Category: Economics: Ch 15

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The UK Autumn Statement 2022

The Autumn Statement was announced by Jeremy Hunt in Parliament on Thursday 17th November. This was Hunt’s first big speech since becoming Chancellor or the Exchequer a few weeks ago. He revealed to the House of Commons that there will be tax rises and spending cuts worth billions of pounds, aimed at mending the nation’s finances. It is hoped that the new plans will restore market confidence shaken by his predecessor’s mini-Budget. He claimed that the mixture of tax rises and spending cuts would be distributed fairly.

What is the Autumn statement?

The March Budget is the government’s main financial plan, where it decides how much money people will be taxed and where that money will be spent. The Autumn Statement is like a second Budget. This is an update half a year later on how things are going. However, that doesn’t mean it is not as important. This year’s Autumn Statement is especially important given the number of changes in government in recent months. The Statement unfortunately comes at a time when the cost of living is rising at its fastest rate for 41 years, meaning that it is going to be a tough winter for many people.

Statement overview

It was expected that the Statement was not going to be one to celebrate, given that the UK is now believed to be in a recession. The Office for Budget Responsibility (OBR) forecasts that the UK economy will shrink by 1.4% next year. However, Hunt said that his focus was on stability and ensuring a shallower downturn. The Chancellor outlined his ‘plan for stability’ by announcing deep spending cuts and tax rises in the autumn statement. He said that half of his £55bn plan would come from tax rises, and the rest from spending cuts.

The Chancellor plans to tackle rising prices and restore the UK’s credibility with international markets. He said that it will be a balanced path to stability, with the need to tackle inflation to bring down the cost of living while also supporting the economy on a path to sustainable growth. It will mean further concerns for many, but the Chancellor argued that the most vulnerable in society are being protected. He stated that despite difficult decisions being made, the plan was fair.

What was announced?

The government’s overall strategy appears to assume that, by tightening fiscal policy, monetary policy will not have to tighten as much. The hopeful consequence of which is that interest rates will be lower than they otherwise would have been. This means interest-rate sensitive parts of the economy, the housing sector in particular, are more protected than it would have been.

The following are some of the key measures announced:

  • Tax thresholds will be frozen until April 2028, meaning millions will pay more tax as their nominal incomes rise.
  • Spending on public services in England will rise more slowly than planned – with some departments facing cuts after the next election.
  • The state pensions triple lock will be kept, meaning pensioners will see a 10.1% rise in weekly payments.
  • The household energy price cap per unit of gas and electricity has been extended for one year beyond April but made less generous, with typical bills then being £3000 a year instead of £2500.
  • There will be additional cost-of-living payments for the ‘most vulnerable’, with £900 for those on benefits, and £300 for pensioners.
  • The top 45% additional rate of income tax will be paid on earnings over £125 140 instead of £150 000.
  • The UK minimum wage (or ‘National Living Wage’ as the government calls it) for people over 23 will increase from £9.50 to £10.42 per hour.
  • The windfall tax on oil and gas firms will increase from 25% to 35%, raising £55bn over the period from now until 2028.

The public finances

A key feature of the Autumn Statement was the Chancellor’s attempt to tackle the deteriorating public finances and to reduce the public-sector deficit and debt. The following three charts are based on data from the OBR (see data links below). They all show data for financial years beginning in the year shown. They all include OBR forecasts up to 2025/26, with the forecasts being based on the measures announced in the Autumn Statement.

Figure 1 shows public-sector current expenditure and receipts and the balance between them, giving the current deficit (or surplus), shown by the green bars. Current expenditure excludes capital expenditure on things such as hospitals, schools and roads. Since 1973, there has been a current deficit in most years. However, the deficit of 11.5% of GDP in 2020/21 was exceptional given government support measures for households and business during the pandemic. The deficit fell to 3.3% in 2021/22, but is forecast to grow to 4.6% in 2022/23 thanks to government subsidies to energy suppliers to allow energy prices to be capped. (Click here for a PowerPoint of this chart.)

Figure 2 shows public-sector expenditure (current plus capital) from 1950. You can see the spike after the financial crisis of 2007–8 when the government introduced various measures to support the banking system. You can also see the bigger spike in 2020/21 when pandemic support measures saw government expenditure rise to a record 53.0% of GDP. It has risen again this financial year to a predicted to 47.3% of GDP from 44.7% last financial year. It is forecast to fall only slightly, to 47.2%, in 2023/24, before then falling more substantially as the tax rises and spending cuts announced in the Autumn Statement start to take effect. (Click here for a PowerPoint of this chart.)

