Sunday, May 28, 2023
Our high inflation wreaks havoc on taxes and inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

Let me today take you back just over two years to March 2021 when Rishi Sunak, the then chancellor, unveiled his second budget. He was, he said, determined to begin the task of repairing the public finances, by announcing a tax policy that was “progressive and fair”. The policy was to freeze income tax allowances and thresholds for five years from April 2022, the exact opposite of the approach that had been followed by Tory chancellors since 2010.

I mention it now because, with the latest inflation figures, we have seen the consequences of the second freeze in those allowances and thresholds. The first freeze, in April last year, occurred with inflation at 9 per cent. The second, last month, occurred with a similar inflation rate, 8.7 per cent. The higher the inflation rate, and associated pay rises, the more the freeze increases the amount of tax people pay. This is fiscal drag at its most aggressive.

This was not supposed to happen. When Sunak announced the freeze two years ago, he was taking a scalpel to the public finances. Inflation, according to the official forecaster the Office for Budget Responsibility, was predicted to be less than 2 per cent for much of the period, only getting to that level in 2025. By 2025-26, the policy was expected to raise an eventual £8 billion annually compared with the usual approach of raising these allowances and thresholds in line with inflation.

But, while the policy has turned out to be much harsher than expected, it was extended for two years by Jeremy Hunt last autumn. High inflation means that it will raise £27 billion a year by 2025-26, more than three times the original plan, and £29 billion by 2027-28. Instead of a scalpel, this is a machete.

It is the biggest stealth tax increase in British history, and the biggest tax increase of any kind according to the Institute for Fiscal Studies (IFS), since Sir Geoffrey Howe increased VAT from 8 per cent (12.5 per cent for “luxuries”) to 15 per cent in 1979. To be fair to the former chancellor, his VAT increase was accompanied by big cuts in income tax.

This huge tax increase will have consequences for years to come. The OBR estimates that it will lead to 3.2 million more income taxpayers, 2.1 million more people paying the higher 40 per cent rate and 350,000 more paying the additional 45 per cent rate. The IFS says that by 2027-28 14 per cent of people will be paying income tax at the higher rate, compared with 3.5 per cent in the early 1990s. By then, 3.1 per cent will be on marginal rates of 45 or 60 per cent (the rate prevailing between £100,000 and £125,140. This is how, despite talk of pre-election tax cuts, Britain is becoming a high tax country.

This stealth tax increase was made much bigger by high inflation, and it not the only effect. The latest inflation figures, though showing a drop from 10.1 to 8.7 per cent, were acutely disappointing. Though inflation is on course to drop more sharply from the middle of the year, particularly with Ofgem’s announcement of a reduction in the energy price cap to £2,074 from July, compared with an average household bill of £2,500 now, the underlying picture remains worrying.

Food price inflation at 19.1 per cent, down only fractionally from 19.2 per cent the previous month, is now taking over from energy as the key inflation concern. For the Bank of England, however, the rise in “core” inflation, excluding energy, food, alcohol and tobacco, from 6.2 to 6.8 per cent, was the most worrying element. UK inflation is proving very sticky.

Sunday, May 21, 2023
How the pandemic dealt another blow to productivity
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

Much as I hate being the bearer of bad news on a spring morning, a few days ago we had some grim figures for productivity, the ultimate driver of living standards. Productivity, measured by gross domestic product per hour worked, dropped by 1.4 per cent in the first three months of the year and was down by 0.6 per cent on a year earlier, its biggest annual fall in “normal” times for 10 years.

The other main productivity measure, output per worker, dropped by 0.4 per cent in the first quarter, and was down by 0.9 per cent on a year earlier. Both measures of productivity show no growth compared with the fourth quarter of 2019, before the pandemic struck. A very weak trend for productivity growth before the pandemic – evident since the 2008-9 financial crisis – appears to have turned into a non-existent one.

This is interesting, because it provides a first test of the claims and counter claims that were buzzing around on productivity during the pandemic. Did cramming 10 years of technological change into a very short period, providing a big increase in, for example, working from home, boost productivity? We may now be closer to knowing the answer.

