Sunday, June 04, 2023
It shouldn't take a recession to bring inflation down to earth
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.

Being chancellor is a funny old game. When the news is better on economic growth, you feel obliged to celebrate, as Jeremy Hunt did recently with International Monetary Fund’s upgrade to its growth forecast for this year to a modest 0.4 per cent.

If, however, that upgrade comes at the expense of an accompanying prediction that inflation will be slower to fall – a prediction consistent with the latest data – then you worry. That was the case with both the recent IMF and Bank of England forecasts. It is a case of swings and roundabouts. Stronger growth in demand means higher inflation than would otherwise be the case.

It was why Hunt had to say, given that he has made reducing inflation a priority, he would support the Bank in raising interest rates further to achieve that, even if it meant pushing the economy into recession. This was not, as some have suggested, risking recession to achieve Rishi Sunak’s target of halving inflation by the end of the year.

The course of inflation over the next few months is pretty much baked in, and any interest rate decisions in coming weeks will not affect it, given the lags in monetary policy. It should halve as energy prices effects turn favourable. Household energy bills last month were 24 per cent up on a year earlier but that will soon drop to zero. Achieving that halving of inflation will, however, be a closer-run thing than seemed likely a few weeks ago, given the rise in underlying or “core” inflation.

Incidentally, before I come on to the nub of the debate, there has been some nonsense around suggesting that, now gilt yields have risen to close to the levels prevailing after September’s mini budget, and many mortgage products have again been withdrawn, Liz Truss must have been right all along, and her unfunded tax cuts cannot have been responsible for the autumn market panic.

It is, as I say, utter nonsense. The adverse market reaction of recent days has been due to the stickiness of UK inflation. The Truss-Kwarteng unfunded and irresponsible tax cuts would have made that stickiness worse and, indeed, the fall in the pound to a record dollar low they generated pushed inflation higher. Market interest rate expectations were higher in the wake of that mini budget than they are now.

The question remains. Do we need a recession to get inflation down to the 2 per cent official inflation target, and stay there? History tells us that recessions are effective at reducing inflation. The UK went into the recession of the early 1990s with inflation at more than 8 per cent (and over 10 per cent measured by the retail prices index) and came out of it with inflation in low single figures and an inflation target to try to guarantee it, successfully as it turned out.

The financial crisis recession of 2008-9 also reduced inflation, albeit it after a brief spurt because of the reopening of the global economy and a VAT increase in 2011. Even the pandemic recession of 2020, the deepest for 300 years, reduced inflation to a low of just 0.2 per cent, before other events took over.

What about this time? Rob Wood, a former Bank economist now with Bank of America, sums up the problem. The UK has had no growth since 2019, with the economy still below pre-pandemic levels, but has “suffered four supply shocks: energy prices, supply chains, Brexit, workforce sickness”. This means that even very modest economic growth runs up against this country’s “chronic labour supply problem” and other supply-side weaknesses. He estimates that the UK’s potential growth rate – how much the economy can grow without generating inflationary pressures – is now a feeble 1 per cent a year.

Does that mean the Bank, as in Bank of England, has no choice but to keep raising interest rates until the economy capitulates and slips into recession? Parts of it are already there, notably manufacturing according to the latest purchasing managers’ survey, and housing looks to be succumbing too, with a fresh fall in mortgage approvals.

The role of the central bank, according to the former chairman of America’s Federal Reserve, William McChesney Martin, is to “take away the punchbowl just as the party gets gong”. The Bank’s role in coming months, it seems, could be to take that punchbowl, fill it up with iced water, and pour it over everybody’s heads, a bit like those charity challenges a few years ago.

Does the Bank need to drive the economy into recession to defeat inflation? Two members of its monetary policy committee (MPC) have voted against its recent rate rises because of the risk of over-tightening. The Bank, having been slow to react to the emerging inflation risk, could now fall into a different trap, reacting too much to data that it cannot do much about. The last three sets of inflation figures have been disappointing, but they are water under the bridge.

If we look at inflation coming down the track, so-called “pipeline” inflation, the picture is more encouraging. Input price inflation, reflecting industry’s raw material and fuel prices, has come down from 24.4 per cent in June last year to just 3.9 per cent now. Output price inflation, sometimes called factory gate inflation, has dropped from 19.7 to 5.4 per cent, but this disguises the fact that prices have effectively been flat since last summer. Globally, food price inflation peaked last year and the UK should follow suit.

The latest money supply data just published is meanwhile consistent with lower inflation, with 12-month growth in the M4 money supply measure, equivalent to that once targeted by the government in the 1980s, down to 1.6 per cent in April, from a peak of more than 15 per cent in 2021. Another money supply measure, known as “Divisia” money, now has a negative growth rate of 3.9 per cent, from a peak positive rate of 19 per cent two years ago.

None of this may be enough to stop the Bank from nudging official interest rates higher on June 22, with markets expecting a rise from 4.5 to 4.75 per cent. Inflation in the rest of Europe is falling faster than expected and the UK risks looking like an outlier. But the Bank needs to be careful. Inflation may take a little longer to get back to 2 per cent after the current shock, but it will do so. That can happen alongside slow growth, which for now is the situation in which we find ourselves. It does not have to happen alongside a damaging recession.