Could the UK be headed for an inflationary recession?
Today, the Bank of England kept its key policy interest rate for the British economy unchanged at the record low 0.25% – but just barely. The three dissents out of eight total votes show how a weak currency and rising inflation are making it harder to keep rates low. The worst case scenario is an inflationary recession, which would topple Theresa May and perhaps set the ground for a change in the UK’s Brexit stance.
The data: Now, if you look at growth expectations for the UK compared to some of the biggest countries in the world, things don’t look so bad.
Expected growth for the UK falls into the middle of the pack. And while the UK was the fastest growing country in the world three years ago, its growth rate has not slipped that much, even after the Brexit vote.
But, of course, these are nominal figures, unadjusted for inflation, when you look at inflation as the Pound has fallen after the Brexit vote, things look much more challenging.
If the British economy actually were to grow 3.0% as the OECD projections foresee, you basically have no growth given current levels of inflation. It’s not hard to imagine scenarios where inflation-adjusted GDP declines. And that would be what I would call an inflationary recession – where growth doesn’t decline significantly until you factor in rising inflation.
Let’s remember that we have falling real wages in the UK right now. And this is depressing consumption. On Monday, I mentioned the data from Visa showing real spending had declined year-on-year. Today we also got very poor retail sales numbers out of the UK as well.
The consequences: Politically, I think this is destructive for Theresa May. She has made no fiscal contingencies to deal with economic weakness in the aftermath of the Brexit vote. In fact, she has done just the opposite, running an election campaign in which she abandoned the “no tax rise” pledge, promised continued cuts to social programs, and made a ghastly error in inserting the ‘dementia tax’ into the Conservative manifesto. These were critical mistakes. And it was all very predictable too.
Here’s how I put it in August: “Let’s see how this pans out. But for now, if I had to re-calibrate on Brexit, I would say the near-term risks in the UK are acute enough to draw a strong response from policy makers. It has now done so on the monetary side. We await a fiscal response. UK Chancellor Hammond said in response to the BoE decision that he is “prepared to take any necessary steps to support the economy and promote confidence,” suggesting a fiscal response is coming. Will he cut VAT rates in the UK or boost infrastructure spending? We don’t know. There is a possibility that he moves up his Autumn Statement to October, however, in order to get in front of any downside risk to the economy. And the possibility of this response leaves me still thinking Brexit will have a muted impact on the UK economy.”
Had May and her Chancellor Philip Hammond taken the affects of the Brexit vote seriously, as the Bank of England did when it lowered its base rate, perhaps we wouldn’t see growth weakening as much as it has done. The unexpectedly robust performance of the British economy after the Brexit vote deceived the Tories into believing they were over the hump – when in fact the economic risks from it are just now ramping up.
But even now, Tories are split between the Brexiteers Johnson and Davis who believe May lost seats at the election because of austerity and Remainers like Anna Soubry and Hammond who believe that May’s adherence to a hard Brexit explains the seat loss.
In the face of that split, we should expect little will be done to deal with the faltering economy. And if that weakness deepens, Theresa May will face a revolt and be deposed as party leader sooner than later.
Bottom Line: Theresa May’s position as party leader and Prime Minister has been significantly weakened by her loss of seats and dependence on the Democratic Unionist Party to stay in power. A faltering economy would topple her government. And inflation presents a clear and present danger to the British economy by depressing real wages, depressing growth, and by tightening monetary policy.
When the Bank of England finally raises rates, the UK’s variable rate mortgage sensitivity will kick in and an inflationary recession becomes a reasonable worst case scenario. If Theresa May were still in power, I don’t believe she would survive this outcome. The question then becomes what would happen next.
Both French President Emmanuel Macron and German Finance Minister responded to the British election by offering a fig leaf to the UK and reiterating their stance that the UK can reverse the Brexit decision at any time. If the May regime falls, a successor British government could seize on this offer and dramatically change the UK’s Brexit position.
Watch: Outside of inflation and growth figures, watch the yield curve. After today’s BoE decision it steepened 2 basis points, putting 10-year gilts 87 basis points wide of 2-year gilts. But as the data come in, if they are weak, I would expect the 10 year to rally, even if the BoE is signalling hikes.
Politically, watch whether or not May actually does loosen the purse strings to bolster the faltering economy. The tragic fire at Grenfell Tower near Ladbroke Road only adds to the sense amongst many in the electorate that budget cuts have created a dangerous economic environment in Britain.