Is the UK the ‘sick man’ of Europe again?
On the surface, UK inflation in 2023 is beginning to resemble the problem of the 1970s, when people spoke of a “British disease” that would make the country the “sick man” of Europe.
Stubbornly high inflation that eclipses the exchange rates of other countries. Index-linked contracts that amplify price pressure. Authorities are struggling to control household costs. And wages are higher following prices.
Wednesday’s data – which showed April inflation at 8.7 per cent, well above the 8.4 per cent expected by the Bank of England – underlined Britain’s particular problem.
The country is feeling both the impact of robust government spending at a time when labor markets are tight — a problem for the United States as well — and the residual effects of last year’s huge rise in wholesale gas prices in Europe.
But with UK inflation significantly higher than almost every other country in Western Europe, and the BoE repeatedly making overly optimistic forecasts, excuses are running out.
Stephen King, Senior Economic Advisor at HSBC and author of the book We need to talk about inflation, was bitter after the National Statistics Office published its data on Wednesday.
“It doesn’t look good, does it?” King said. “Depressed growth, not helped by Brexit. Real wage resistance. Core inflation is the highest it has been in decades. The BoE has admitted that it has been using a model that has not worked well recently. Key interest rates remain very low compared to core inflation of 6.8 percent. . . oh dear.”
UK inflation is now much higher than the Eurozone average of 7 per cent. The other two Western European countries where the rate exceeds 8 percent are Italy – where inflation is the same as that of the United Kingdom – and Austria. In April, food prices are still rising at a rate of 19.1 percent.
The London School of Economics published new research on Wednesday which found that Brexit trade barriers contributed 8 percentage points to the 25 per cent increase in food prices between 2019 and March 2023.
For three consecutive months, the BoE also lost out, failing to understand the short-term dynamics of prices. In February, the central bank expected inflation to drop to 9.2 percent by March, but inflation remained at 10.1 percent.
When the BoE revised its forecasts this month, it built in new error margins to improve accuracy. Officials said privately that the central bank was doing everything it could to ensure that forecasts were not too optimistic again.
BoE Governor Andrew Bailey acknowledged on Tuesday that the bank has “very big lessons to learn” about managing and forecasting inflation.
He said the failure to understand immediate food price pressures was partly a result of the adverse weather in Morocco, which the BoE could not predict, and which affected supply chains for perishables such as cucumbers and tomatoes.
But Bailey also accepted that the BoE had failed to recognize that food producers had entered into long-term wholesale contracts on global food commodity prices, which were close to last year’s peak.
It’s clear the governor didn’t see the latest 1.2 per cent monthly rise in British prices either. He also did not expect the price increases to be this large, which came as a result of the increased cost of used cars and significant increases in the price of mobile phones, books, sports and gardening equipment and pet products.
The rise in cell phone rates was partly due to index-linked contracts, which were a staple of the 1970s and are still the cause of inflation today.
Even before the latest forecast errors, BoE officials were under pressure to explain themselves to Treasury representatives in the House of Commons on Tuesday.
Although Bailey said the bank had already used its judgment to push its projections higher, committee chair Harriett Baldwin criticized him for using a model based solely on data reflecting 30 years of relative price stability.
According to Huw Pill, the BoE’s chief economist, the central bank looks closely at historical data to gain insights into how to manage inflation. “We are thinking [whether] we should be using models or revisiting frameworks that were applied to data from the 1970s and 1980s,” he said.
“But most importantly, while you can learn from it, there’s reason to think the experience isn’t immediately relevant,” Pill added.
According to Pill, inflation remained persistent during these decades because companies and workers began to expect inflation to remain high and set prices and demanded wage increases accordingly.
Despite Bailey’s acceptance that the wage-price spiral is fueling inflation, his chief economist says the current situation is different from the 1970s.
“The structure of the labor market is very different. . . and especially the regime in which monetary policy is conducted is very different,” Pill said.
The BoE stressed that much of the inflation was caused by sharp rises in the price of gas and food, which the UK imports and which the central bank cannot control.
As economists pointed out on Wednesday, the problem with the BoE blaming imported energy and food prices for inflation is that it is increasingly inconsistent with the data.
Core inflation jumped from 6.2 percent in March to 6.8 percent in April, when the average of economists’ expectations remains unchanged.
Official data also showed that goods and services with few import elements increased the general inflation rate more and more.
In April, according to the ONS, items with an import intensity of less than 10 percent, such as rents, contributed 1.76 percentage points to inflation of 8.7 percent. Compared to March’s 1.38 percentage points, this is the highest level since the series began in 2006.
Allan Monks, UK economist at JPMorgan, says this is alarming and prompts the BoE to raise interest rates further.
“[The data] it cannot be written off as a one-off or simply an indirect by-product of rising food and energy prices, as the BoE and the dovish have tended to suggest until recently,” Monks said.
Echoes of recent times spooked financial markets on Wednesday, sending expectations for future interest rates sharply higher. According to financial markets, interest rates will rise to 5.3 percent by the end of the year.
According to Sandra Horsfield, Investec’s British economist, this may exaggerate the problem, who expects another quarter-point increase of 4.75 percent in June.
In a time of stagflation like the 1970s, with little growth and high inflation, he said: “There’s little to rule out, but it’s questionable whether the brakes need to be that much stronger.”