What if the UK has used up all its inflation allowance for the whole decade?
This question assumes there is an optimum level of inflation – a 2% average – and that the UK has already used its entire allocation for the 2020s.
It’s a proposition with traction in some quarters of the City, based on the hypothetical calculation that an economy can stand only so much inflation before all participants – workers, investors and company managers – abandon their belief in steady prices.
An inflation rate that will be easily more than 20% over the first three years of the decade means UK prices growth needs to be zero for the following seven years, according to this way of thinking. And the knock-on effect of keeping prices flat for the rest of the decade would be a deep recession – and not just for a year, but probably longer.
The only alternative would be to allow a higher level of inflation that encourages workers to chase rising prices with rocketing wage demands in a permanent cycle of self-harm, the thinking goes. If the UK goes it alone with higher inflation, it becomes more uncompetitive in international markets.
This outlook would be nothing short of tragic for a UK economy struggling to recover from 12 years of austerity and a Brexit vote in 2016 that has undermined business investment.
Bank of England governor Andrew Bailey has begun subscribing to the notion that inflation must be crushed. Speaking last week, he said this project could involve interest rates remaining high for much longer than many expect.
Not to be outdone, Christine Lagarde, the head of the European Central Bank, said at the same conference that she would consider a drop in inflation to 3% by next year insufficient to begin lowering interest rates. Inflation at 3% would still be too high.
Sounding like an emissary from the ultra-conservative German Bundesbank, or maybe channelling the former Federal Reserve boss Paul Volcker, who is credited with eliminating US inflation in the early 1980s with high interest rates, Lagarde sent a message to businesses and consumers across the eurozone that a tough line was the only option.
Jerome Powell, the current Federal Reserve boss, has adopted the Volcker doctrine since last summer, saying he will do whatever it takes to prevent a repeat of the 1970s inflation cycle, and that could include a recession.
Sitting on the same panel as Bailey and Lagarde, he repeated his message and refused to rule out a US recession.
Economists have re-examined their forecasts in the light of these comments and many now predict recessions across the eurozone, the UK and the US at various points over the next year.
Dhaval Joshi, chief strategist at BCA Research, said: “Among the major economies, the most vulnerable to a deep recession is the UK, which has used up its 20% inflation quota for the entire 2020s in just the first three years.
“Having used up this quota, the UK must experience negligible inflation in the coming years if it is to prevent inflation expectations from un-anchoring.”
With the concept of “un-anchoring”, he takes us back to the opening question, and what level of inflation triggers a cycle of high wage demands and then high prices.
Is it 2%, as he would argue? Or maybe in the post-pandemic world where labour markets are adjusting to new forms of working (from home) and the ill-health and early retirement of many older workers, the target rate should be more forgiving of rising prices. Maybe it should be 3% or more?
Writing in the Financial Times last week, Adam Tooze, a Columbia University history professor, called for a wide-ranging debate about the best inflation target. “That means not slamming the door shut to argument by invoking the bogeymen of the 1970s and demanding that central banks must do whatever it takes.
“That is the old neoliberal logic of ‘there is no alternative’,” he said.
Many on the left would agree, arguing that conservative inflation targeting should be sidestepped in the drive to increase living standards.
They had a strong argument in the aftermath of the 2008 banking crash, when the UK, despite playing host to many of the worst-hit banks, was still considered a safe haven by international investors.
Today the situation is markedly different. Financial markets look much less favourably on the UK, and that cannot be easily dismissed when UK borrowings are so high.
For at least a year or two, any extra expenditure by the government will be considered inflationary, no matter how good for the economy’s long-term health it appears to be.
No doubt Keir Starmer would embrace a re-evaluation of inflation targets, should it be conducted at an international level and lead to an agreement among all the major economies.
In the meantime, Labour has been left with little choice and must rein in its spending plans.
