Time for some straight talking from Bank governor about UK economy

What cannot be unseen, however, is how, once again, the UK has borne the brunt of the shift in market expectations for both interest rates, and inflation. Markets perceive that the UK is one of the countries most exposed to a surge in global inflation. The bond market is signaling that a recession is a very real possibility. Unfortunately, that signal illustrates that for all the Chancellor, Rachel Reeves’ aspirations for economic stability, the UK economy is still seen as acutely vulnerable to external shocks. Resilience is in short supply. The cost of borrowing for ten years to finance a UK fiscal deficit running at £140bn/ year has surged to levels last seen in 2008. The interest rate paid on UK government debt is 0.6% higher than any other country in the G7. Investors in UK assets are demanding a new inflation premium for what might be just around the corner.

Whilst Middle Eastern events are the root cause of the spike in UK borrowing costs, there are also domestic components that have heaped fuel on the fire. Factions within the Labour Party have chosen an inopportune moment to gear themselves up for a leadership challenge. The potential for a change in Prime Minister that ushers in even more public spending, and more borrowing, has spooked investors. Catalysing those fears was commentary from the Bank of England that suggested they might not be as amenable to looking through transitory inflation as they were in 2021. Taken together it has been quite the cocktail for financial markets to absorb.

For a government that has, somewhat awkwardly, patted itself on the back for being in office whilst six interest rate cuts have been delivered by the Bank of England, this has come as a shock. The cornerstone of Labour’s economic message is being chiseled away. There is a decent chance that Labour MPs, having begun to turn their guns on the Office for Budget Responsibility - and emboldened by an increasingly vociferous Angela Rayner - turn their crosshairs on the Bank of England. For former Prime Minister, Liz Truss, imitation must be the sincerest form of flattery.

Such political fallout would pose a challenge that both the Bank of England Governor, Andrew Bailey – privately - and external members of the MPC - publicly - should address head-on. This is not the moment for mixing their words.

The reason that the Bank of England is seen by investors as having to react so forcefully is that successive UK governments have deeply impaired the supply-side of the UK economy. It has resulted in a rapid buildup of public sector debt, and tax rates at an eighty-year high. A once flexible and nimble UK economy has been weighed down with luxury beliefs that have acted to crush living standards, trend growth, and the run rate of economic activity that can occur in the without generating high inflation.

The UK economy’s flexibility and its capacity to absorb shocks has been steadily diminished. Brexit has damaged the fluidity of cross-border trade. Employment regulations have damaged the flexibility of the labour market to adapt to change. Energy rationing has made us price takers for an essential economic input. Administrative and legal barriers to construction have seen the UK build at half the rate of the wider G7. You can’t do this much damage to the supply side of your own economy - over the course of decades - and expect to have a high level of resilience.

For the Bank of England Governor – who we are informed is in daily contact with the Chancellor throughout this crisis – he should be delivering some home truths. The job of the monetary authority is made harder should these supply side barnacles be allowed to persist, and grow. Should the looming spike in UK inflation trigger the political necessity for a bailout to underscore demand, the Governor should be very clear this will necessitate higher interest rates. UK inflation has averaged 3% a year since 2010, and there are only so many occasions that a monetary authority can look through shocks and retain its credibility. For a Governor now into his last two years of an eight-year term this is the time to speak truth unto power.  

For the four external members of the Monetary Policy Committee – occupying roles explicitly added to the Committee in 1997 to provide independent thought and challenge – the role is different. It should involve explaining, publicly if necessary, how higher interest rates, should they be required, will be a result of this increasingly sclerotic supply side presided over by successive governments. There has been too little made of the fact that the job of setting interest rates at a level that supports growth has become progressively harder since the Bank of England gained independence. It may not be a popular message in Westminster, but it is a message that needs to be heard. Supply side reforms are not intuitively popular, but the connection to higher interest rates, less investment, lower living standards needs to be made. Cabinet Ministers have too often shied away from them. Truss’ attempts at such a supply side agenda required a sniper’s precision. She unleashed a misfiring blunderbuss. 

Events 3000 miles to the East of the UK may yet mean the economy dodges a bullet. Let us hope so. But recent events should act as a salutary lesson that the UK economy’s ongoing rationing of key aspects of its economy - notably energy, land, and capital - gives policymakers few palatable options when shocks hit. British living standards get squeezed either way. The Bank of England has an important job to do in explaining why.