Before I come on to that, let me add that if I chose, I could be the bearer of even worse news. The productivity calculations are based on employment and hours worked figures derived from the Office for National Statistics’ Labour Force Survey (LFS), which show no change in the number of people in work compared with the end of 2019.

Some economists are, however, concerned about the accuracy of the LFS figures. Another measure of employment produced by the ONS, workforce in employment, shows a stronger picture for employment, up 2 per cent since before the pandemic, and thus an even weaker picture for output per worker. PAYE data from HMRC also suggest more buoyant employment than the LFS figures. More people in work but with no increase in GDP equals lower productivity.

The debate over the statistics cannot disguise the fact that over the past three years a bleak UK productivity performance has turned even bleaker. This is very early evidence, but what can we conclude about the impact of the pandemic? A couple of things, I think.

Working from home (WFH), which has now evolved into hybrid working for many people – part at home, part at the place of work – has been a bone of contention between employers and employees, and that continues. Many employers believe that, as well as losing the benefits of in-person collaboration between workers, a key part of the creative process, unsupervised workers are less productive, so WFH reduces productivity. This is why there is what looks like a concerted drive at present to get people back into the office.

Surveys of employees, in contrast, tend to find that, as well as preferring a combination of face-to-face and remote working, most think that their productivity has gone up because a result of WFH. There are fewer distractions, and less time is wasted.

These two views are hard to reconcile, though you would have to say that the evidence so far, while preliminary, tends to favour the view of the bosses rather than the workers. If there was a productivity gain from WFH you would expect to see some early signs of it now.

One possible explanation comes from research on time savings due to WFH by Professor Nick Bloom and others, published by America’s National Bureau of Economic Research. When you cut out commuting, people save time, estimated at an average of two hours a week in 2021 and 2022 (averaged across the whole working population).

Some 40 per cent of those time savings are devoted to work, the rest of leisure and caring responsibilities. But even that 40 per cent means that when working at home, people are putting in more hours to accomplish the same tasks, thus reducing productivity. There have also been plenty of stories of Zoom fatigue and people working well beyond normal hours, and being expected to do so, when at home.

Sunday, May 14, 2023
Halving inflation isn't going to transform Tory fortunes
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

This is a difficult time for Rishi Sunak, the chancellor turned prime minister. After the Tory drubbing in the local elections, opinion polls taken since have snuffed out for now the idea of a “Rishi revival”, which some commentators were talking enthusiastically about a few weeks ago.

Sunak is a pragmatic prime minister, lurching to the right to side with an unpopular home secretary on what is likely to be a vain attempt to stop the migrant boats, while also infuriating some Tory Brexiteers with a sane and sensible plan to scale back the repeal of EU laws.

Stopping the boats, or at least passing laws to try to stop them, is one of his five pledges to turn things around. Another is to cut NHS waiting lists, though there is no promise to reduce overall lists to acceptable levels.

As befits a former chancellor, three of his pledges are economic. One, to “make sure our national debt is falling” should not detain us for too long. The debt rose by £193 billion to £2,247 billion in the fiscal year just ended, 2022-23, and from 97.3 to 99.6 per cent of gross domestic product. This measure has not yet peaked relative to GDP and the underlying measure, excluding the Bank of England, is not predicted to do so until 2026-27, well after the election. The main purpose of the pledge may be to fight a battle with Labour on fiscal responsibility but, even under Sunak, the Tories have a lot of ground to make up on that following the premierships of Boris Johnson and Liz Truss.

It is the other two economic pledges that matter. A lot of my economist friends get upset by the prime minister’s pledge to halve inflation this year, saying that this crosses a line over Bank of England independence, and that it not within the government’s gift to achieve it. Some would love to see the government with egg on its face on this.