Figure 3 shows public-sector debt since 1975. COVID support measures, capping energy prices and a slow growing or falling GDP have contributed to a rise in debt as a proportion of GDP since 2020/21. Debt is forecast to peak in 2023/24 at a record 106.7% of GDP. During the 20 years from 1988/89 to 2007/8 it averaged just 30.9% of GDP. After the financial crisis of 2007–8 it rose to 81.6% by 2014/15 and then averaged 82.2% between 2014/15 and 2019/20. (Click here for a PowerPoint of this chart.)

Criticism

The government has been keen to stress that Mr Hunt’s statement does not amount to a return to the austerity policies of the Conservative-Liberal Democrat coalition government, in office between 2010 and 2015. However, Labour Shadow Chancellor, Rachel Reeves, said Mr Hunt’s Autumn Statement was an ‘invoice for the economic carnage’ the Conservative government had created. There have also been some comments raised by economists questioning the need for spending cuts and tax rises on this scale, with some saying that the decisions being made are political.

Paul Johnson, the director of the Institute for Fiscal Studies has commented on the plans, stating that the British people ‘just got a lot poorer’ after a series of ‘economic own goals’ that have made a recovery much harder than it might have been. He went on to say that the government was ‘reaping the costs of a long-term failure to grow the economy’, along with an ageing population and high levels of historic borrowing.

Disapproval also came from Conservative MP, Jacob Rees-Mogg, who criticised the government’s tax increases. He raised concerns about the government’s plans to increase taxation when the economy is entering a recession. He said, ’You would normally expect there to be some fiscal support for an economy in recession.’

Economic Outlook

High inflation and rising interest rates will lead to consumers spending less, tipping the UK’s economy into a recession, which the OBR expects to last for just over a year. Its forecasts show that the economy will grow by 4.2% this year but will shrink by 1.4% in 2023, before growth slowly picks up again. GDP should then rise by 1.3% in 2024, 2.6% in 2025 and 2.7% in 2026.

The OBR predicts that there will be 3.2 million more people paying income tax between 2021/22 and 2027/28 as a result of the new tax policy and many more paying higher taxes as a proportion of their income. This is because they will be dragged into higher tax bands as thresholds and allowances on income tax, national insurance and inheritance tax have been frozen until 2028. Government documents said these decisions on personal taxes would raise an additional £3.5bn by 2028 – the consequence of ‘fiscal drag’ pulling more Britons into higher tax brackets. The OBR expects that there will be an extra 2.6 million paying tax at the higher, 40% rate. This is going to put more pressure on households who are already feeling the impact of inflation on their disposable income.

However, this pressure on incomes is set to continue, with real incomes falling by the largest amount since records began in 1956. Real household incomes are forecast to fall by 7% in the next few years, which even after the support from the government, is the equivalent of £1700 per year on average. And the number unemployed is expected to rise by more than 500 000. Senior research economist at the IFS, Xiaowei Xu, described the UK as heading for another lost decade of income growth.

There may be some good news for inflation, with suggestions that it has now peaked. The OBR forecasts that the inflation rate will drop to 7.4% next year. This is still a concern, however, given that the target set for inflation is 2%. Despite the inflation rate potentially peaking, the impact on households has not. The fall in the inflation rate does not mean that prices in the shops will be going down. It just means that they will be going up more slowly than now. The OBR expects that prices will not start to fall (inflation becoming negative) until late 2024.

Conclusion

The overall tone of the government’s announcements was no surprise and policies were largely expected by the markets, hence their muted response. However, this did not make them any less economically painful. There are major concerns for households over what they now face over the next few years, something that the government has not denied.

It has been suggested that this situation, however, has been made worse by historic choices, including cutting state capital spending, cuts in the budget for vocational education, Brexit and Kwasi Kwarteng’s mini-Budget. It is evident that Britons have a tough time ahead in the next year or so. The UK has already had one lost decade of flatlining living standards since the global financial crisis and is now heading for another one with the cost of living crisis.

Articles

Videos

Analysis

  • Autumn Statement 2022 response

    • Institute for Fiscal Studies, Stuart Adam, Carl Emmerson, Paul Johnson, Robert Joyce, Heidi Karjalainen, Peter Levell, Isabel Stockton, Tom Waters, Thomas Wernham, Xiaowei Xu and Ben Zaranko (17/11/22)

  • Help today, squeeze tomorrow: Putting the 2022 Autumn Statement in context

    • Resolution Foundation, Torsten Bell, Mike Brewer, Molly Broome, Nye Cominetti, Adam Corlett, Emily Fry, Sophie Hale, Karl Handscomb, Jack Leslie, Jonathan Marshall, Charlie McCurdy, Krishan Shah, James Smith,
    Gregory Thwaites & Lalitha Try (18/11/22)

