One of the main advantages of the UK has always been its commercial geography – between North America and continental Europe. But for now, he’s getting the worst of both worlds. As Andrew Baileygovernor of the Bank of England, warned last weekThe UK economy “weakens earlier and somewhat more than others”. The country is waiting for a “further step forward” in inflation later this year – and his prices will have a problem”more persistence“.
Like the US, there has been a strong post-Covid surge in Britain. But two years of pent-up demand and shifting tastes hit an economy that couldn’t keep up. This contributed to rapid growth, but the mismatch between supply and demand also generated inflationary heating.
From Europe, the UK imported the impact of a particularly nasty energy price shock, largely caused by Russia’s war in Ukraine. Consumer price inflation rose 9.1% year-on-year through May. Much of this has been driven by a sharp increase in spending on households and transport, or in other words gas, electricity and gasoline. But high inflation in the UK has spread to most goods and services. The Bank of England believes that inflation is ingrained in corporate psychology.
There are also some peculiarly British phenomena: the energy regulatory system, which includes caps on consumer tariffs, means that households have not yet felt the full impact of higher energy prices. The same system will introduce an additional dose of price increases in October, prolonging the period of inflationary pressure.
The UK is also under particular pressure on the labor force. About 380,000 more people of working age over 25 have left the labor market since the pandemic, and many of them will be very difficult to get back. Most of the net increase was in people over 50 who left the labor market: they may believe they were out of action for the last time.
This, to a limited extent, also applies to Brexit. While non-EU workers continue to arrive in large numbers, Brexit has reduced the ability to quickly attract workers from abroad. The deterioration of the UK trade position continues to hold back growth. The weakness of the pound has also made recent price shocks more painful. The pound has lost over 10% of its value against the US dollar this year.
There is no elegant solution. The UK must be prepared for inflation to still rise – possibly to double digits – months after it started to decline elsewhere. The cost of energy, the deterioration of trade, the loss of some of the workers – all this has the same result: the country is poorer than it thought.
This means that Britain must share the pain of adaptation. The key question is how. For the UK government, it also means thinking about what would happen if prices rose by one-fifth within three years. This will affect everything from the application of its fiscal rules to tax thresholds and public sector payroll calculations, as well as how social safety nets should work for those most in need.
The task facing monetary policy makers at the Bank of England is difficult, but in some respects less so. The central bank needs to tighten policy even further to demonstrate its determination to restore inflation expectations closer to 2%. It is possible that the Bank of England will do too much and go too far: calibrating the right level of tightening will require more luck than common sense. This could squeeze too much life out of the struggling British economy. But that shouldn’t be a major problem—policy could be loosened quickly if necessary. In the medium term, the situation will be much worse if the UK becomes a place where people do not believe that the currency has value.