The Bank, though, does not appear to have a problem with it and, as well as raising Bank rate from 4.25 to 4.5 per cent on Thursday, on a 7-2 vote as expected, predicted that whether the pledge will be met will be on a knife-edge. It forecasts 5.1 per cent inflation in the final quarter of this year. Others, including the National Institute for Economic and Social , think it will be higher, though not much, 5.4 per cent by the end of the year.

In the case of both forecasts, it might be necessary to get the calculators out. Inflation in January was 10.1 per cent, so 5.1 per cent is not quite half, though a more typical comparison would be the fourth quarter of last year when it averaged 10.7 per cent. And if falling inflation in coming months is accompanied by further interest rate hikes, as the Bank suggested might be the case, it will not be a cause for celebration.

That will be one of the issues when the inflation pledge is assessed by voters, but it may not be the main one. When many people hear a promise of halving inflation, they automatically think that means lower prices, not an easing of the pace of price rises. There is a big difference between the two; between levels and rates of change.

As it is, those levels have gone up a lot, and much of it occurred on Sunak’s watch, either as chancellor or prime minister. Since the December 2019 election, consumer prices have risen by 18.8 per cent, with huge increases in essentials, food and beverage prices up by 24.5 per cent, household energy bills by 34.5 per cent, and transport by 18.3 per cent. High food prices, a big concern for households, have also worried the Bank. A fall in inflation will not wipe out the overwhelming majority of those price rises. People will be squeezed by those high prices, and tut-tutting about them, for some time to come.

A related problem with the inflation pledge is that it is one thing to promise to fix a problem that you inherited from your political opponents - a tactic that worked for David Cameron and George Osborne in 2010, and more particularly in the 2015 election – and quite another to do so for a problem that emerged while you were in charge. Even a halving of inflation would leave it well above levels that people thought was the norm and, indeed, the official 2 per cent target,

Sunday, May 07, 2023
Pay's the issue, but don't forget public sector pensions
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

There is as yet no end to the wave of industrial disputes mainly affecting the public sector and former nationalised industries such as the railways. In the NHS, the government has yet to settle its dispute with the Royal College of Nursing and junior doctors represented by the British Medical Association, though it has just pushed through a 5 per cent pay rise for most employees to try to force the issue. Teachers were on strike during last week and the unions are talking of co-ordinated action in the autumn.

Rail unions intend further walkouts, some of which are due to coincide with the Eurovision song contest in Liverpool next weekend and the FA Cup Final next month.

One milestone has been passed in these strikes. More than three million working days were lost because of industrial disputes between June last year, when the Office for National Statistics (ONS) resumed publication of the data, and February this year, the latest figures. To put that in perspective, it is roughly 12 times the annual average total for days lost over the 2015-19 period. A problem that we thought had been solved has returned.

Another development, which has happened without fanfare, is that the gap between private and public sector pay growth has narrowed significantly. A year ago, the annual growth in private sector pay was 7.8 per cent, well ahead of the public sector’s 1.4 per cent. Now, while the private sector is still ahead, the difference is much less marked, with annual increases of 6.1 per cent versus 5.3 per cent over the latest three months. Both, of course, are well below current double-figure inflation.

Mention of public sector pay rises, and the wave of disputes, brings me to a point which is often raised with me. This is the fact that public sector workers benefit from much more generous pensions than is typically the case for their private sector counterparts.

Most public sector workers, more than 80 per cent, are in defined benefit pension schemes, traditionally final salary schemes, which provide a pension as a proportion of salary on retirement. In contrast, defined benefit schemes are now rare in the private sector, covering just 7 per cent of workers.

According to the Institute for Fiscal Studies nearly half, 47 per cent, of public sector workers had an employer contribution to their pensions of more than 20 per cent in 2021, compared with just 2 per cent of private sector workers. Every increase in pensionable salary means an increase in those contributions, which is one reason that in some of the disputes, the government has been offering one-off, non-pensionable cost of living payments.

