In line with similar aggressive steps by the European Central Bank and the US Federal Reserve in the face of soaring inflation, on August 4 the Bank of England (BoE) raised interest rates by 50 basis points, its largest single increase since 1995, and projected the UK’s longest recession since the global financial crisis of 2008. The sixth consecutive increase in interest rates takes the borrowing costs to 1.75 percent and the 0.5 percent hike is the first since the bank was made independent from the British government in 1997.
Citing inflationary pressures in the UK and rest of Europe, the bank said Britain faces a protracted recession and biggest squeeze on living standards in more than 60 years. The BoE’s grim forecasts suggest that Britain is facing a much bleaker economic outlook than either the US or the Eurozone, given that households are more exposed to the energy price shock than in the US and less protected by government measures than in the Eurozone, in addition to the UK economy having been damaged by the effects of Brexit.
The BoE’s forecast is that the UK would slide into a 15-month recession, starting from the fourth quarter this year, with the GDP shrinking by more than 2 percent, as real household post-tax income falls sharply in 2022 and 2033 and consumption begins to contract. Leading economists’ forecast for the US is GDP growth of 1.5 percent, while for the Eurozone it is 1.7 percent in 2023. Because of the latest surge in gas prices, driven by Russia's restriction on supplies, the bank expects inflation to rise above 13 percent at the end of the year, much higher than its forecast in May. Inflation will remain at “very elevated levels” throughout 2023 before falling back to the 2 percent target by the end of 2024.
The central bank’s dire outlook for economic growth in the UK and the rest of Europe suggests that even when the recovery begins, growth would be “very weak by historical standards”. The bleak forecast led to angry political recriminations between the ruling Conservative Party and the opposition Labour Party amid reports that the winner of the Conservative party leadership contest will face huge extra costs (about 50 billion pounds) to service the nation’s debt and pay social security benefits as a result of rising inflation and interest rates. Meanwhile, the latest GDP figures released last week show that the UK economy shrank 0.1 percent in the second quarter, reflecting the cost of living crisis starting to hurt households.
Liz Truss, the favourite to win the Conservative Party leadership contest and succeed Boris Johnson has reportedly said that she will consider reviewing the central bank’s inflation mandate and the extent of its independence from the government if she becomes the prime minister. But Rishi Sunak, former chancellor and her rival for the Tory leadership, said the projected surge in inflation reinforced his claim that Truss would be reckless to increase borrowing and cut taxes now. “The bank has acted today and it is imperative that any future government grips inflation, not exacerbates it,” he said. “Increasing borrowing will put upward pressure on interest rates.” But Truss has claimed Sunak is partly responsible for pushing Britain towards recession because of the series of tax rises he introduced as chancellor.
As the war of words broke out between the two Tory leadership contenders over how to handle the crisis, economists and fiscal policy analysts say that rising energy bills could force the candidates to do more to tackle the impending cost of living crisis than merely focusing on tax cuts. Paul Johnson, director of the respected Institute for Fiscal Studies said that what he finds remarkable about the Conservative leadership is that Sunak and Truss don’t seem to be talking about the things that are really going to be in the need of public finances. “They are going to have to find many more billions to support households. The support packages that were announced a few months ago and the sort of tax cuts that are being talked about are not going to be enough to tackle the inflation crisis.”
While allies of Sunak and Truss have clashed over the best way to avert the looming economic crisis, business secretary Kwasi Kwarteng, who is backing Truss and is widely tipped to be her chancellor if she wins, said Truss would offer “immediate relief financially” for households in an emergency budget. Renewing his attacks on Sunak’s stance that tax cuts can only be implemented when inflation is back under control, Kwarteng said: “You have got a world where prices are going up. If we are going to help people, how are we going to help people by putting up their taxes? Just simply carrying on with our economic policy at the moment is not going to help us get out of this difficulty.”
But Liam Fox, a former international trade secretary who is backing Sunak, suggested that Truss was offering “magical solutions” rather than being honest with people by actually saying it’s going to be tough. “The question in the leadership contest is: do we maintain what is a traditional Conservative response to this or do we try something completely different and take a risk with the economy. It’s not going to be easy and this is a key difference between candidates in this (leadership) election,” he said. Meanwhile, the Bank of England governor Andrew Bailey has come under fire over the worsening economic outlook. The Truss camp’s criticism of Bailey is that he should have done more to tackle inflation last year before it took off.
But the governor rejected claims from his critics that the central bank should have raised interest rates sooner. He insisted that raising interest rates last year could have risked damaging the jobs market as the UK economy emerged from the pandemic and blamed global shocks, including the war in Ukraine, for the sharp rise in inflation. Notwithstanding Bailey’s defence of his monetary policy, rising inflation over the last one year underlines that like the Federal Reserve, European Central Bank as also our own RBI, BoE has also been behind the curve in tightening its accommodative monetary policy.
The writer is a senior independent Mumbai-based journalist. He tweets at @ali_chougule