The author is Chairman of the Peterson Institute for International Economics and a former member of the Bank of England’s Monetary Policy Committee.
Sometimes reality bites. Britain’s outlook for stagnating rising prices and slowing economic growth this year and next reflects the realities brought about by Brexit.
Of course, the Covid pandemic, the difficulties in reopening the economy, and now soaring energy and food prices are not caused by Brexit.
But the UK’s vulnerability to these shocks, and therefore the amplification of their impact on inflation, is largely due to Britain’s departure from the EU. This is why the Bank of England will end up having to raise interest rates over the next year more than it expected this month, and even more than the markets have already expected. . Given the very hard Brexit, the Bank of England and the British economy were partly dragged into the 1970s.
As a result, the Bank’s Monetary Policy Committee is no longer in a position to look beyond external economic shocks as it did during the exit from the European Exchange Rate Mechanism in 1992 or the depreciation of the sterling in 2009. In these cases, they had the luxury of defining monetary policy only in terms of strong national forecast data. But after Brexit, the MPC should be more concerned about the “spillover” of international events on inflation expectations.
This is due to a combination of the UK being a smaller economy in its own right, less buffered by its integration into the EU, and an erosion of confidence in UK governments to pursue disciplined economic policies. Therefore, any shock will likely lead to higher and longer lasting inflation than before Brexit.
Moreover, as the UK has waged a trade war against itself, Brexit has a direct effect on inflation. There is a decline in purchasing power – a one-time but significant movement that takes a few years to materialize as various aspects are implemented. This takes the form of administrative costs and regulatory hurdles as well as reduced tariffs and policy choices.
There has also been a reduction in both the level of labor supply and its elasticity with the effective exclusion of European migrant workers. Labor is a differentiated good with no simple substitution when workers in a given industry, skill set, or region are no longer available. Importantly, this has translated into a growing mismatch between available workers and jobs, as well as the perceived bargaining power of domestic workers in some sectors.
The UK avoided the US mistake in 2021 of handing out too much fiscal stimulus in too short a period when the economy was recovering but lacking in labour; on the contrary, fiscal policy was too austere. The UK, like the EU, has also avoided Washington’s mistake by tying Covid aid to laid-off or laid-off workers, subsidizing jobs and furlough schemes instead.
Yet the UK inflation rate is high, similar to US levels, and has been for some time. It is higher than the euro zone rate, although price increases have accelerated across the bloc mainly due to the Russian war in Ukraine. Brexit did it. Due to the limitations of today’s UK labor market, the UK economy faces the same labor shortages and wage pressures as the US.
The price increases in the UK reflect, in part, the idiosyncrasies of the UK natural gas and food markets. However, the lack of supply options for farm labor and fuel has compounded and persisted these inflationary effects. The introduction of trade barriers and new standards between the UK and the EU single market only compounds the problem.
I do not share the MPC’s assessment that the projected decline in real incomes and the projected monetary tightening will be sufficient to bring inflation back to target within two to three years. Monetary policy must be exercised because in a small, closing economy with an inflationary tendency – like Britain in the 1970s – inflation does not correct itself with general movements in demand.
Wage increases are not keeping up with inflation, but that is precisely why monetary policy needs to tighten further now, not wait. Preserving the real income of working households is exactly why the Bank should fulfill its mandate of keeping prices stable around the 2% target.