Once these more generous pension arrangements are considered, and adjustments are made for other factors such as education and skill, public sector workers earn more. The Office for National Statistics estimated that in 2019 the public sector premium – the greater rewards enjoyed by public sector workers including pension contributions – averaged 7 per cent. A more recent estimate by the IFS calculated that public sector workers earn 6 per cent more in total.

Sunday, April 30, 2023
The Bank's in a mess, and badly needs inflation to plunge
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

This is a torrid time for the Bank of England, probably the most difficult since it was granted independence 26 years ago next month. Since it began to raise interest rates in December 2021, inflation has risen from 5.4 per cent to more than 10 per cent, where it has been lodged for longer than expected. Average earnings growth, measured by regular pay, has risen from 3.6 to 6.6 per cent over the same period. The figures appear to be cocking a snook at the Bank’s efforts.

Meanwhile, Huw Pill, its chief economist, has achieved a rare feat by uniting the Tory tabloids and the trade unions with remarks in which he said that people had to accept they were worse off because of the higher energy prices resulting from the Russian invasion of Ukraine and other factors. Pill was pilloried, pun intended, by the tabloids and the unions in equal measure, with Unison, a union, describing him as “living on another planet”.

This is not the first time that the Bank’s verbal interventions have gone down like a lead balloon. Pill perhaps could be said to have been “taking one for the team”, or at least for his boss, the governor Andrew Bailey, who has usually been on the receiving end of such criticism.

Pill’s comments were well meant and economically accurate. People have been made worse off by the negative economic shocks of recent years. But, like those of Bailey, they were almost guaranteed to be misunderstood, implying that the Bank is blaming workers and businesses for high inflation. They also ran the risk of smacking of desperation.

Since the Bank started raising rates nearly 18 months ago, one of the questions I have been asked most often is: What is the point of doing so when the shock is largely an external one? A close second is: How exactly is raising rates supposed to bear down on wage growth, which is clearly one of the Bank’s big worries?

Both are very fair questions. After all, until it became converted to the idea of responding to the inflation threat late in 2021, the Bank’s view had been that the rise in inflation was “transitory”. In those days before the Ukraine war, its view was that the reopening of the world economy after the pandemic had pushed up inflation, but it was only temporary.

As for pay, I have always argued that we were not seeing a wage-price spiral and would not do so. Stronger growth in nominal pay – wages in cash terms – are a consequence not a cause of high inflation. Real wages are falling, by 2.3 per cent on a year ago for regular pay, and 3 per cent for total pay. This, according to Office for National Statistics, is one of the largest falls in real wages on record.

How do I answer those questions? The shift from “transitory” to troublesome occurred a little before the Russian invasion when it became clear that the UK was not just experiencing an external shock. Core inflation, excluding food, energy, alcohol and tobacco, rose – and is strong now at 6.2 per cent - as did service-sector inflation. Thus, some of the UK’s inflation is domestically generated and higher rates were the appropriate response to that. The question is whether they should have gone up a little earlier.

As for pay, the main driver of lower nominal pay increases will be falling inflation, but the Bank has been keen to help that process along, not just by clumsy comments, but also by reminding those negotiating wages and salaries that it can intensify the monetary squeeze. Before anybody says it, higher interest rates to not cause inflation by encouraging people to push for bigger pay rises to compensate for their higher mortgage costs. The direction of travel is the other way.

Sunday, April 16, 2023
Don't expect a return to pre-Covid interest rates
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

A debate has been running for the past few days which should be of intense interest to borrowers and savers, to anybody in business and to the financial markets. With the Bank of England contemplating whether it needs to take UK official rates to a new 14-year high next month, the question is whether we have said goodbye permanently to the near-zero rates that prevailed for well over a decade after the 2008-9 financial crisis.

It is a question I get asked a lot. People who have a year or so to go before re-fixing their mortgage want to know whether rates will be lower by then. The medium and long-term level of rates matters hugely for a wide range of business decisions. Savers who are finally getting something in return for their money (though still a significant negative real return) want to know by the Ither even this will be snatched away from them again.

