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Britain’s recovery may soon fall victim to the cost of agonising economic trade-offs
This is going to be a pivotal week for financial markets and all those concerned about the effects of financial matters on their lives.
The week begins with an important anniversary. On Sep 16, 1992, the UK left the European Exchange Rate Mechanism (ERM). This year the 16th falls on a Monday, but in 1992 it fell on a Wednesday. That day immediately became known as “Black Wednesday”.
The exit unleashed a short period of economic chaos and disillusion which quite quickly morphed into a realisation that we had been released from a straitjacket and now the economy could recover. And recover it certainly did, with strong and well balanced growth and improving public finances. “Black Wednesday” became known as “White” or even “Golden” Wednesday.
Yet the governing Conservative Party never recovered from the ignominy of that ERM exit and the election in 1997 was lost to Tony Blair’s New Labour by a landslide. It inherited an economy in rude health, continuing to prosper until the global financial crisis of 2007-9.
Nothing like the drama of that day in September 1992 is likely this week but this is a period heavy with significant data releases and policy announcements.
The really big question is the perennial one about the mixture between inflation and economic activity. In this regard, the UK has recently done remarkably well.
Inflation has come down sharply to 2.2pc. And, at least until the stagnation in June and July, this has happened alongside pretty robust growth of GDP.
This combination is known in the markets as “immaculate disinflation”. Something similar has happened in the US. But can it continue?
In Wednesday’s inflation figures, the headline number is likely to remain pretty close to last month’s 2.2pc, so only slightly above the 2pc target. And the immediate outlook is quite good, with a small fall in the rate likely next month.
But thereafter things get more difficult. In October, the Ofgem price cap will rise by 10pc and accordingly October’s inflation outturn (published in November) is likely to be about 2.4pc.
Moreover, in subsequent months inflation may pick up again to nearly 3pc, as favourable figures a year ago fall out of the annual comparison.
The detail of the inflation number could be more revealing. It is the core inflation figure that indicates the underlying position. This week that core figure may rise to something like 3.6pc.
What’s more, it is going to remain in that ballpark, possibly pushing up close to 4pc over the winter.
This will constitute a dangerous backdrop to wage negotiations. Recent bumper settlements for some public sector workers will doubtless be followed by calls for something similar in other parts of the public sector.
Private sector workers will surely be influenced by these increases and want something similar for themselves. In April comes the new settlement for the minimum wage and the National Living Wage.
If these are increased significantly, that is going to be a powerful factor in higher wage inflation, which could easily feed through into higher price inflation. So the battle against inflation is far from over.
But none of this is likely to stop the Monetary Policy Committee (MPC) from cutting interest rates on Thursday, probably by 0.25pc. This is likely to have been preceded on Wednesday by a cut by the US Federal Reserve, probably by the same amount but possibly by 0.5pc.
Following last week’s reduction by the ECB, there will surely be a sense in the markets of an interest rate bandwagon on the move.
Yet, although the leading central banks’ interest rates do tend to change more or less together, this is not bound to happen. It all depends upon whether their economies are experiencing broadly similar economic forces. They often are. But not always. Further interest rate cuts here will depend upon how underlying inflation evolves.
The second part of “immaculate disinflation” concerns real output. Elsewhere in the world, there are distinct signs of a weakness in aggregate demand. In the US, the jobs market has become much looser and there is even talk of an imminent recession.
Weakness is probably most acute in China. Meanwhile, across the channel, the economies of our closest trading partners are decidedly sluggish.
If our economy also starts to slow significantly this should ease pressures on underlying inflation and therefore strengthen the case for interest rate cuts. But, of course, such an outturn would be far from immaculate.
Quite apart from the damage in the labour market, a significant economic slowdown would tend to weaken the public finances. We get the latest snapshot of the government borrowing situation on Friday. This will be the penultimate set of borrowing figures before the Budget.
If the public finances look like turning out worse than previously envisaged, this will pressurise the Chancellor into a tougher package of spending cuts and tax increases.
Unfortunately, that would tend to weaken aggregate demand, despite the accompanying improvement in the prospects for interest rate reductions.
Sadly, economics is full of trade-offs. Things like immaculate disinflation are the exception, rather than the rule. This government faces some agonising choices, made worse by its early blunders over public sector pay.
Immaculate disinflation offers the prospect of economic support for both the bond and equity markets. The bond market can savour lower inflation and the lower interest rates that should go with it, while the equity market should enjoy the hope of strong profits that would normally accompany a strong economy.
By contrast, disinflation accompanied by a weak economy might be good for bonds but it would not help the equity market – or the Government.
If only there were an escape mechanism like the ERM exit. With one bound, we could be free! Ironically, many Labour MPs fondly imagine that such an escape may come from a re-entry, namely rejoining the EU, or something close to it. They are gravely mistaken.
Roger Bootle is senior independent adviser to Capital Economics.
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