Andrew Sentance’s economics blog

This page hosts Andrew Sentance’s economics blog which I have been posting on and off since 2011. The latest series of blogs date from the end of 2023, with the most recent article at the top of the page.

Growth – the missing ingredient in UK Economic Policy

published in The Times, 23 January 2024

Rishi Sunak and his Chancellor, Jeremy Hunt, have recently been very keen to trumpet their success in reducing inflation – one of the Prime Minister’s five pledges which he made at the start of last year. They are, however, less keen to remind us about their lack of progress towards another of the PM’s economic pledges, which was to create a growing economy.

Prior to the Global Financial Crisis (2007-09), the UK economy achieved an average annual growth rate of over 2% a year. Yet in the latest twelve months (to November 2023), UK GDP has increased by just 0.2%. That is a big ‘fail’ for one of Rishi Sunak’s key economic pledges. So why has UK economic growth been so weak, and what can be done to reinvigorate it?

The UK’s poor economic growth performance is not a new phenomenon. Since 2007, GDP in the UK has expanded by just over 1% per annum. Our economy is not alone in experiencing this track record of disappointing economic growth over the past decade and a half. Being part of a slow-growing world economy affected by the shocks of the Global Financial Crisis and the Covid pandemic has also reduced economic growth in our peer group of economies – in Europe and North America.

However, even allowing for subdued global growth and major shocks, UK economic growth performance has been very disappointing. Since the end of 2019 – before the start of the pandemic – UK GDP has risen by just over 2%, around 0.5% a year. So over the past four years, UK economic growth has been less than a quarter of the rate we had been accustomed to before the Global Financial Crisis.

There is therefore a long term and a short term dimension to the UK’s disappointing economic growth. In addition to the global growth slowdown since the Global Financial Crisis, the UK has performed particularly badly in the past few years – and government economic policy has not been able to combat this growth slow down.

Why does this matter? Economic growth underpins rising living standards and a sense of improved economic well-being. That is why Rishi Sunak made it one of his five pledges at the beginning of last year. Economic growth also provides the underpinning for increased public spending on health, education and other public services by generating higher tax receipts. So our recent very disappointing growth performance is feeding into the malaise created by the ‘cost of living crisis’ and dissatisfaction with public services.

What could the government have done to combat this poor growth performance? Government policies to stimulate economic growth fall into two categories. In the first category are policies which are aimed at pumping more money into the economy to provide a short-term spending boost.  However, such policies are not sustainable over the longer term if all they do is pump more borrowed money into the economy.  A lasting improvement in economic growth can only come about from well-targeted ‘supply-side’ policies which provide better conditions for businesses to create jobs, raise productivity and generate higher economic activity. However, the growth benefits of successful supply-side policies are only realised over the long-term, e.g. in a period of at least 5-10 years. They do not provide a quick fix for economic growth, which Rishi Sunak and Jeremy Hunt appear to be looking for.

The types of policies which would make up a successful supply-side growth plan include investment in transport infrastructure, education and skills as well as reducing regulation which holds back business – for example from the planning system.  It is also important that policies aimed to help business are pursued consistently and as part of a coherent strategy. Frequent changes in policy undermine business confidence and deter investment.

When we look at the actions of the government in the last few years, however, they have not followed a consistent and coherent growth strategy of this sort. The northern phase of HS2 has been cancelled and many other policies which could boost long-term growth performance – such as higher investment in skills and education – are struggling due to lack of funding. Brexit has also been a millstone dragging down UK growth as it has resulted in increased regulation for businesses dealing with our most important overseas markets in Europe

Rishi Sunak and Jeremy Hunt are now hinting strongly that tax cuts will provide the boost to growth they are looking for, and a cut in National Insurance for employees has already taken effect this month. But tax cuts will only be sustainable if they can be achieved without undermining progress in reducing public borrowing. This means that tax cuts this year will either be very modest or will need to be followed by tax increases or spending cuts after the General Election.

The Labour Party, which is riding high in the polls, is also setting out a narrative which is founded on boosting UK economic growth. Unfortunately there is also a policy deficit in their plans. Keir Starmer has also set out a five-point plan but Labour’s policy proposals are generalised and unspecific. A key component of Labour’s growth-plan is a commitment to increase house-building – but that is something that the current government has also been trying to achieve over many years, with limited success.

On both sides of the political spectrum therefore, the cupboard is bare when it comes to specific policies to increase our national economic growth rate. The first half of this decade has seen very little progress in raising the output of the UK economy. On the basis of the current proposals from both major political parties to boost economic growth, the second half of the 2020s does not look much more promising either.

