Updated: Dec 30, 2022
The start of the pandemic brought a fast crash in GDP and then later, a very quick recovery as the ketchup bottle economy manifested. Yet, despite this, the current economic climate seems evermore so turbulent. With the Bank of England forecasting a long and slow recession as well as inflation rates of up to 13%, (Elliot, 2022) it is important to examine the long-lasting effects that policy responses, as well as the pandemic itself, will have on the stage of the UK’s business cycle. By exploring measures such as the annualised rate of money broadly defined, and, the UK’s productive output, the following column will aim to forecast what will occur to CPI inflation rates, asset prices, and interest rates in the coming years.
The UK's total GDP has recovered since the start of the pandemic. (Figure 1) This recovery in economic growth has been fuelled by an expansion in aggregate demand aided by significant monetary & fiscal stimulus. Concerning monetary policy, M4 rose drastically (Figure 2a) when QE measures of £895bn were implemented. (Romei, 2022) This decision, whilst yielding increased liquidity for the financial sector, did not materialise into higher growth as the monetary transmission mechanism was frozen in a deadlock state due to lockdowns. Yet, approximately one-year post-injection, vaccine doses per 100 reached 80, (Figure 3) and the relaxation of lockdown restrictions followed allowing economic agents to take advantage of the now more plentiful, and cheaper, credit as interest rates were cut to historic lows. (Chapman, 2021) Moreover, high savings due to the fiscal stimulus provided in schemes like Furlough (ONS, 2022) allowed the UK to recover from the pandemic demand shock. All of this led to the ‘ketchup-bottle’ scenario where a large amount of liquidity and spending was released into the economy as lockdowns distorted consumer spending and saving patterns. Consequently, this initial boost led to a quick increase in aggregate demand levels, a conclusion that is reinforced when looking at the fast growth and recovery in UK GDP.
However, this perspective neglects the aggregate supply recovery, and, with the Ukraine conflict, popular consensus suggests the UK’s output has been significantly hindered. However, figures demonstrate that the UK’s total output has almost returned to pre-pandemic levels, showing that this is not the case. (Figure 4a) In fact, the Ukraine conflict is placing little pressure on UK aggregate supply as the economy receives a large portion of its gas imports from the Norweigan pipeline. (BEIS, 2022) Aside from the conflict, other global cost-push channels such as China’s COVID policy which has 30 million under lockdown (Bloomberg, 2022) are placing some strain on UK production as China is the UK’s largest import partner. (Trading Economics, 2021a) As such, with productive output being slightly below the base year, (Figure 4b) the remaining slack indicates that from a supply point of view, the UK is still recovering, this means the recovery in GDP from COVID can be traced to aggregate demand levels that are above trend.
Yet, the boom in aggregate demand is a fragile one. Granted, a tight labour market, (Figure 5) rising credit, (Figure 6) and increasing nominal wages (Figure 7) do indicate that demand pressures will continue to rise. But, this growth is sourced from an artificial expansion in broad money. (Figure 2b) Rising nominal wages are a product of a tight labour market supported by demand derived from cheaper and plentiful credit. All of this is feeding into higher rates of inflation, (Trading Economics, 2022) forcing the Bank of England to respond with interest rate hikes. (Trading Economics, 2021b), Such a trend will continue in future as policymakers attempt to steer economic agents away from cheap credit. Additionally, rising interest rates can tame spending by depreciating risky assets such as equities, yielding a negative wealth effect. Forecasted CPI prices of 13% paired with higher interest rates will accelerate the reduction in real disposable incomes that come from Krugman’s doctrine of higher inflation solving high rates of inflation. This scenario will depress aggregate demand levels, which, will bring inflation closer to the 2% CPI target and will yield the correction the Bank of England is looking for. This is despite the Bank of England forecasting CPI prices to be below target. Such overcompensation is a necessary correction that comes as a result of the UK economy experiencing an over-stimulation of aggregate-demand growth fuelled by overzealous expansions of loose monetary policy.
Bank of England (2022). How High Will Inflation go? [online] www.bankofengland.co.uk. Available at: https://www.bankofengland.co.uk/knowledgebank/will-inflation-in-the-uk-keep-rising#:~:text=The%20rate%20of%20inflation%20is
BEIS (2022). About This Release Information on Energy production, trade, and Consumption in the UK for Total Energy and by Specific Fuels. [online] Available at: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1086807/Energy_Trends_June_2022.pdf
Bloomberg (2022). Bloomberg - Some 30 Million People Face Covid Curbs: China Lockdown Tracker. [online] www.bloomberg.com. Available at: https://www.bloomberg.com/news/articles/2022-07-11/some-30-million-people-face-covid-curbs-china-lockdown-tracker
Chapman, B. (2021). Bank of England Warns Supply Problems Will Slow UK Economy. [online] The Independent. Available at: https://www.independent.co.uk/news/business/bank-england-interest-rates-latest-b1951388.html
Elliot, L. (2022). Bank of England Hikes Interest Rates and Says Inflation Will Hit 13%. [online] The Guardian. Available at: https://www.theguardian.com/business/2022/aug/04/bank-of-england-raises-interest-rates-to-1-point-75-per-cent-in-biggest-hike-in-27-years
ONS (2022). Economic Modelling of Forced Saving during the Coronavirus (COVID-19) Pandemic - Office for National Statistics. [online] www.ons.gov.uk. Available at: https://www.ons.gov.uk/economy/nationalaccounts/uksectoraccounts/articles/economicmodellingofforcedsavingduringthecoronaviruscovid19pandemic/2022-06-06#:~:text=1
Romei, V. (2022). BoE Signals ‘Very Gradual’ Approach to Quantitative Tightening. Financial Times. [online] 25 Feb. Available at: https://www.ft.com/content/67aa9433-db2b-400a-90cd-2019b404f8eb
Trading Economics (2021a). UK Interest Rate. [online] Tradingeconomics.com. Available at: https://tradingeconomics.com/united-kingdom/interest-rate
Trading Economics (2021b). United Kingdom Imports by Country. [online] tradingeconomics.com. Available at: https://tradingeconomics.com/united-kingdom/imports-by-country
Trading Economics (2022). UK April Inflation Rate below Forecasts at 2.1%. [online] Tradingeconomics.com. Available at: https://tradingeconomics.com/united-kingdom/inflation-cpi