The Bank of England’s (BoE) jumbo 75 basis point interest rate hike last Thursday (3 November) came with a bleak warning that the UK economy is heading for recession that could last until mid-2024.
CPI inflation nudged back above double digits to 10.1% in September. The BoE now forecasts inflation to peak at around 11% before year-end and falling “probably quite sharply” from the middle of next year, partly due to base effects. However, the BoE warns that the trend reversal is contingent on further interest rate increases – the primary tool to combat inflation. Base rates are now 3% – the highest level since 2008. Economists now expect rates to peak at between 4.25% and 4.5% in mid-2023.
The grim macroeconomic outlook invites comparisons with the acute stagflationary challenge that the UK economy struggled with back in the 1970s. History reveals the economic consequences of adhering to rigid monetary targets. Margaret Thatcher’s first administration raised interest rates to 17%, as the government was convinced high interest rates was critical to controlling inflation. John Hoskyns, head of Thatcher’s Policy Unit, admitted the UK government had “accidentally engineered” a major recession to control inflation – which peaked at 22.6% in 1975, according to Office for National Statistics (ONS) records – and had “done the economy a great deal of damage by mistake”.
Of course, economic historians will point to the structural changes in the UK economy, labour market and global markets which limit the relevance of a direct comparison and the likelihood of a 1980s monetary policy-induced recession repeat. But history is starting to rhyme. A blanket dismissal of the lessons from this period of economic history risks blinding policymakers, central bankers, businesses, and households to the consequences of rigid monetary targets and the utility of interest rates to control inflation.
Some of the parallels with almost half a century ago are striking. Back then, exceptionally high inflation spikes were preceded by oil crises in 1973 and 1979, and further influenced by sharp increases in food and commodities prices worldwide as well as elevated inflation expectations. In addition, back then, as now, these were global trends compounded in the UK economy due to the weakness of pound relative to the US dollar. Thus far, the comparisons to today are self-evident. Additional UK-specific challenges further weakened public finances, productivity, and UK competitiveness internationally, notably the power of trade unions that pushed for higher pay under the threat of strike action, which created a “wage-inflationary spiral”.
‘Inflation is always and everywhere a monetary phenomenon’
In the late 1970s, Thatcher’s government sought to aggressively control inflation by familiar monetary policy tools. First, by raising interest rates to dampen demand. Second, by reducing the UK’s budget deficit by raising taxes and reducing public spending. Third, by attempts to control the money supply and meet declining money supply targets. All these strategies are re-employed today. These monetary and fiscal policies did eventually bring inflation back down to below 4% by 1983, but this came at a heavy price. It led to a period of stagflation – where anaemic economic growth was twinned with high inflation – which caused sweeping industrial action and protracted high unemployment and resulted in what was called the ‘Winter of Discontent’.
In 1980 to 1981 the UK entered the deepest recession since the 1930s; interest rates peaked at 17% and weakened to US$2.40, causing British firms to struggle to compete internationally. UK GDP fell by almost 5%, while manufacturing investment and output declined by 26% and 15% respectively, hurting British exports as a result. During this period unemployment reached four million, levels not seen since before the war. As the UK economy moved out of recession in 1982, interest rates started to come back down to below 10%. This coincided with declining unemployment, growth in real incomes, and the expansion of banks’ participation in the residential mortgage market (previously dominated by building societies), which coincided with relaxed lending criteria and spurred the proliferation of owner-occupied housing. Mortgage lending increased from less than £15 billion in 1983 to £40.2 billion in 1988, aligned to the housing market’s peak and rapid downturn. By mid-1988 the government admitted the economy was expanding at an unsustainable rate, creating renewed inflationary pressures and a deterioration in UK public finances. Ultimately, the housing market downturn led the economy into another recession, characterised by rising residential mortgage defaults, arrears and home repossessions which peaked during 1990–92. Over this entire period, interest rates went from 17% in 1979 down to 9% in 1982, and back to almost 15% in October 1989, partly under the pressure of house price rises. Once again, interest rates were the go-to tool to tame inflation.
Such was the economic toll of the 1970s UK stagflation, it was assumed to have “forever changed the way that financial officials think about keeping economies stable and in good health”, reported The Times. But, to a significant extent, the same monetary tightening strategy played out again in the late 1980s to early 1990s – and risks doing so again today. Norman Lamont famously said in 1991: “Rising unemployment and the recession have been the price that we have had to pay to get inflation down. That price is well worth paying.” It was a sentiment not shared by all. For some, taming inflation through excessive reliance on interest rates delivers too steep a price on the economy – and there were some who called for inflation to be controlled by different levers to avert the economic collateral damage that maintaining high interest rates will inevitably cause in a weakening economy.
In the late 1970s, the trade-off was between inflation and unemployment. Today, it is between inflation and the cost of living crisis with wage increases failing to keep pace with the rising energy and food prices that are squeezing real household incomes. Rising prices and elevated borrowing costs are also depressing business investment, hiring and profitability, which the BoE believes has already plunged the UK into a recession. Today’s UK labour markets are much less unionised, but the fall in real incomes did lead to a rise in industrial action disputes over wages this summer, (e.g. in UK railways and the underground, Post Office, NHS workers, the aviation industry and barristers).
Raising interest rates is a “very blunt instrument to control inflation”, British Chambers of Commerce’s (BCC) David Bharier said last week. The combined impact of the BoE’s monetary tightening, the government's Autumn Statement – which is expected to implement tax increases and spending – and quantitative tightening, risks delivering the kind of painful medicine the UK economy endured in the early 1980s. Businesses today are trapped between rising energy prices, the cost of raw materials and the cost of borrowing, as well as weakening consumer demand.
Expectations play a significant role in the outturn for the inflation pathway. Higher rates of inflation are associated with less stable inflation outlooks, which multiplies uncertainty and makes businesses and households preoccupied with wealth preservation, rather than wealth creation. More rational decisions are made when inflation expectations are well anchored. Around one-third (30%) of UK directors believe inflation will peak next spring, while more than half (53%) expect the peak to come even later, according to a survey by the Institute of Directors (IoD). The IoD described last week’s jumbo interest rate hike as “the least-worst option, to anchor inflation expectations”. The UK economy is set for a prolonged recession. In this environment and a new wave of defaults is inevitable. “As evidence of a recession mounts, cost pressures on businesses may yet continue as the energy price cap expires next April,” added the BCC. “Businesses will be extremely worried about what the future holds.
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