High wage growth threatens to undermine falling inflation

published in The Times, 12 December 2023

Today, the Office for National Statistics will release its latest overview of UK labour market data. So far this year, we have seen a gradual weakening in the growth of employment, accompanied by a slight rise in the unemployment rate – from below 4 percent to just over 4 percent. The number of vacancies has also dropped below one million.

But while these trends in employment, unemployment and vacancies have pointed to a cooling labour market, they still look reasonably healthy in a long-term historical context. An unemployment rate of around 4 percent is close to the level which most economists regard as “full employment”. And the number of unfilled vacancies was estimated at over 950,000 in the three months August to October, compared with 7-800,000 before the pandemic.

The figures from the labour market which are likely to create the most interest to economists and at the Bank of England, however, are the estimates of wage increases. Even though consumer price inflation fell below 5 percent in October, wage increases have continued to run at an extremely high rate. The figures released last month showed pay increases of nearly 8 percent across the economy as a whole. In the private sector, regular pay (excluding bonuses) was 7.8 percent up on a year ago and in the public sector pay was rising at 7.3 percent.

Earlier this year, the concern was that pay was not keeping up with inflation – contributing to the cost of living squeeze. Now the worry is that wage increases are too high and threaten the continued fall in inflation towards the 2 percent target. Pay will normally rise slightly faster than prices because businesses are raising their productivity – which also enables the living standards of workers to rise in real terms.  This pattern of rising productivity and increasing living standards in turn supports the growth of the economy.

Before the pandemic, when consumer price inflation was running at around 2 percent, wages were rising at 3-4 percent a year. This is consistent with longer-term trends in pay and price inflation, with wages rising 1-2 percent above prices each year.  However, 7-8 percent pay growth is totally incompatible with 2 percent inflation. We need to see wage increases falling back to around 3-4 percent again if inflation is to return to the Bank of England’s 2 percent target and stay there.

At present, this seems most unlikely – for two main reasons. First of all, employees are still looking for above-inflation pay increases to compensate for the cost of living squeeze created by the inflation surge in the past two years. Second, employers in the private sector seem willing to increase pay to ensure they can recruit and retain workers. The relatively low unemployment rate – not far above 4 percent – and the high vacancy level, close to one million unfilled jobs – continue to point to a relatively tight labour market and further upward pay pressure.

The latest evidence on wage increases and from the labour market more generally will be closely scrutinised by the Bank of England Monetary Policy (MPC) Committee when it next meets on Wednesday and Thursday. The MPC has kept rates on hold since August, and that decision appeared to be vindicated by the larger than expected fall in inflation revealed last month. But a closer look at the latest consumer prices figures gives more grounds for concern about the inflation outlook.

Though the headline CPI inflation figure dropped by more than two percentage points, from 6.7 percent to 4.6 percent, indicators of underlying inflation fell much less. “Core inflation” – excluding food, energy, alcohol and tobacco – dropped by just 0.4 percentage points, from 6.1 to 5.7 percent. A large proportion of the drop in headline inflation was accounted for by falling energy and goods prices. Services sector inflation, however, remains stubbornly high – dropping only slightly from 6.9 percent in September to 6.6 percent in October (the November figure is not available until next week).

The stickiness of these measures of underlying inflation provides further evidence that achieving the 2 percent will be a long haul. That runs counter to the optimism about falling inflation which followed the fall in inflation below 5 percent in October, and the government’s apparent success in meeting its target of “halving inflation by the end of the year”. Persistently high wage increases – continuing into next year – will give further grounds for caution about the prospect of inflation continuing to fall speedily back to the 2 percent target.

At last month’s MPC meeting, three members – a third of the Committee – voted for a further rise in interest rate to 5.5 percent. Further evidence of high wage increases and inflation stickiness could soon persuade a majority of the MPC to vote for a further rate rise, if not this week then early next year.

It is worth recalling that previous surges in inflation – in the 1970s, 1980s and early 1990s – have required interest rates to be raised to double digit levels to bring price rises under control. In these previous episodes, high wage inflation was also a factor exacerbating and perpetuating the inflation surge.

History never repeats itself exactly and we should not be expecting double digit interest rates in the current circumstances. But we cannot be confident that interest rates have reached their peak until inflation is decisively on a downward trend and is getting close to meeting the 2 percent target.

While wage increases continues to run at 7-8 percent and labour market conditions remain relatively tight, inflation is likely to remain significantly above the official target. That poses a major challenge for the MPC. It would be premature to conclude that interest rates have peaked until we have more convincing evidence from the labour market and the rate of pay increases that inflation is heading decisively back to target.