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Britain has no good options as the threat of recession looms

The writer is author of ‘Two Hundred Years of Muddling Through: The Surprising Story of the British Economy’

The Bank of England’s new forecasts make for an exceptionally gloomy reading. In recent months, the bank’s governor, Andrew Bailey, warned that the institution is walking “a narrow path” between the risks of continued high inflation and the prospect of a recession. The UK will now experience both, forcing the next prime minister to make some uneasy choices.

The BoE predicts that inflation will peak at an annual rate of more than 13 percent and remain above 10 percent for much of 2023. She foresees that the economy will slide into recession in the coming quarter and only grow again in 2024. the eventual recovery will be anemia. Unemployment, in the bank’s central scenario, will rise every year for the next three years.

The BoE expects the depth of the recession to be similar to that of the early 1990s, and milder than that following the financial crisis or pandemic-related lockdowns, but the blow to household income will be much deeper. The projections show the largest decline in household real disposable income in two years.

Despite forecasting a recession, the Monetary Policy Committee has raised interest rates by 0.5 percent — the largest increase since the bank became operationally independent in 1997. While the UK is far from unique among the advanced economies when it comes to suffering high inflation, the nature of UK inflation is starting to look more worrying.

European inflation is primarily a story of rising energy prices, while US inflation is now driven by a tight labor market that is driving up costs in the services sector. Britain has a dose of both.

The MPC was pleased to consider inflation above target driven by higher global commodity prices and pandemic-related supply chain disruptions, but now believes that domestically generated price pressures require tougher action. Easing that domestic pressure will take a painful drug, according to the MPC: higher interest rates to delay hiring decisions and take some of the heat out of the job market, even as high energy prices are already putting pressure on consumer incomes and spending. .

That opinion is certainly open to question. Cornwall Insight, a consultancy, estimates that the average household energy bill will be around £3,500 in 2023 – up from nearly £1,000 in 2021. With consumers forced to spend around 9 percent of their after-tax income on energy by 2023 , up 4.6 percent before the price hike, discretionary spending on other goods and services will fall sharply.

Labor-intensive, customer-centric service providers can rethink their hiring plans relatively quickly when demand dries up. Some of the over-50s who retired earlier than expected in 2020 and 2021 may return to work to make ends meet, increasing the labor supply. Rising energy bills are inflationary in the short term. But in the medium term, they act as a deflationary tax increase for households and businesses.

But whether the BoE’s predictions are correct or not about how the labor market and domestic price pressures will develop, they are almost certainly wrong when it comes to how the Treasury will respond. The bank’s latest figures, as always, depend on no change in fiscal policy. However, once Britain has a new prime minister in early September, some form of fiscal easing in the form of tax cuts, further cuts in energy bills or both will follow. It’s hard to see that all of these measures are enough to stave off a recession right now, but they could ease some of the pressure on household incomes in the coming months.

Whoever becomes Britain’s next prime minister, their relationship with the BoE will become increasingly fraught. An MPC willing to raise interest rates into a forecast recession says it will take steps to offset any fiscal easing from the government with tighter policies.

The bank has concluded that a recession is necessary to bring inflation back up to standard. Liz Truss, the favorite to win the conservative leadership contest according to both polls and bookmakers, has been berating the BoE in recent weeks for failing to control inflation. It’s unlikely to be particularly happy with a central bank willing to take action by raising interest rates in a slowing economy and nullifying any policy easing by a government it leads.

Against a backdrop of global energy price inflation, a mix of easing fiscal policy and tighter monetary policy may well be appropriate for Britain. Targeted fiscal support can support the households most at risk from rising prices and prevent other viable businesses from going under. Higher rates could support the value of the pound and help dampen pressure on imported prices.

But choosing the right policy mix for Britain is now like taking the least wrinkled shirt out of the laundry basket: the best option isn’t necessarily a good one. The country is poorer than it thought. In the short term, that is inevitable. The real policy debate is about how that pain is distributed between households, businesses and the balance sheet of government — not how it is avoided.

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