Strategy blog: Inflation and growth

Another bad UK CPI doesn't help…

The UK consumer price data for July – yet another upside surprise, with the year-on-year rate pushing into double digits earlier than feared – will do nothing to cool the frazzled public mood.

Inflation has been prompting economists to cut their growth forecasts across the world in 2022, and the UK is seen as particularly vulnerable, as we noted a few posts back. Just a fortnight ago the Bank of England amplified the UK recession warning it first sounded on this account in May.

Keeping things in perspective is not easy at the best of times, and things are certainly difficult now. Economists may think they are looking forwards, but often we are responding to events, and not always thinking as carefully as we could about what might happen next, and why.

… but how will it hit growth?

For example: why exactly might inflation (rising prices) cause recession (falling output)?

In the case of a single item, it seems obvious: price goes up, demand falls. But what happens when all prices, including that of labour, are rising?

Prices are numbers, but output is real. Price labels do not directly affect quantities produced (and are increasingly capable of being updated costlessly). If all prices inflate together, our accounts change, but little else does.

In practice, prices don't all rise at the same pace – the price of labour in particular. If wages, and non-wage incomes like pensions and benefits, lag behind consumer prices, "real" pay falls and spending power and well-being with it.

Similarly, interest rates – the price of time? – don't always keep pace with prices. When "real" interest rates fall, savers' and lenders' spending power (and wealth) is weakened.

And consumer prices themselves can grow lop-sidedly. Energy prices have been rising faster than most others, particularly in Europe, where economies are more dependent on Russia's natural gas, and squeezed "terms of trade" represent a loss of national spending power.

Wiggle room exists…

It is not clear how potent these various forces will be in practice. Just how far consumer spending falls in response to lower real pay will depend, for example, on how much wiggle room households have. Do they already spend all their income? Do they have assets to help tide them over? Have they pre-committed and budgeted for some spending in advance?

Here in the UK, real pay has fallen sharply in the last year, but is doing so after rising unexpectedly after the pandemic. Did consumers get used to that higher level of pay? If not, wiggle room now may be higher.

Similar uncertainties apply to the changes in real interest rates and the terms of trade.

What each of these channels between inflation and the real economy have in common is that they reflect altered relativities – between prices and pay, between prices and interest rates, and between energy and other prices.

But those relativities mean that for every loser, there must be a winner, including: businesses that benefit from lower real pay; borrowers (especially governments) who benefit from lower real interest rates; and the energy producers who benefit from higher energy prices.

For inflation to shrink the global economy, then, the losers' foregone spending has to exceed any extra spending by the winners. Overall, this is likely to be the case – but again, the link is not as mechanical as some of those altered forecasts seem to suggest.

For example, European governments are using fiscal policy to mute some of the damage done to household spending power. They may not realise (or admit) that they are redistributing some of their own inflationary gains, which would otherwise be reducing their debt ratios meaningfully, but that is what they are doing.

… even where monetary policy is concerned

Of course, another of the consequences of higher inflation is tighter monetary policy. We talk of those higher interest rates precipitating recession (which may or may not be a policy "mistake": it depends on the central banks' priorities), and there is a grand tradition of seeing US recessions in particular as the product of monetary policy.

In the current episode, however, the monetary stable door is being closed with the inflation horse happily cantering in the paddock. Historically too it is surely too simplistic to attribute the US business cycle solely to the workings of monetary policy: booms and busts are likely part and parcel of the workings of a market-led economy.

Interest rates even now are well behind inflation – a fall in "real" interest rates of the sort noted above has so far been making life easier for many borrowers, not harder – and are unlikely to become significantly restrictive soon. Even if policy weren't so slow off the mark, the workings of fixed-rate mortgages and lengthened corporate bond maturities would mute the impact of higher rates.

This may not stop businesses and consumers from cutting back immediately. As they see nominal interest rates going up, they may not stop to think about how low they are in real terms, but instead respond instinctively – encouraged perhaps by those lowered economic forecasts. And at some stage, as headline inflation begins to subside while interest rates stay elevated, their real burden may indeed become more onerous.

But today's inflation does not make a major economic downturn inevitable. And some of it, remember, reflects the welcome fact that developed-world unemployment is lower than it has been for most of our working lifetimes. As noted, that wage inflation is – so far – lagging well behind prices. If it continues to do so, it may yet pose a question that few economists dare ask currently: are more flexible labour markets here to stay?

In the meantime, we still see most important consequence of the cost of living "crisis" as its distributional impact – its unfairness – rather than its macro effect. European governments face a difficult winter politically, whatever happens to growth.

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