UK Economy on a Knife Edge

What’s going on with the UK economy? For the second month in a row, Inflation data has come in better than expected. Whilst the Bank of England expected a rise in inflation, the UK is seeing lower inflation, despite the Iran war and rising transport prices. For years it was the opposite, inflation higher than expected.

And economists fretted that UK inflation was persistently higher than other countries, but now, UK inflation is no longer an international outlier. Lower structural inflation would be a big deal. A fall in oil prices and lower inflation has already seen a fall in UK bond yields from 5.2% to 4.75%. That means cheaper borrowing costs for the government and less pressure to increase taxes. It is not just headline inflation, but lower core inflation and lower owner occupier costs. Lower inflation also helps to improve the dire forecasts for real wages.

UK Real wage growth is still pretty anaemic, and all it would take is a small jump in inflation to cause another fall in real wages. The big question is will the ceasefire hold and Hormuz actually re-open. It’s ironic how much rests on events outside the country.

Don’t Get Carried Away by Inflation staying at 2.8%

 

But, before we get carried away by a few months data, there is a more pessimistic or perhaps you might say realistic take. Firstly, producer input price inflation is running at 8.7%. This foreshadows higher inflation later in the year. Secondly, inflation expectations are still pretty high in the UK, and this makes it more likely firms will try to pass on price rises. Also, for all the talk of slightly lower inflation rate, inflation is still above the Bank’s target – despite weak economic growth.

For the average household who doesn’t obsess about monthly inflation data, they will still see an economy where the price level is rising, the cost of living going up. And one of the reasons for lower inflation is the government’s temporary budget support for energy prices. But, this will end in July, and this is when energy prices will go back up by an estimated 13%, and then once again inflation will rise to an estimated 3.5%, that means a return to stagnant real wages.

So what is actually happening with inflation? We can see that transport is the big driver of inflation with air fares and petrol more expensive as you might expect with higher oil prices. But, some food prices are actually falling and clothing and furniture virtually no change.

Will UK Benefit from AI?

Another big change in global economy is AI. But, is the UK economy able to benefit from the AI revolution. Well probably not. The first problem is high electricity prices. Amongst the highest in the world, and a report by PwC argues that the UK is set to lose £250bn of economic activity over the next decade without lowering energy costs. The report highlights 25% of British manufacturers have moved operations overseas or are considering doing so due to energy costs. But, in the future, high electricity costs will deter frontier technology firms and data centres. Not only that but the UK’s relative strength in recent decades has been financial services, Yet, this is an area of the economy that could be first to be hit by AI replacing these services. Already London has seen a fall in growth, and employment opportunities not helped by excessive living costs. Some might say, London is too dominant. But, don’t forget London is a net contributor to government finances. If London’s financial services are hit by AI, it is not clear where growth will come from.

Nevertheless, despite a terrible track record on productivity and growth in the past 16 years. There are tentative signs of improving productivity. This would be the holy grail for the UK economy. Higher productivity is what would enable sustained improvements in real wages. But here there is great uncertainty. The FT reports how the Bank of England said UK economy output per hour increased last year by 0.4% or perhaps 2.1%. That is essentially the difference between bad news and good news. The confusion rests on which measure of employment you prefer. But, one explanation is that higher minimum wages have increased income but encouraged firms to use less labour. This would be more of a structural problem than signs of an improving economy. And there has been some rise in unemployment in recent months. Of particular concern is the UK NEET rate amongst young people. Which is now the highest in Europe. It reflects growing inactivity, due to rising health problems and a new generation held back from economic activity. It has put pressure on both benefits and limited economic opportunities.

UK on Knife Edge

But, to go back to the main question, the UK economy is currently on a knife edge because a lot is currently resting on geopolitical events beyond its control. If Hormuz reopens, there is a chance by 2027, oil prices will fall considerably and this will be a relief for a government desperate for lower inflation. But, if the much-touted solution fails to materialise, Hormuz remains closed and inventories run out, then there is still scope for a devastating rise in oil prices, inflation and interest rates. The government say the response to the Iran crisis is all about moving beyond fossil fuels. That’s all very well in theory, but you can’t achieve that overnight, especially when prices are high.

Quick questions on state of UK economy

What single thing could the UK do to improve economic prospects? Reduce electricity prices and aim for the electrification of economy. Move away from gas and petrol. Be aggressive in reducing red tape, cutting tax on electricity as the benefits to the economy and environment from electrification will outweigh the downside.

Are Bank of England fit for purpose? It’s very easy to criticise the Bank of England. But I think the first thing that sticks out, is you can only do so much by changing interest rates. Higher interest rates won’t really bring down cost-push inflation. Lower interest rates won’t cause strong economic growth. The truth is, interest rates have less impact on the economy than in past. There are less people with variable mortgages. There are more people with substantial savings. In the past if you increased interest rates this reduced growth, spending and inflation. But now the link is much weaker. Increase interest rates and many feel better off. You really have to squeeze business and homeowners. The problem is not so much demand, but more on the supply side of the economy.

 

 

 

 

 

I disagree with the later versions of QE. There was no need in 2016 and 2020.

 

https://www.ft.com/content/161a60ae-130d-42e1-a5c9-886d98f28d3d

https://www.agcc.co.uk/news-article/lower-energy-bills-or-economy-faces-250bn-hit-pwc-warns

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