Inflation looms over budget choices

The prospect of UK being the country with highest inflation out of all G7 has recently grabbed headlines. After a worryingly long period of above target inflation, the outlook remains bothersome, especially that rapid price increases coincide with continued weak growth performance: a tough trade-off for policymakers to navigate. 

As we know, inflation and it’s return in recent years has been a major factor in shaping economic activity, and our politics, as ordinary families are forced to pay more for energy, food, and other essentials.  

It is difficult to say how much of an outlier the UK will prove to be in terms of inflation outcomes. Historical correlation of inflation across the developed economies is high, suggesting that easing inflation pressures elsewhere will also, in time, be felt in the UK as well. But then historical correlations tend to break exactly when one starts overly relying on them — a version of the famous Goodhart’s law. In which a measure becomes a target and ceases to be a good measure. A kind of broken driver of economic action.

The recent pick up in inflation in the UK has, to some extent, been expected. Monetary policy must judge the outlook for inflation in the medium term, and so should look through the near term pick-up if it is judged to be temporary. Still, it needs to be mindful of the risk that higher than target inflation (which has persisted for a while now) will become a norm for price and wage setting processes across the country. For the Bank of England this now represents the key axis of judgement: be forward looking anticipating the disinflation on the one hand; and manage the risk of embeded higher inflation on the other. 

For fiscal policy, higher inflation has the effect of raising nominal GDP and so, holding everything else constant, improving the debt/GDP ratio. Indeed, the post Covid inflation has eroded debt/GDP ratios across advanced economies — debt/GDP today is about 15 percentage points lower in the developed world than what was embedded in the IMF forecasts in 2020 (80% of annual GDP, vs. the 2020 forecast of 95%). The holders of nominal bonds suffered large losses on the real value of their portfolios — a transfer of real resources from them to the government.

But, everything else is not constant: in particular, interest rates could start reflecting higher inflation expectations and risk premia, as investors’ appetite to hold nominal debt erodes. The rise in long-term borrowing costs has been stark: long-term interest rates have increased as much as short-term rates across many countries, but especially in the UK. The UK 10 year yield currently stands at 4.75%, which is above Bank Rate of 4%. The 30-year rate is even higher, at above 5%. Recent research shows that a persistent reassessment of the safety aspect of holding government debt could lead to persistently higher interest rates. 

Partly in response to this rise in long-term rates the Bank of England has recently adjusted the pace of Quantitative Tightening. The higher long-term rates also will feed back into the economy, slowing demand and easing medium-term inflationary pressures, which policy will need to take into account. 

Clearly, the above analysis already shows just how strong and important are the feedbacks between monetary and fiscal policy. What policymakers will be hoping for is that the fiscal risks do not start driving the inflation dynamics. Perhaps this explains, in part, the recent focus of the Chancellor on the continued fight with high inflation. As we look forward to the budget in November, all eyes will be on the measures chosen, and the threat posed by inflation to ordinary peoples living standards. For as our own polling at the UCL Policy Lab shows, the cost of living remains crucial for the government’s agenda.

Lukasz Rachel is Assistant Professor of Economics at (UCL) and Academic Co-Director (Economics) for the UCL Policy Lab.