Britain needs new practical economic rules. The old norms and assumptions are not even remotely suitable for a world with severe shocks in the supply of gas and other goods, high inflation, and extremely low rates of core productivity growth.
In the past, the labels that most economists have used to describe a complex and dynamic economy like Britain’s have served quite well. The British economy could sustain economic growth at around 2% a year without causing inflation. Interest rates should have been raised if unemployment was low and growth was higher. The opposite happened if unemployment was high or growth rates fell well below 2 percent. If a recession was looming, everyone thought politicians should step on the accelerator by lowering interest rates, which may have been helped by tax cuts.
This thinking is alive and active in British political circles. This is at the heart of a story this spring by Bank of England Governor Andrew Bailey about how to navigate the “narrow path“Between an economy that is too hot or too cold. Predicting the stagnation of the UK economy, recommended by OECD “The government should consider slowing down fiscal consolidation to support growth.” And Liz Truss, one of the Conservative leadership candidates, has repeatedly called for tax cuts, saying recent increase were “a mistake now that we are facing such strong economic headwinds.”
All of these comments implicitly or implicitly assume that the supply side of the UK economy is following the traditional rules of thumb, and then they seek to regulate demand to keep inflation low but positive.
The problem is that the UK’s ability to supply goods and services has been far from stable and predictable. The UK is not the only one facing a severe energy shock, but it also has additional headwinds in the form of a hard and harmful Brexit, a sharper decline in productivity than other countries since the financial crisis and workforce reduction.
With potential growth so low, unfortunately high energy prices are pushing the UK economy into recession while still in excess spending. Spending is falling, but potential supply has shrunk even further, so we still have excess demand. We learn that it is entirely possible for a mild recession to continue to be inflationary.
The Bank of England is increasingly openly acknowledging this difficult trade-off. His tone on inflation has become tougher and I expect the governor to soon recognize that he needs to be more aggressive on inflation, with bigger interest rate hikes even as the clouds roll in.
Along with central bank action, we need new rules of thumb and a new language to accurately describe the economy. When considering inflation, supply must precede any talk of accelerators, brakes, or demand. The questions we need to ask include whether supply conditions are getting better or worse, and what are the trends in wage policy and corporate pricing.
The answers to these questions matter much more than the question of whether growth is slowing or even positive or negative. We also need to keep track of monthly price changes by asking questions such as what percentage of all goods and services is increasing or decreasing in price. In the UK in June, 94 percent of items in the consumer price index have risen in price over the past year or more. 70 percent grew at an annual rate of more than 4 percent. This is high and wide inflation with the most modest signs of moderation.
Therefore, a much tighter monetary policy is needed. We don’t need to talk about growth rates to realize that too many prices are going way above the double inflation target, and it’s now ingrained in corporate pricing decisions. Until inflation is beaten, this is the new way to talk about the UK economy. Nobody considers it pleasant, but it is necessary.