Yahoo Finance UK economy is overheating and veering towards stagflation
Rising inflation may force the Bank of England to increase interest rates and put the brakes on growth
The UK economy performed surprisingly well in 2016. Indeed, when looking across the OECD economies, it is hard to find a better performer on key metrics such as growth and employment. However, when looking beneath the surface, the UK economy is, in fact, overheating. Already on the rise, the result is going to be the largest surge in inflation for many years, squeezing household budgets and placing the Bank of England in a bind largely of its own making.
Already weak prior to the surprising Brexit referendum result, sterling declined sharply thereafter and has not recovered since. Year over year the pound is down about 20% against both the dollar and the euro. Combined with the sharp 70% rise in oil prices over the same time frame, UK energy and food costs are set to soar this year. These developments alone will push up UK consumer price index by 1 to 2 percentage points.
Related: UK firms brace for further Brexit price rises, surveys show
That may not seem so much, especially when CPI is currently only 1.2% year-over-year. But there is an even more troubling trend: following years of low wage growth, unit labour costs began to rise sharply last year. This is due in part to rising wages but also to persistently weak productivity growth. Labour compensation is the single largest contributor to inflation. Thus while some workers will no doubt enjoy pay rises over the coming year, when combined with the food and energy effects it is unlikely that most will keep up with the rising cost of living.
In 2016 the Bank of England found itself persistently on the defensive, including over government claims that its aggressive monetary policies, such as quantitative easing, have exacerbated inequality. While there is evidence to that effect, a sharp rise in the cost of living will only serve to reinforce this perception. The wealthy have ample means to protect their wealth from being eroded by inflation. The middle class and pensioners have little, if any. Anyone living on a salary is in particular trouble unless they receive a commensurate pay rise.
And therein lies the greatest potential problem: workers who sense that they are falling behind are going to demand higher wages. Those in government or in industries such as healthcare and transport, in which competition is limited, are likely to see strikes as an increasingly attractive wage negotiation strategy. Although the public is rightly annoyed by the huge inconveniences that strikes can cause, if they take place alongside a palpable rise in the cost of living then striking workers may find some public compassion. The government may thus find that it has less political leverage to de-escalate and settle strikes on its preferred terms.
UK has been living on borrowed time and borrowed money ever since the financial crisis struck in 2008
In this context, the Bank of England will eventually need to bite the bullet and begin increasing interest rates if it is to keep CPI anywhere near the 2% target. Combined with soaring energy prices, this will place the brakes on growth. While a recession may not be in store in 2017, slower growth almost certainly is.
If this unpleasant, “stagflationary” mix of sharply rising prices yet slowing growth sounds a bit like what occurred in the 1970s, that’s because it is. The fact is the UK has been living on borrowed time and borrowed money ever since the financial crisis struck in 2008. Sterling devalued sharply back then as the Bank slashed rates to zero and began QE. These “emergency” measures, now in place for over eight years, have kept the economy on life support by subsidising a huge expansion of debt, public and private, and the associated property bubble. They have not created the necessary conditions for a truly self-sustaining economic recovery. Indeed, the opposite could be argued, that by keeping the monetary spigot open for so long the Bank has encouraged debt-fuelled speculation rather than a salutary economic de-leveraging.
As the Bank finally moves to raise rates in response to sharply higher inflation, bond yields are likely to rise and share prices may well decline or, at a minimum, fail to keep pace with the cost of living. The much-maligned British saver, suffering for years from artificially low interest rates, is only going to find things getting worse as portfolio valuations decline. Borrowers, meanwhile, will find they are tapped out.
They call economics the “dismal science” for good reason. There is no free lunch. With inflation finally on the rise, the QE piper will now need to be paid.
• John Butler is vice president of Goldmoney Wealth
