Jupiter Merlin Weekly: The Bank of England seems stumped by inflation
The Jupiter Merlin team look at the latest inflation data. While in the US the figures are open to interpretation, in the UK it’s grim and the Bank of England is stumped.
US inflation: something for everyone
Powell clearly finds himself in a jam here. His post-policy meeting press conference revealed his quandary. If not of the rabbit-in-the-headlights disposition of his counterpart at the Bank of England, nevertheless his lack of surefootedness was revealing. On the one hand, he knows that much of the reason that the jobs market is tight is because the economy is proving remarkably resilient (some might say unresponsive) to the big surge in interest rates over the past 15 months Indeed in Q1 of this year, it accelerated to 1.6% year-on-year from 0.9% in Q4 2022. This relatively buoyant economy is still creating jobs where there are insufficient numbers to fill the capacity. On the other hand, to bring labour inflation rates down requires in his own words “loosening the jobs market”, that is to say manufacturing economic contraction and actively putting people out of work. However uncomfortably that sits with his mandate of maintaining a strong labour force, his inclination is to try and draw the steam out of wages but without crashing the economy in the process.
Time will tell whether this approach works or not. The policy hawks maintain that a short, sharp shock with aggressive tightening through both ramping up interest rates and constraining market liquidity would allow the economy and core inflation quickly to be re-set. The doves point to the risks of over-tightening and inflicting significant long-term economic damage which might take years to recover from. But it is important not simply to look at monetary policy as a stand-alone pillar of the economy; its counterpart, government fiscal policy, continues almost as though in a different dimension. Whatever the minor constraints applied recently in the debt ceiling row, it is the natural political inclination of Joe Biden and Janet Yellen his Treasury Secretary (and Powell’s predecessor at the Fed) to spend, spend, spend. It is a policy which is certainly making it no easier to moderate growth and jobs and to bring core inflation back to target.
The net effect of Powell’s meandering narrative on monetary policy over the past few months, and his latest nuance, is that investors have had to re-think the outlook for US interest rates. Having been fed the line that further tightening is a possibility, US government funding rates as measured through Treasury bond yields have maintained their upward pressure. By definition, the peak interest rate (known in the jargon as the ‘terminal rate’) has to be closer than a year ago when the rate rising cycle was in its infancy. However, we have seen many a false summit along the way. The one thing you learn in such times is that making hard-and-fast predictions about outcomes when you have little direct control over the inputs is tantamount to a mug’s game (and why we on the Jupiter Merlin team prefer to keep an open mind and react if/when the facts change).
UK private sector wage inflation 7.6% and rising
Jeremy Hunt, carts and horses
That seems very unlikely! We have long argued in these columns that reducing the rate of tax is demonstrably a Good Thing: empirical evidence shows that over time lower personal and business tax rates increase the nominal tax collected as they stimulate reinvestment in economic growth. We are not about to start arguing against that now. But the government needs to be serious about coherent economic strategy rather than merely throwing the electorate a bung with lower taxes. A prerequisite of reducing the tax burden and allowing sustainable, self-supporting economic growth, is fundamental reform of public sector spending.
The Office of Budget Responsibility’s latest estimates for the fiscal year 2023/4 show total government spending of £1.19 trillion, 46.2% of GDP. Almost exactly 40% of that is attributable to the aggregate expenditure on health & social care (£176.2bn), Universal Credit (£83.0bn), state pensions (£124.3bn) and ‘other’ welfare of £87.2bn. Included in welfare is around £24bn of disability payments to people of working age. Weighing in at a sum even bigger than Universal Credit is the upwardly revised interest charge on UK government debt: at an estimated £94bn (8% of all government expenditure) it is now £10bn higher than the previous estimate of only a few months ago and more than double the annual pre-pandemic cost.
Clearly there is a political expediency in putting clear blue water between Labour and the Conservatives when it comes to economic policy, especially with the Tories stuck 15 points adrift of Labour in today’s polls. But economic common sense says that the logical order in which to proceed is first to reform public services (as distinct from simply cutting expenditure; reform and cost cutting are most definitely not the same) to put them on a sound footing, to make them sustainable and capable of delivering incremental benefit at lower cost; having ensured that reform is embedded, then one can begin comprehensively cutting tax rates and offering incentives for private sector investment to deliver a match-fit economy capable of enduring growth. Self-sustaining growth without constantly having to rely on the Bank of England to grease the wheels through quantitative easing (i.e. adding yet more debt) must be the target (the evidence from 6 years of constant QE in the eurozone was that far from having a multiplying effect on the economy, as time went on, every successive euro’s worth of QE increasingly obeyed the law of diminishing returns tending towards zero benefit). But as we know only too well, public sector reform requires significant political bravery and determination to see it through, as well as a decent majority in parliament and the full support of your own MPs to have any chance of success of implementing it in the first place.
The risk of doing it in reverse, putting the cart before the horse for purely political purposes, is that the economy continues to haemorrhage cash, driving up the nominal debt even further with all its associated costs. The likely reaction of the bond markets taking a dim view is not difficult to predict. The problem is that the Tories are rapidly running out of time, faced with a hard deadline with the electorate in a maximum 18 months’ time. After 13 years in office, it’s a bit late!
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