The Bank of England has hiked interest rates and predicted a UK recession as the country battles record inflation that has sparked a cost of living crisis
The twin economic pressures of a recession and high inflation have raised fears that the UK is on course for a period of “stagflation” – a situation the country has not faced since the 1970s.
But what exactly does this term mean, why is it bad – and how can it be fixed?
What is stagflation?
Stagflation is an economic term used to describe a period of high inflation, relatively high unemployment, and low demand for products.
These do not necessarily occur in that order.
Stagflation was a major problem for the UK in the 1970s, but the National Institute for Economic and Social Research (NIESR) think tank warned it could be back on track.
In his latest UK economic outlook reporthe predicted that GDP growth will slow to 3.5% in 2022 and 0.5% in 2023, while unemployment will exceed 5% – it is currently at 3.8%.
It also predicted further increases in inflation and a drop in real terms in consumer purchasing power of 2.5%.
Currently, the UK is already experiencing high inflation – 9.4% in June 2022 – while the Bank of England has predicted that a recession is on the way from the last quarter of 2022.
What causes stagflation?
A sudden shock in the supply of goods can cause prices to rise rapidly.
This has been seen since the onset of the energy crisis in the autumn of 2021, when a gas shortage caused wholesale prices to spike and many UK suppliers struggled to cope with costs.
There are other examples elsewhere as well, with the slowdown more pronounced in manufacturing, where output has grown only modestly over the past 12 months due to severe supply chain disruptions and a slowdown demand.
Why is stagflation bad?
Stagflation is a period when there is a disruption in product demand, high inflation, and higher unemployment.
Ultimately – if the economy shrinks, demand falls and more people end up unemployed – the private sector becomes less willing or unable to invest in the UK economy, and the government cannot generate as much revenue. money through taxation.
Less revenue for the public treasury means that public spending could be reduced – which could lead to cuts in public services and public sector wages, as well as a lack of fiscal space to provide more cost-of-living support .
That leaves the UK’s next prime minister – Liz Truss or Rishi Sunak – facing tough decisions on how to get the economy back on track.
For example, high inflation and weak demand saw the Purchasing Managers’ Index (PMI) – an indicator of manufacturing confidence – fall to a 25-month low of 52.1 in July 2022.
“Rising market uncertainty, the cost of living crisis, the war in Ukraine, ongoing supply issues and inflationary pressures are all hitting demand for goods at the same time, while the ongoing post-Brexit and a darkening global economic backdrop is hampering exports,” said Rob Dobson, director of S&P Global Market Intelligence – a financial analyst firm.
“With the Bank of England implementing further interest rate hikes to fight inflation, the outlook is plagued with downside risks. is not surprising.”
However, Mr Dobson added that there was a silver lining as inflation and supply chain disruption appear to have peaked.
How to solve stagflation?
Once stagflation occurs, it can be difficult to stop it, with policymakers having to reduce inflation and unemployment at the same time.
Lower inflation in the long term is believed to generally increase unemployment in the short term. Similarly, lower short-term unemployment increases long-term inflation.
In its report, the NIESR urged the government to tackle the problem by introducing more targeted support for vulnerable households, raising public sector wages and lowering trade barriers with the UK’s biggest trading partner, the EU.
On the latter front, he warned against starting a trade war with the EU over the Northern Ireland protocol.