The issue was raised by the International Monetary Fund in its latest World Economic Outlook and summarised in an IMF blog headlined “Interest rates likely to return to pre-pandemic levels when inflation is tamed”.

The blog, by two of the authors of the World Economic Outlook chapter, Jean-Marc Natal and Philip Barratt, notes that a range of factors, including demographics, have pushed interest rates down in recent decades.

As they put it: “Since the mid-1980s, real interest rates at all maturities and across most advanced economies have been steadily declining. Such long-run changes in real rates likely reflect a decline in the natural rate, which is the real interest rate that would keep inflation at target and the economy operating at full employment–neither expansionary nor contractionary.”

Students of economics will know that the natural rate has a long pedigree in economics and was applied to interest rates in the late 19th century and subsequently taken up by Keynes. The natural rate of unemployment is another familiar concept.

According to the IMF authors, the natural rate of interest for most advanced economies remains very low. And, in what looks like a very bold claim, they expect it to reassert itself quite soon.

“Overall, our analysis suggests that recent increases in real interest rates are likely to be temporary,” they write. “When inflation is brought back under control, advanced economies’ central banks are likely to ease monetary policy and bring real interest rates back towards pre-pandemic levels.”

There is a big ‘if’ there, which is the question of when inflation is brought back under control, which I shall return to. There are also a couple of caveats. So, if governments lost control of debt and deficits, this would push bond yields, and thus the natural rate across all maturities, higher. Related to this, funding the shift to a green economy through deficit financing could have a similar effect.

The central conclusion looks, however, to be clear. The inflation shock has pushed interest rates higher than is warranted and, as it subsides, they can be expected to come down again.

Does this mean a return to the long [period between March 2009 and May last year, when official interest rates in the UK never rose above 0.75 per cent? Is this just another way of saying what central banks did when they were initially very reluctant to raise interest rates in response to the post-pandemic rise in inflation, regarding it as temporary or “transitory”.

Sunday, April 09, 2023
Housing's still adjusting to the interest rate shock
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

It is Easter, and plenty of people’s thoughts turn to the housing market about now. This is traditionally the time of the spring awakening, when sellers who have had their properties up for sale over the winter can hope for at least a few nibbles and when the supplements are full of helpful advice.

Reading the housing market now is more difficult than usual, for reasons that will shortly become clear. The year began with plenty of predictions of big house prices falls, alongside much lower transactions after the Covid recovery years of 2021 and 2022.

This matters, and beyond just the housing market. Rising house prices, while raising the barrier for first-time buyers, have a wealth effect which lifts consumer spending. Increases in housing transactions also fuel spending; when people move, they also tend to improve the property they have bought. Skips are hired and carpets replaced, even kitchens.

The difficulty of reading the market is underlined by the contrasting fortunes of two closely watched house prices measures. The Nationwide, Britain’s biggest building society, said recently that house prices fell for a seventh consecutive month in March, dropping by 0.8 per cent, and are now 3.1 per cent down on a year earlier, and 4.6 per cent below their peak last August.

The Halifax, another major mortgage lender, offered a very different view in its latest house price reading on Thursday. It put the cat among the pigeons by saying that prices rose by 0.8 per cent last month, after a in what it described as a show of resilience and were 1.6 per cent up on a year earlier, though 0.4 per cent down in the latest three months.

The one thing both indices can agree on is that prices have fallen from their peak in August last year, when they were still benefiting from the most unusual boom in history, the one that unfolded during the pandemic. In Halifax’s case though prices are only 2 per cent below that peak. The official house price index, produced by the Office for National Statistics, is also down from the peak, though so far only by 1.8 per cent.

Short-term differences between the Nationwide and Halifax measures are not unusual, reflecting different samples and methodology, but they do not change the big picture.

Everybody can agree that the housing market suffered a huge, confidence-sapping shock last autumn, with the Kwasi Kwarteng-Liz Truss mini budget on September 23 last year. My keyboard wants to put the word “disastrous” in front of mini budget in that sentence but there is no need to rub it in any more.

