Since the Labour Government’s first budget, delivered by Chancellor Rachel Reeves, a number of subsequent measures have prompted negative comment, perhaps most obviously the rise in employers’ national insurance payments. As the new year starts and economic data indicates Great Britain is either in, or very near, a technical recession (two quarters when GDP is falling), many have linked this slowdown to Reeves’ budget.
Leaving aside the question of the relatively poor economic growth that Britain has experienced over the last decade or more, how likely is it that Reeves’ budget has been the cause of the latest dip in what was already a weak record of economic performance?
While increasing costs to employers might immediately hit business sentiment, they do not actually come into force for a couple more months, so let’s look at the possibility that the Bank of England’s interest rate policy has played a more significant role in this most recent recessionary period.
Why interest rate policy and time lags matter
Interest rate policy is one of the key fiscal mechanisms used by all governments to constrain and reduce inflation. The British government uses the Bank of England to affect this policy by providing a target for aggregate (or headline) inflation, which is currently 2%, and leaving the Bank to operate interest rate policy to reach that inflation target.
By manipulating the interest rates available in the market for credit, the Bank aims to influence financial conditions (the provision of credit), shaping the expectations of market actors, and reducing economic activity (through the availability of credit) and thereby slowing inflation.
The Bank sees inflation as primarily a monetary phenomenon; too much money chasing too few goods. By raising interest rates the Bank seeks to bring down inflation by reducing demand which, in turn, is seen as partly reliant on the availability of credit. The goal is that by making credit more expensive (interest rates are the price of credit) so demand for credit and by extension the purchase of goods and services is reduced, thereby reducing inflation.
I’ll return to the issue of whether inflation is only caused by credit-based demand below, but first, what is the speed of impact of interest rate policy changes? As Catherine Mann (a member of the Bank of England’s Monetary Policy Committee) points out there is always a lag between a decision to raise interest rates and the impact on economic activity.
Ms. Mann notes the conventional wisdom that this lag is between 18-24 months. However, she argues this may be quickened if interest rate changes take place during a period where there are also ‘external shocks’ to the economy but equally after a period of sustained low interest rates and low inflation, market actors may take longer to react to changed market (credit) conditions. But even with external shocks, it is clear that a change in interest rates takes some time to reach the ‘real’ economy.
This suggests that when we look at the current economic slowdown, we should link this not only to recent proposed policy changes, but to actual shifts in fiscal policy, specifically interest rate policy, over the last two years.
The Bank of England’s expressed intent
In November 2023, Andrew Bailey (Governor of the Bank of England) was clear that the Bank was waiting for an economic slowdown to ‘squeeze inflation out of the system’ while also stressing that a forecast recession in 2024 would not be a reason to lower interest rates. And while Bailey has not explicitly used the term, his relaxed approach to the prospect of recession echoes a famous remark by John Major on fiscal policy: ‘if the policy isn’t hurting, it isn’t working’.
So, while Bailey earlier in 2023 might have said: ‘we are not expecting, we are not desiring a recession. But we will do what is necessary to bring inflation down to target’, what this also confirmed was that if ‘what is necessary’ included a mild recession then so be it. And given that a recession has traditionally been the tried and tested method of bringing down inflation, by reducing ‘inflationary pressures’ to the point where inflation is reduced to the targeted level, a short recession was deemed acceptable.
The Bank of England’s clear intent has been to reduce inflation by engineering a slowdown in economic activity and given that it has been doing so for a couple of years, it should be no surprise to us that the UK is currently experiencing a period of recession or stagnation of economic growth. This is often presented as a ‘price worth paying’ which requires us to see recession as a lesser problem than inflation, but that is a different issue.
Why isn’t this being identified and reported?
As I noted, inflation may be driven by more than just a credit supported demand by British consumers. There have been a number of external issues, most clearly the rise in energy prices prompted by the war in the Ukraine. Equally, it now seems clear that Brexit has had a recent negative impact on the British economy and may have raised the inflationary pressures that the Bank of England is concerned about.
However, given the express intent of the Bank’s interest rate policy has been to produce an economic slowdown, and we are experiencing one, why haven’t the Bank’s actions been identified more clearly as a key cause?
For instance in the wake of Reeves’ Autumn Budget, the BBC was reporting two quarters of zero GDP growth (not quite a technical recession but almost) and quoting warnings from business groups regarding the impact of Reeves’ policy measures, but did not reference the Bank of England actions. And while the Daily Express did mention the Bank of England in its discussion of the ‘problems’ caused by Reeves’ budget, this was only as another institution that would respond to the situation, making no mention of the role of previous interest rate policy .
The key point is there are regular discussions of the Bank of England’s Monetary Policy Committee’s (MPC) deliberations and monthly decisions in the media. However, a separation is maintained between the future impact of interest rate decisions, including the dependence on the MPC’s judgement about inflationary pressures in the UK economy, and the economic impact of past changes in interest rates.
This is not to say that Reeves’ budget will have had no negative impact on economic activity; clearly employers are already warning of the impact of raising employment costs. However, while Reeves’ budget also included growth encouraging measures to balance the costs to business of the immediate rise in national insurance contributions, all of these are in the future. Certainly, that might imply some economic slowdown, but the shift into recession in actual economic activity is already pronounced enough for commentators to be talking about it.
However, although it is too soon for Reeves’ budget to have impacted anything other than business sentiment, there is a clear policy that can be linked to the economic slowdown; the Bank of England’s use of interest rate rises to attempt to reduce inflation.
So, the question must be: why is this being downplayed or even ignored in the media?
I will leave you to draw your own conclusions.
