Two year forecast for the UK economy

The scale of the oil-price shock now hitting the British economy is clearly similar to that of the 1970s. Indeed the prices paid by manufacturers for their fuel and materials soared by 30.3% in the year to June, the biggest jump since November 1974. This suggests that the prices those firms in turn charge retailers will rise even higher than the 10% annual increase in June, which was the highest rate of factory-gate inflation since early 1982. Read original article.

Unless retailers absorb the cost increases coming down their supply chain by cutting their margins, this will bring more pain for already hard-pressed households. Consumer-price inflation is moving even farther away from the government’s 2% target. In just two months, it has climbed almost a percentage point, from 3.0% in the year to April, to 3.3% in May and then 3.8% in June—the highest for 16 years.

As far as most shoppers are concerned, the consumer-prices index (CPI) is merely starting to catch up with their daily experience. The CPI may be used for the inflation target, but it commands little confidence because it excludes owner-occupier housing costs. The broader and longer-established retail-prices index (RPI) increased by 4.6% in the year to June. RPI inflation excluding mortgage interest payments—the measure used for the target from 1992 until the end of 2003—rose by 4.8%, also the highest for 16 years.

Whatever index is used tends to understate people’s inflationary alarm, which is coloured by the fact that the prices of everyday essentials are rising so fast. Road-fuel costs, for example, leapt by 24% in the year to June. Annual food-price inflation accelerated from 8.7% in May to 10.6% in June, according to the CPI; on the RPI measure, which stretches back much longer, it is a little lower (9.7%) but still the highest since 1982. Shoppers are keenly aware of these increases and pay little attention to the fact that less frequent purchases like cameras are getting much cheaper.

The labour market has remained one bright spot amid the enveloping gloom, but this is now clouding over. Figures based on the labour-force survey released on July 16th showed that employment continued to grow and that the jobless rate remained steady at 5.2%. Little comfort can be drawn from this, however, not least since the data extend only to May. The more timely figures for people claiming unemployment benefit showed a rise of 15,500 in June, the biggest monthly increase since 1992. Since then a number of homebuilders have announced big lay-offs. In the months ahead unemployment, which lags the economic cycle, looks set to rise, although this may be tempered by migrants returning to eastern Europe as jobs in Britain become scarce.
The return of stagflation has put the Bank of England in a bind. On the one hand, the fierce upsurge in inflation threatens to rekindle an inflationary mentality, in which both firms and workers expect prices to carry on rising rapidly. Although the annual growth of average earnings remains subdued, rising by only 3.8%, unions are flexing their muscles (see article). That calls for a pre-emptive rise in interest rates to show that the central bank means business about restoring price stability. On the other hand, a rapidly weakening economy should bring down inflation in due course. There is an increasing risk that the downturn could be severe, not least because of the fragility of Britain’s mortgage lenders as the housing market subsides. That calls for lower interest rates.

Caught in this quandary, the central bank’s rate-setters decided for the third consecutive month to keep interest rates on hold at 5.0% when they met on July 10th. They seem likely to maintain this do-nothing stance for some time. As long as inflation is accelerating, the monetary-policy committee will be loth to lower the base rate for fear that this may undermine the Bank of England’s credibility.

What this suggests is that the economic malaise will stretch well into next year, and maybe into 2010. This should not come as a surprise. Banking and housing crises tend to drag economies down in their wake for several years. And if there was one lesson that policymakers learnt in the 1970s, it is that there is no easy cure for stagflation. After the nice years, a hard slog lies ahead.
That casts a long shadow over Gordon Brown’s chances at the next election, which must be held by June 2010. Labour swept into office in 1997 with the catchy slogan “Things can only get better”. During the “nice” years, that turned out to be the case. Voters rewarded economic success at the polls in 2001 and 2005. They are unlikely to forgive more recent failure when they next have the opportunity to pass judgment on Labour’s record.

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