That shock, with hundreds of mortgage products rapidly withdrawn and replaced with new ones at significantly higher rates, and money market expectations for official interest rates rising sharply, was deeply felt, particularly among potential buyers.

Sunday, April 02, 2023
The battle won't be over until food inflation slumps
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

Some statistics still have the capacity to shock, even after all the turbulence of recent years. One such shocker was the latest reading for food price inflation. In February, food prices were up by 18.3 per cent on a year earlier, which is extraordinary. Add in non-alcoholic beverages (though we all need a drink after figures like that) and the rise was 18 per cent.

Why such a shocker? If I tell you that the rise in food prices over the past 12 months has been as much as the cumulative increase over the previous 11 years and four months, you get the idea of the extent to which current food price inflation is off the scale.

And, while energy price inflation has grabbed the headlines, and in February for households was a massive 88.6 per cent, the surge in food prices is a reminder that this has been the nastiest of bouts of high inflation, honing in on the things that people cannot do without; keeping warm and eating.

Central bankers tend to look at “core” inflation, which excludes energy and food, and which is running at 6.2 per cent. But it is overall inflation that matters to people and businesses, and when it is driven by energy and food it is painful. Not until they have come back down to earth can inflation be said to have been beaten.

It is reasonable to expect energy price inflation to subside, both because the government has extended the energy price freeze until the summer, maintaining average bills at £2,500 a year until then, and because international gas prices have fallen.

Food price inflation remains an enigma, however, not just because it is so high but also because, if the British Retail Consortium (BRC) is right, it has yet to reach a peak. The BRC, using a slightly different measure to the official figures, says food price inflation accelerated to 15 per cent in March from 14.6 per cent in February, with fresh food inflation up from 16.3 per cent to a new record of 17 per cent.

I could have done this myself, with a little foresight, but I am grateful to TradingPedia for giving some examples of higher food prices, in this case at Tesco, last month compared with March 2022. The highlights included a 60 per cent increase in the price of Tesco’s mild cheddar, a 67 per cent rise for noodles and 57 per cent for half a dozen medium-sized eggs. Not everything went up as much, plainly, though it is is striking that some of the biggest increases in supermarket food prices have been in low value items.

Why is it happening? The Russian invasion of Ukraine has clearly been a prime factor, pushing up the cost of energy and reducing the supply on to world markets not just of grain and other agricultural products but also fertiliser.

Higher energy prices have added to the cost of packaging and transport. The pound, while much stronger than it was during Liz Truss’s turbocharged turbulence last autumn, remains generally weaker against the dollar and euro, adding to import costs. Poor European weather may have been a factor in recent weeks. Brexit is said by many to be an additional explanation, though the UK’s food price inflation is only a little higher than the eurozone’s 17.3 per cent.

There remain a couple of puzzles. The first is that we have come to regard the UK’s supermarket sector as highly competitive, reinforced by the arrival and rapid expansion of the German low-cost chains, Aldi and Lidl. Even in the recent past, whenever food price inflation threatened to be gaining strength, it was brought back down by supermarket price wars. The supermarkets, it was said, lacked pricing power in this environment, because there was always a competitor that most shoppers could switch to. That lack of pricing power meant that they frequently put the squeeze on suppliers.

Thus, in the 10 years leading up to this episode, food price inflation averaged just 0.8 per cent annually. Low food inflation was a factor keeping overall inflation under control, whereas now it is a factor driving it higher.

The second puzzle is that, while much of the current food price inflation has been driven by international factors, the global picture has changed quite significantly over the past year. The United Nations’ Food and Agriculture Organisation (FAO) produces a monthly index for world food prices. How much do you think it has gone up over the past year? The answer is that it has not. It has, in fact, fallen sharply.

In February, the index was 18.7 per cent lower than in March 2022, the peak, with the latest monthly fall explained by lower prices for vegetable oils, dairy, cereals and meat, partly offset by a rise in the sugar price. The index has moved in exactly the opposite direction to UK food prices, and by a similar magnitude.