UK economic issues pit government against BoE

In January, UK Prime Minister Rishi Sunak made a bold promise to halve inflation by the end of the year, with an eye on the critical general election in 2024. However, recent data has shown that the path to achieving this target is far from smooth.

At the time of the pledge, consumer price inflation was running at a high annual rate of 10.1%. Most economists expected it to naturally decrease as the impact of soaring energy prices subsided, making Sunak’s goal appear easily attainable for his Conservative government.

Despite these expectations, May’s headline consumer price inflation remained stubbornly high at 8.7%, unchanged from the previous month. Core inflation, which excludes volatile energy, food, alcohol, and tobacco prices, rose to 7.1%, reaching its highest level in 31 years.

The situation is further complicated by an unexpected surge in long-term sickness, leading to a labor force participation rate decline. Despite this, average wage growth, excluding bonuses, accelerated to a record 7.2% in the February-April quarter, indicating a labor market that remains hotter than anticipated.

In addition to these economic challenges, the UK’s economic growth has stagnated, and public debt has surpassed 100% of gross domestic product for the first time since March 1961.

To address the situation, the Bank of England increased the Bank rate by 50 basis points to 5% in June, opting for a faster pace of interest rate hikes than other major central banks. This decision has raised concerns about potential mortgage crises in the country.

According to Shaan Raithatha, a senior economist at Vanguard, the UK is grappling with the “worst of both worlds.” The country experienced a labor market shock similar to that of the United States, with a notable impact from long-term sickness on labor supply. Additionally, there was a European-style energy shock arising from the conflict in Ukraine. Surprisingly, the UK faced a larger energy shock compared to most of mainland Europe.

Raithatha suggested that the government’s response to the energy crisis might have been a contributing factor. Policymakers were possibly slow to intervene during the early stages, and when they did, energy prices were capped at higher levels than in other countries.

The resilient nature of the UK economy, coupled with the slower transmission of inflation to mortgages, poses a challenge for the Bank of England in controlling inflation. As a result, further measures might be necessary to achieve the goal of curbing inflation effectively.