecasting two consecutive quarters of falling output – but it will certainly feel like it. Living standards are about to take their biggest hit in decades. In another echo of yesteryear, sterling took a dive on the currency markets after the Bank’s interest-rate decision.
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Six months ago, the Bank thought inflation would peak at 5%. It now believes it will top out at just over 10%, easily the highest level since Threadneedle Street was granted operational independence 25 years ago.
The Bank says there is little it can do to prevent the harm to household budgets and company profit margins caused by rising global energy profits, and that its task is to hit the government’s 2% inflation target while minimising the damage to the economy. Confronted with the dilemma of whether to worry more about the risk of recession, or of inflation becoming embedded, the Bank has opted for a middle course, raising interest rates by a quarter point to 1% – their highest level since early 2009. But the vote was not unanimous: three of the nine members of the monetary policy committee (MPC) wanted a half-point increase.
Having been too optimistic about the economy in the past, the Bank may now be too gloomy. There are two reasons for that. The first is that Threadneedle Street’s forecasts are based on what the financial markets think will happen to interest rates – and given the prospect of prolonged stagnation, the current City belief that borrowing costs will peak at 2.5% looks much too high. The Bank says it would result in inflation falling to 1.3% – well below its target – in three years’ time. Two MPC members think it is possible no further tightening will be needed.
The second reason is that it is hard to envisage the government watching the economy slide into recession without doing something to alleviate the pain. The Bank has upped the pressure on Rishi Sunak to act – and act big.