The
Monetary Policy Committee of the Bank of England (hereafter ‘the
Bank’), by raising interest rates over the last six months, intends
to play its part in creating a prolonged UK recession. This is not
speculation but a statement of fact. The Bank’s latest forecast,
similar to the one in August that
I
highlighted in an earlier post, suggests negative
growth in GDP in the third quarter of this year, forecasts a further
fall in the fourth quarter, with further falls during the first half
of next year.
Why
does the Bank think it needs to help create a prolonged recession? It
is not because energy and food prices are giving us around 10%
inflation, because a UK recession will do almost nothing to bring
energy and food prices down. Instead what has worried the Bank for
some time is that the UK labour market appears pretty
tight, with low unemployment and high vacancies, and that this tight
labour market is leading to wage settlements that are inconsistent
with the Bank’s inflation target. Here is the latest [1] earnings
data by sector.
Earnings
growth is around 7.5% in the wholesale, retail, hotels and
restaurants sector, about around 6% in finance and business services
and the private sector as a whole.
Of
course these numbers still imply large falls in real wages for most.
For many it seems odd to describe the UK labour market as overheated
when real wages are falling. Perhaps the easiest way of thinking
about it is to imagine what would happen if the labour market was
slack rather than tight, and as a result firms had complete
discretion over what wage increases it would pay. Domestic firms are
under no obligation to compensate their employees for high energy and
food prices, over which they have little control and which are not
raising their profits. As a result, if firms were free to choose and
there was abundant availability of labour, they would offer pay
increases no higher than the increases we saw during 2019. The fact
that in the real world firms feel they have to offer more is
consistent with a tight labour market where many firms are finding it
difficult filling vacancies.
Average
private sector earnings running at around 6% are not a problem for
the Bank because it is anti-labour, but because it believes wage
growth at that level is inconsistent with its inflation target of 2%. It’s not the kind of wage-price spiral we saw in the 1970s, but if earnings growth were to continue at 6% over the next few years then the Bank would almost certainly fail to meet its mandate. But earnings growth will slow as the UK recession
bites. The big question for the Bank is whether they are overreacting
to a tight labour market by creating a prolonged UK recession. Are
they using a sledgehammer to crack a nut?
To
try and answer this question, we can look at the Bank forecast based
on no further increases in interest rates. The reason for
looking at this forecast, rather than the ‘headline’ forecast
based on market expectations of further rate increases, is that the
Bank has been explicit in its scepticism about these market
expectations. (Why the Bank cannot tell us how they expect rates to
change in the future remains
a mystery to many of us.)
The
blue line is the Bank’s forecast for year on year consumer price
inflation. It is expected to come back down rapidly, ending up close
to target in mid 2024. The red line is GDP relative to the pre-Covid
peak quarter in 2019. [3] It shows a recession hitting its bottom in
around a year’s time, but then recovering at a snail’s pace
subsequently, so that GDP by the end of 2025 is still below the 2019
peak! This prolonged recession implies steadily rising unemployment,
increasing from current levels of about 3.5% to over 5% and rising by
the end of 2025.
If
we take this forecast seriously, and we presume the Bank does, then
there is little need for rates to increase further than 3%, and we
would expect the Bank to start cutting rates by 2024 at the latest.
The reason to expect this is that inflation is undershooting its
target by the end of 2025, suggesting unemployment of 5% is too high
to achieve stable inflation. We will have gone from an overly tight labour market to one which is overly weak. Interest rates influence inflation with
a significant lag, so to stop this undershooting and get a stronger
recovery interest rates need to start falling by 2024 if not before.
This
observation invites another. Rather than raising rates now, and
creating a significant recession, only to have to cut them again
after a year or two, wouldn’t it be more sensible to not to raise
rates by so much right now? [2] That might mean inflation takes an
additional year to go back to a target, but after a massive energy
price shock that would be more than understandable. If the Bank
thinks their remit requires them to get inflation down below 3%
within two years, that remit looks far too ambitious after double
digit inflation.
Is
the Bank’s forecast of a recession an inevitable result of having
10% inflation today? The short answer is no. To repeat the point made
at the start, the Bank cannot control energy and food prices which
are the main cause of 10% inflation. The correct question is does a
tight labour market now inevitably require a recession to correct it?
In
the 60s and 70s macroeconomists used to think that an economic boom
(in this case an over tight labour market) had to be followed by an
economic downturn (or even recession), because that was the only way
to get inflation back down. It was the logic behind the phrase ‘if
it’s not hurting it isn’t working’. But nowadays
macroeconomists believe it is possible to end a boom and bring
inflation down without creating a downturn or recession, because once
the boom is brought to an end a credible inflation target will ensure
wage inflation and profit margins adapt to be consistent with that
target.
The
Bank might argue that this will only happen if interest rates are
increased now, because otherwise the inflation target loses
credibility. But as Olivier Blanchard observes
here, the lags in the economic system mean a central
bank should stop raising rates while inflation is still
increasing. If a central bank believes it will lose credibility
by doing this, and feels it has to continue raising rates until
inflation starts falling, this will lead to substantial monetary
policy overkill and an unnecessarily recession.
If
that is why central banks in the UK and the Euro area keep raising
interest rates as the economy enters a recession, then the truth is
central banks are throwing away a key advantage of a credible
inflation target. Credibility is not something you constantly have to
affirm by being seen to do something, but something you can use to
produce better outcomes. Furthermore central banks are more likely to
lose rather than gain credibility by causing an unnecessary
recession.
Of
course raising interest rates to 3% is not enough on its own to cause
a prolonged recession. Probably more important is the cut to real
incomes generated by higher energy and food prices, which is enough
on its own to generate a recession. On top of that we have a
restrictive fiscal policy involving tax increases and
failing public services (more on that next week). Both together
should be more than enough to correct a tight labour market. To have
higher interest rates adding to these already large deflationary
pressures seems at best very risky, and at worst extremely foolish.
The question we should be asking central banks is not why they are
raising interest rates in response to higher inflation, but instead
why they are going for inflation overkill by making an expected
recession even worse.
[1]
Data up until September should become available this week.
[2]
A policy of raising rates when you can see a weak recovery and below
target inflation in three years time, because you think you can deal
with those problems later, is a good example of what macroeconomists
call ‘fine tuning’. Fine tuning makes sense in a system where you
have exact control and can forecast accurately, but makes much less
sense for a macroeconomy where neither is true. The danger of trying
to fine tune the macroeconomy is that errors in timing mean the
economic cycle gets amplified.
[3] I chose this way to show GDP because it illustrates just how poor the economy has performed in recent years, reflecting a decline relative to most other G7 countries that began over a decade ago.
