Sunday, November 20, 2022
Inflation wreaks havoc, and gives us a world of pain
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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

By now you will have absorbed much of the detail of Thursday’s autumn statement. For some this will have been a painful if well trailed exercise. There were no rabbits out of the hat, in line with Jeremy Hunt’s promises. There were not many laughs either.

For those at the top of the income scale, this has been a cruel autumn. In the space of a couple of months they have seen the abolition of the 45p top rate of income tax dangled before them, only to see it snatched away by the chancellor who announced it, Kwasi Kwarteng, and made more punitive by his successor Jeremy Hunt, with the rate now due to kick in at a lower level of income, £125,140, rather than £150,000.

Not many tears will be shed for the victims of that tax grab. At the other end of the income distribution, people will be pleased by the chancellor’s announcement of targeted measures to ease the energy bill pain. Such help, aimed at pensioners, those on the lowest incomes and people receiving disability benefits will, however, reduce rather than remove an intense squeeze on incomes.

As for those in the middle, a broad swathe which includes what Theresa May used to describe as “just about managing” families, many will be left wondering whether they can in fact just about manage when average household energy bills rise by another 20 per cent to £3,000 in April. Even that price guarantee exposes the public finances to the vagaries of international gas prices, though by less than the Liz Truss two-year freeze at an average of £2,500.

People will also be caught by an even longer freeze on income tax allowance and thresholds, to 2028. Once, becoming a higher rate taxpayer was an ambition, even a badge of honour. Now, creating more higher rate taxpayers is one of many stealth tax rises announced on Thursday.

The big positive of Thursday’s package, though, was that most of the pain is deferred, thus mainly avoiding hitting the economy further hen it is already in recession, the triple whammy I referred to a couple of weeks ago. Markets have to take that deferred pain on trust, and so far mainly are doing so.

There were two key economic backdrops to the chancellor’s autumn statement. The first is inflation, which we heard on the eve of the announcements had hit a new high of 11.1 per cent. Inflation ran through the statement rather like the writing in a stick of rock.

The other significant and related backdrop, as highlighted by Richard Hughes, the chairman of the Office for Budget Responsibility (OBR). Is that what is known by economists as the terms of trade effect will make us a lot poorer. This describes the fact that we are paying much more for those things for which this country is a net importer, mainly energy but also food and other products. It makes us, in fact, spectacularly poorer. The OBR was gloomy about what would happen to household incomes in March, before the full implications of Russia’s invasion of Ukraine were clear. Now it is much gloomier.

Real household disposable incomes per head are predicted to fall by 4.3 per cent this year, 2022-23, the biggest drop since records began in 1956, and by a further 2.8 per cent in 2023-24. This combined 7.1 per cent fall is enormous, and will take real incomes back to where they were in 2013-14; literally a lost decade for incomes. It was a phrase used by George Osborne when he launched austerity in 2010, but as far as the squeeze on incomes is concerned, we really are all in it together.

If you have been wondering why consumer confidence is so weak, there is your answer. GfK has been monitoring consumer confidence since the 1970s and, while it edged up slightly this month, this was from record low levels.
The income squeeze was also highlighted by the latest average earnings figures, which are showing annual increases of 6 per cent for total pay and slightly less for regular pay. While that is too high for comfort for the Bank of England, it is well below double-figure inflation.

Incidentally, if you have wondered why the falls in real wages which lead the news bulletins are not bigger, it is because official statisticians use their preferred measure of inflation, CPIH, the consumer prices index including owner-occupiers’ housing costs, which has inflation running 1.5 per centage points below the 11.1 per cent rate for the consumer prices index. If you prefer the retail prices index, which some do, the fall in real wages is very scary indeed. RPI inflation is running at 14.2 per cent.

Inflation and the terms of trade effect are, then, wreaking havoc on household incomes, which is why the chancellor was keen to say that the government is working in “lockstep” with the Bank to get it down. It is an old trick; the causes of high inflation are global but the credit for getting it down should go to the authorities in the UK. It will be interesting to see if it works politically.

Inflation and the higher interest rate response to it also lie behind the sombre message, backed up with actions, of last week. If you are looking for the single reason why Hunt had to be tough, it is because of the rising bill for government debt interest. That bill, £120.4 billion this year, or 4.8 per cent of gross domestic product, takes us to similar relative levels to those at the end of the Second World War, when debt was about 250 per cent of gross domestic product, compared with just under 100 per cent now.

This year is exceptional, boosted by the impact of very high inflation in the returns on index-linked gilts, but the debt interest bill, has been increased by an average if £43 billion each year from 2023-24 to 2026-27, almost doubling. Without this rise in the debt interest bill, the autumn statement could have been a much more cheerful affair.

One interesting aspect of this is that, as a result of quantitative easing, and the additional commercial bank reserves the Bank created as part of the process, which receive the equivalent of Bank rate as interest, each increase in official interest rates by the Bank’s monetary policy committee comes with a significant bill attached. QE, and its reversal, will cost the Treasury money over the next few years, the OBR predicting that the Treasury will have to transfer a hefty £133 billion to the Bank.

When will the inflation nightmare be over? The OBR, like the Bank, thinks much lower inflation is on the horizon. It expects annual inflation to be just 0.6 per cent in 2024 and for that rare beast, deflation, or a fall in the price level, to occur in 2025, with the consumer prices index falling by 0.8 per cent.

Very low inflation, even temporary deflation, will help a lot, allowing real household incomes to recover. The OBR thinks that this, in combination with a big fall in the saving ratio, will give us 2.6 per cent economic growth in 2025 and 2.7 per cent in 2027. If Liz Truss were still prime minister, she would be proclaiming job doe in raising the economy’s growth rate.

It would be wrong to do so, and those forecasts look rose-tinted to me, even though economies grow faster when they are bouncing back from recession. The OBR thinks the economy’s “trend” or long-run growth rate is 1.75 pe cent, and this is slower than in the 2010-19 period, though looks higher than recent experience would justify.

Overwhelmingly though the picture that we have had of the economy is one of weakness and deep underlying problems, not strength. Productivity growth is expected to be weaker, not least because of the performance of business investment, which is not expected to return to pre-referendum levels until the late 2020s.

The public finances, too, remain very fragile, the chancellor only meeting his softer fiscal rules by a small margin. Even with some uncompromising measures, the government will be borrowing a cumulative £312 billion more by 2026-27 than the OBR expected in March. It is not pretty picture.