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Grim times lie ahead for UK as inflation combines with low growth

The UK is gripped by the kind of labor unrest not seen in decades. This is visible in the railways, London Underground and British Airways. Teachers and other public sector employees can participate. The explanation for this is clear. Unforeseen inflation produces losses that everyone wants to make up. This causes social conflict.

But if inflation is bad, so is the cure. Unless it is believed that it will magically disappear, the way to end entrenched inflation is through a period of below-trend output and rising unemployment. This will be”stagflation” — a combination of high inflation with weak growth that lasts for some time and may require more than one tightening before it stops.

Start with the inflationary process itself: how far is inflation imported and how far is it due to too much domestic demand?

In the UK, prices for goods other than energy and food have risen by 8 percent over the past two years. The comparable figure in the US is 10 percent. In the eurozone, however, it is only 4.7 percent. This supports the view that domestic inflationary dynamics in the UK (and the US) have been stronger than in much of the eurozone.

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The last Economic Outlook The OECD also shows that the inflation process is now widespread in the UK. For example, the share of goods and services with an annual inflation rate of more than 4 percent rose from 14 percent to 66 percent between April 2021 and April 2022. Finally, the ratio of unemployed to job vacancies in the UK in the first quarter of this year was lower than in the previous two decades. The situation in the US is similar.

The OECD also predicts that headline inflation in the UK will still reach 4.7 percent by the end of next year. So it is inevitable that people will try to recover the great losses in their standard of living. This means that there will be strong pressure on higher wages. These pressures will be further compounded by a growing lack of confidence in the Bank of England’s ability or determination to meet its inflation target. Contrary to popular belief in central bank circles, inflation targets are not met because they are credible: they are credible because they are met. But if wages do indeed catch up with past (and expected) price increases, there will be a further spiral of domestically generated inflation, partially offsetting any fall in imported inflation.

In short, in countries like the UK and the US, the economy needs to be weakened enough to eliminate domestic overheating and eliminate the possibility of a destructive wage-price spiral.

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This raises two questions: how large is an attenuation needed and how is it achieved?

An optimistic take on the first question is that taking a little deductible from the labor market is enough to remove the risk of a domestic inflation spiral. This seems highly unlikely. Given the declines in real incomes that have occurred, workers in any reasonably robust labor market will expect and receive a catch-up increase in wages. It is likely that unemployment will have to rise substantially to limit it.

The answer to the second question depends on the extent to which such a delay will occur anyway. The view that it will happen anyway points to the shrinking impact of higher energy and food prices, fiscal tightening (partly because money limits will bite in real terms), likely cuts in credit growth as confidence deteriorates, falling asset prices and the war in Ukraine. The British economy will therefore have to slow down directly, but also indirectly, because the global economy has slowed down. The OECD’s forecast for the UK for next year is zero growth.

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Does more need to be done to bring inflation back to target? Possibly not, certainly not if, as seems plausible, actual growth next year will be even lower than forecast. But the longer this inflation lasts, the harder it becomes to meet the target. The deliberate tightening of the policy may have to be greater than is currently expected.

The market currently expects the Bank of England short-term interest rate to peak around 3 percent from now on. That would still be a substantially negative percentage in real terms under all plausible inflation expectations. This seems like a mouse of a speed, given the magnitude of current and future inflation overruns.

Central banks have made big mistakes, such as Mervyn King has argued. At the moment, the Bank, like other central banks, hopes that a very modest tightening will suffice. If so, it will be because the economy is going to slow down tremendously anyway. Bad times lie ahead. The question is how bad.

martin.wolf@ft.com

Follow Martin Wolf with myFT and further Twitter

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