Stubborn inflation is the root cause of our sluggish economy
By Simon French, Chief Economist and Head of Research
The UK has an inflation problem. It is one that predates the ongoing conflict in Iran, and the Ukraine War. Consumer price growth has averaged 3% a year since 2010. Across the remainder of the G7 the equivalent average inflation rate has been just 2%. This doesn’t sound like a huge difference. But compound this over sixteen years and the purchasing power of the Pound, the real-terms growth in UK living standards, and economic growth have all faced into considerable headwinds from inflation. There is little prospect of a sustained rebound in these important economic measures without diagnosing - and then addressing - the cause of the Renewed British Disease. In short, the price of conducting economic activity in the UK has become internationally uncompetitive. Attracting the jobs of the future, building the homes and infrastructure needed, and encouraging investment relies on high pace, and low price. The UK has developed the opposite combination.
The current Labour government came in saying all the right things. Growth was to be its number one Mission. Stability was to be a watchword. After two years it hasn’t worked out that way. GDP growth per person at just 0.7% a year has been even slower than under the Conservatives and Coalition at 0.9%. There are now fewer jobs in the UK than there were at the start of the Parliament. Electricity costs remain the highest in the world with the UK’s energy policies attracting sympathy, rather than respect from our international peers.
Defenders of the government – and I find myself doing this a lot in my day job – point to longstanding issues that emerged long before Labour took office. The problem with that truism is the widespread suspicion that in key areas necessary for vibrant economic growth things are getting worse.
And in my view all roads lead back to inflation. Three areas stand out.
House prices for purchase and for rent are not just a serious impediment to labour mobility, they also push up inflation. Since 1980, the UK has built housing at half the rate of the G7 average. Since July 2024 housing starts across the UK have fallen 15% from their rate under the Conservatives.
Turning to energy. Electricity costs have risen from the same level as the US as recently as 2004, to four times their level today. The most recent allocation round for Contracts for Difference (CfD) - whilst securing welcome additional supply - lock in what are currently internationally uncompetitive wholesale prices. “Wack-a-mole” support schemes for businesses and households do little to tackle the underlying problem that building out new generating and grid capacity in the UK is an expensive endeavour. Billpayers, ultimately, pick up the tab in the form of higher prices.
Then there is investment. The higher cost of capital faced by UK businesses stems back to regulatory and tax changes made in recent decades that actively encourages investment away from the UK. Mandating powers to direct investment - something the government appears keen to persist with despite fierce opposition in the House of Lords – recognises the problem, but has flunked the solution. The result is higher domestic prices for building infrastructure and conducting research.
A country where land use, energy consumption, and capital deployment is expensive will have a high inflation rate. And this is precisely what has happened.
My fear is that rather than diagnose these upstream causes of inflation and prioritise getting down the costs of land, energy and capital - the government is focusing on downstream solutions. It is the wrong, and more costly, approach.
Faced by high costs of building the taxpayer has been asked to find £39bn for an affordable housing program. There are also sustained market rumours of a successor to Help to Buy being required to address stalling demand. Both put additional requirements on an already stretched government balance sheet.
Faced by high energy costs, the government has been forced to unveil a British Industrial Competitiveness Scheme for energy-intensive businesses. The left flank of UK politics is also heaping on pressure to also provide energy cost support for households. Any such interventions will eat into the Chancellor’s precarious headroom against her fiscal rules. It will also make the Bank of England’s job of returning inflation to 2% all the harder.
Faced by a high cost of capital, the government have created a phalanx of Public Sector Financial Institutions (PuFins). The British Business Bank, The National Wealth Fund, and the National Housing Bank. These are costly admissions of failure of capital markets regulation. Rather than allocating purely strategic capital, these institutions are being asked to operate in arenas where private capital has been regulated away.
The downstream approach to tackling the UK’s economic problems is an ongoing problem. Often the intellectual insights that frame public policy originate within think tanks for whom new institutions and new programs are the default recommendation. The current cohort of MPs has a healthy representation of people with a background in these think tanks, rather than from the private sector. The policies that result have, despite their noble intent, obscured the timeless value to be found in price signals.
It is possible that the Prime Minister’s troubles over the Mandelson affair, and what looks to be crushing local election results for Labour, will trigger a political reboot. With financial markets already applying a high inflation premium on UK government debt and the tax burden already set to rise by the fastest amount in the G7 the room for direct changes to tax and spending policies are constrained for all pretenders to the throne.
The only path is to head upstream to address the root causes of the UK’s sluggish economic performance. The prize is huge at a time of significant economic and security peril. By my estimates a removal of the UK inflation premium on UK government debt will unlock £16bn a year of reduced debt interest payable to the UK’s creditors. That will be more than enough to unlock the funding gaps in the Defence Investment Plan. Even before recent events in the Gulf, inflation was always going to define this Parliament. Nothing has changed.
