I warned of a pyrrhic victory over inflation. That is what we are now seeing as the UK economy contracted in the second half of last year under the weight of tight macro-economic policy.
Inflation is 4% and is decelerating and likely to reach the 2% inflation target by the second quarter. Yet macroeconomic policy in terms of monetary and fiscal policy has remained too tight.
The latest UK GDP figures confirm a very weak economy. While the economy grew by an annual rate of 0.1% last year, it fell in the second half of the year, declining in two successive quarters: by 0.1% in Q3 and 0.3% in Q4.
This followed no growth in Q2 and a modest rise of 0.2% in Q1 last year. Taking into account the growing population, GDP per head contracted 0.7% in 2023.
The headlines and political reaction have focused on a “technical recession” as the economy shrank for two successive quarters in Q3 and Q4 last year. Sometimes definitions of a technical recession can be inappropriate. Interestingly, and just for comparison, one may argue that this is indeed the case in Japan.
It was also announced today that Japan is in a technical recession with GDP having decreased for two successive quarters, too. But the mood there is very different, with the economy seen by many as turning around and the stock market rallying as a result.
Many economists prefer not to focus on a technical recession definition and instead prefer the US approach which is based on the National Bureau of Economic Research’s (NBER) focus on the depth, diffusion and duration of the downturn. But all this misses the point, as it is not about the technicalities surrounding the definition. The UK economy is weak and has been stagnating for the last eighteen months, income per person is falling and policy is too tight.
As has been said for some time, the UK is a low growth, low productivity and low wage economy, which has some deep-rooted structural problems such as low investment since the 1970s, and a trade deficit since the mid-1980s. Its current challenges, though, are not unique, with the major economies of western Europe all being in a similar current low growth environment.
The UK has grown faster than Germany and Italy in recent years, and slightly slower than France but effectively these four major economies in western Europe (all of whom are in the G7) are in a similar position of poor performing economies facing similar challenges. These were not caused by the war in Ukraine but were not helped by the effect that had on pushing energy prices higher.
Policy changes take time to feed through and in the UK policy has been too tight. Fiscal policy was tightened during 2022-23, with higher taxes on the supply-side of the economy. While there has been some easing over last year the trouble is that the room for policy manoeuvre has been limited.
Fiscal policy has been constrained by the high debt-to-GDP ratio and the fiscal rules. When growth is low more of the budget deficit is seen as structural as opposed to cyclical and policy flexibility is limited. There is an economic case for some fiscal easing in the upcoming Budget but the fiscal rules will set the parameters and the politics will decide where.
Meanwhile, monetary policy has moved in recent years from too loose to too tight, with excessively tight financial conditions in the second half of last year, as reflected in weak monetary growth and bank lending. While inflation has constrained monetary policy it continued to be tightened last year even though it was clear that inflation was falling, the economy was weak and that policy acts with a long and variable lag.
As the voting patterns at the Monetary Policy Committee reflect, with a recent three-way split, it is a judgement call as to where appropriate monetary policy should be. Last year I felt monetary policy was too tight, with both interest rates rising too far and the Bank of England’s balance sheet shrinking through quantitative tightening. I thought interest rates should have peaked at 4.5% and I think there is a case to cut them now.
In addition to the GDP figures, we have also seen the release in recent days of the latest jobs, wage and inflation data.
The UK labour market has been resilient despite the sluggish GDP data. Given the market’s focus on when the BoE will cut rates, attention has been focused on the wage data. These showed wage pressures easing, although wage growth is outstripping the rise in inflation. Earnings rose by an annual rate of 6.3% in the three months to December, compared with 6.7% in the three months to November. Including bonuses, there was a sharper deceleration from 6.7% in the three months to November to 5.8% in December.
Even though a continued fall in vacancies is consistent with a softening in the labour market, an unemployment rate of 3.8% and an employment rate of 75% suggests that the labour market is robust. This should underpin consumer confidence as inflation decelerates, and if earnings growth continues to outstrip it, as seems likely over the remainder of the year.
Inflation is decelerating. It peaked at 11.1% in October 2022, was still as high as 10.4% in February last year. By December it had decelerated to 4%. The annual rate remained at 4% in January. It was a mixed picture, with goods price inflation decelerating from 1.9% to 1.8%. Meanwhile, service price inflation, which the Bank of England has drawn attention to, rose from an annual rate of 6.4% in December to 6.5% in January.
In their February Monetary Policy Report the Bank of England noted that it would, “Continue to monitor closely indications of persistent inflationary pressures and resilience in the economy as a whole, including a range of measures of the underlying tightness of labour market conditions, wage growth and services price inflation.” So, with the latest data showing service sector inflation edging up and wage growth persisting above 6%, this will likely reinforce the Bank’s desire to keep rates on hold.
In February they also noted, “Key indicators of inflation persistence remain elevated. As a result, monetary policy will need to remain restrictive for sufficiently long to return inflation to the 2% target sustainably in the medium term in line with the MPC’s remit.” The two factors that led to the surge in inflation in 2021 and 2022 have been reversed: namely supply-side shocks; and the then very loose monetary policy. Now, monetary policy is too tight, as the GDP figures reflect.
Although I think rates are already too high and should come down, I also still think the Bank will wait before cutting rates before the end of the second quarter, as by then inflation will be below the 2% target.
The next four months will be compared with a period last year when inflation rose sharply on a monthly basis, by 1.1% in February, 0.8% in March, 1.2% in April and 0.7% in May. Even though inflation is still above the 2% target, it is noteworthy that in the eight months since May last year, consumer prices have risen in total by less than 0.2%. In those last eight months, the largest monthly rise was 0.5% and in five of those months the monthly rise was 0.1% or less. This is a disinflationary environment.
Conclusion
Recent days have seen the release of not just the GDP figures for the end of last year but also the latest UK data for jobs, wages and inflation for January.
Between them, these three figures have captured the economy’s current state of play. It is weak, having stagnated for some time and falling into recession at the end of last year, inflation is trending lower and wages are now rising at a faster rate than inflation.
This is now boosting real incomes, and as inflation decelerates further, gains in real wages should give consumer spending a boost, allowing a modest uptick in growth as the year progresses. But policy will need to ease, too, with interest rates falling and some help from fiscal policy in the Budget. The economy’s weakness suggests policy stimulus is needed.
