Sunday, October 22, 2023
We'll be counting the costs of this high inflation for years
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.

Unlike a month ago, the latest inflation figures did not set many pulses racing. They showed the headline rate unchanged at 6.7 per cent, whereas the previous figure had shown a marginal fall from 6.8 per cent, at a time when most people, including Treasury and Bank of England officials, had expected a rise.

That fall helped tip the balance for the Bank to pause with its interest rate rises last month after 14 successive increases. And, while there was no repeat this time, the consensus in financial markets is that there has been nothing in either the inflation data or the latest pay figures to persuade it that it needs to raise rates next month.

A 6.7 per cent inflation rate is, of course, far too high, and well above the official target of 2 per cent. The latest figures marked the 20th month in a row in which inflation has been above 6 per cent, and the 29th in succession in which it has exceeded the target. Inflation so far in this Parliament has averaged 4.9 per cent, the highest for 30 years. The peak a year ago of 11.1 per cent was the highest since 1981.

Before inflation starts to fall quite sharply, as it should when this month’s figures are released in November, to 5 per cent or so as a result of favourable comparisons with the big energy price rises of a year ago, it is worth reflecting on the long-term effects of this bout of inflation. For, make no mistake, those effects will pan out over many years.

A few days ago, the great and the good attended a memorial service for Lord (Nigel) Lawson, the former Conservative chancellor and hero of Rishi Sunak, who spoke at the ceremony. In 1977, Lawson, as a Tory whip, offered his party’s support to what was known as the Rooker-Wise amendment, brought forward by two Labour MPs, the effect of which was to commit governments to raise income tax allowances and thresholds in line with inflation, or require primary legislation not to do so.

As you will know, Sunak is going against this convention, in a spectacular way. Under his government’s plans, set in train when he was chancellor, income tax allowances and thresholds will be frozen until 2027-28, as will those for national insurance (NI).

The effects of this were laid bare by the Institute for Fiscal Studies (IFS) in is latest “green” budget. When the freeze was first announced by him in March 2021, and intended to last for four years, it was intended to raise an additional £8.2 billion in revenues in 2025-26, the final year of the plan.

Two things have happened since then. One is that the freeze has been extended and applied to NI. The other is that inflation has been much higher, so that the freeze will bite harder. The IFS, using inflation forecasts from the Bank, estimates that the policy will be raising an additional £52 billion in revenue in 2027-28, compared with what would have happened under indexation. That not only leaves the original £8.2 billion estimate for dust but is also higher than the £37 billion calculated by the Office for Budget Responsibility (OBR) in March.

This is a massive stealth tax increase, much of it explained by the loss of control of inflation. It will more than double the number of higher rate taxpayers, to nearly nine million, and is the equivalent of increasing the basic and higher rates of income tax by six percentage points or putting up VAT from 20 to 26 per cent.

My fear is that this, the biggest stealth tax increase, or indeed any tax increase in history is not fully understood by those on the receiving end of it. When I talk to people about it, their eyes glaze over. That is not so unusual but if it means that this massive tax rise by stealth is working, it is worrying.

It is, of course, not the only impact of inflation of taxpayers’ pockets. The cost of the government’s borrowing has been soaring, both because of the direct effect of inflation on the quarter of government debt that is index-linked, but also because of the rise in bond yields. Bond markets have been having another moment in recent days, pushing up yields, because of fears that in order to control inflation, interest rates will need to stay high.

Again, the IFS has some useful and worrying figures on this. Even when inflation settles down, and interest rates edge lower, the legacy of this period of high inflation will be felt. The government’s debt interest bill spiked above an annual £100 billion under the impact of inflation on index-linked gilts. But even in 2026-27, on official forecasts, it will still be just under £90 billion, the equivalent of 3.1 per cent of gross domestic products (GDP). Under market interest rates expectations, it would be £108 billion, the IFS points out, or 3.8 per cent of GDP. That’s right, nearly 4 per cent of national income spent on servicing the government’s debt.

These lasting effects will serve as a grim monument to the high inflation we have seen. In the meantime, the effects of the interest rate hikes we have seen will weigh down on economic activity for some time.

Housebuilders are paring back their targets for new homes over the next 12 months as higher mortgage rates impact on demand. The latest purchasing managers’ index for the construction sector showed the biggest drop in residential activity, outside of the pandemic, since April 2009.

This is an important sector for employment and, while we get new figures this week, the labour market appears to be on the turn, with employment and vacancies falling and unemployment rising.

There was also a notable shock on Friday, with the long-running GfK consumer confidence index, which had been recovering, showing a nine-point fall. It has not returned to the levels of last winter, when confidence was at all-time lows, but it does suggest that, while inflation has come down from its higher, and should fall further, all that households are noticing is that prices are still rising. It also points to the fact that the statistical turning point, with earnings growth now outpacing inflation, may be just that, a statistical nicety.

“This sharp fall underlines that the cost-of-living crisis, and simply not having enough money to make-ends-meet, are still exerting acute pressure for many consumers,” said Joe Staton of GfK. “The fierce headwinds of meeting the accelerating costs of heating our homes, filling our petrol tanks, coping with surging mortgage and rental rates, a slowing jobs market and now the uncertainties posed by conflict in the Middle East, are all contributing to this growing unease.”

The government will take some comfort from the fact that inflation still looks to be on course to have by the end of the year compared with late 2022. On the evidence of this, they should not take too much comfort. It will be a very long time before people will feel that the burden of high inflation is lifting.