Government documentation

Data

Questions

  1. What do you understand by the term ‘fiscal drag’?
  2. Provide a critique of the Autumn Statement from the left.
  3. Provide a critique of the Autumn Statement from the right.
  4. What are the concerns about raising taxation during a recession?
  5. Define the term ‘windfall tax’. What are the advantages and disadvantages of imposing/increasing windfall taxes on energy producers in the current situation?
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The Pound Sterling – A week of Turmoil

On 23 September, the new Chancellor of the Exchequer, Kwasi Kwarteng, announced his mini-Budget. It revealed big tax-cutting plans with the aim of stimulating economic growth. See the blog From Reaganomics to Trussonomics for details. However, the announcement triggered a crisis of confidence in the markets. The government says the measures will kickstart economic growth, but with the tax cuts funded through extra government borrowing, markets have raised alarm over the plans, sending the pound plunging.

On Monday 26 September, traders in the UK awoke to see that the pound had fallen to the new lowest level on record against the dollar of $1.03. Although it came at a time when the markets expected the pound to weaken, the announcement pushed a fall in the pound beyond previous expectations. Concerns about where the extra money would come from to pay for the tax cuts were reflected in market movements. A weaker currency suggests investors’ faith in a country’s economic prospects is wavering.

What does a falling pound mean?

The pound’s value affects everyone – from shoppers to business owners and investors. The main impacts of the falling pound include:

  • Higher prices. A fall in the value of the pound will increase the price of goods and services imported into the UK from overseas. When the pound is weak against the dollar, it costs more for companies in the UK to buy things such as food, raw materials or parts from abroad. Firms are likely then to pass on some or all those higher costs to their customers.
  • Higher mortgage repayments. By increasing inflation, a falling pound is likely to push the Bank of England to raise interest rates to counter this. With two million people in the UK on a tracker or variable rate mortgage, monthly costs could increase substantially. Lenders are also likely to increase the rates charged on credit cards, bank loans or car loans.
  • Further pressure on energy costs. The price of all of the gas that the UK uses is based on the dollar – even if the gas is produced in the UK. As oil prices are based on the dollar, petrol and diesel could also be more expensive for UK drivers as it costs more to be imported by fuel companies. Although the dollar price of oil has been falling in recent weeks, consumers are not likely to see the benefit at the pump due to the slide in the value of the pound.
  • Stronger sales for UK firms who sell goods abroad. Some businesses in the UK could get a boost from a fall in the value of the pound. A cheaper pound makes it less expensive for people from around the globe to buy goods and services from British firms, making them more competitive.
  • More expensive trips abroad. The plunge in the pound means that people’s holiday money won’t stretch as far, particularly for anyone planning a trip to the USA. The depreciation of the pound could also see airlines face sharply increased costs, with fuel and aircraft leases often denominated in dollars.

Threat to confidence

The Bank of England said a weaker outlook for the UK economy as well as a stronger dollar were putting pressure on sterling. However, market responses were clear that Kwarteng’s mini-Budget was threatening to undermine confidence in the UK. The pound plunged to its lowest since Britain went decimal in 1971, as belief in the UK’s economic management and assets evaporated.

By Tuesday 27 September, there were expectations that the Bank of England would have to raise interest rates to counter the extra spending in the mini-Budget. Economists from the City suggested the slump in the pound would not just force the Bank of England into raising rates at the next MPC announcement in November, but to intervene now by announcing an emergency interest rate rise to support the currency. This sent mortgage activity into a frenzy as brokers worked around the clock to help clients secure deals before lenders pulled their products or replaced them with more expensive ones. By the end of the week there were 40% fewer products available than before the mini-Budget.

The Bank of England

In August, the Bank predicted that the UK would go into recession, lasting some 15 months. It did so as it raised interest rates by the highest margin in 27 years (0.5 percentage points) in a bid to keep soaring prices under control. Higher interest rates can make borrowing more expensive, meaning people have less money to spend and prices will stop rising as quickly. The Bank of England is expected to raise interest rates by an even larger amount to combat the inflationary impact of the mini-Budget, as a weakening pound drives up costs of imports. The money markets are pricing a doubling of UK interest rates to more than 5% by next summer.

On Thursday 29 September the cost of government borrowing was rising to levels many economists thought were concerning. After the mini-Budget, the UK Debt Management Office, which borrows on behalf of the government by issuing new government bonds (‘gilts’), plans to raise an additional £72bn before next April, raising the financing remit in 2022/23 to £234bn. The investors in bonds are mainly large institutions, such as pension funds.

New bonds are issued at a fixed payment per annum based on the face value. If interest rates rise, then new bonds must pay a higher amount per annum to attract purchasers. Old bonds with a relatively low payment per year will fall in value. For example, if a £100 bond issued a while back paid £2 per annum (a nominal 2%) and interest rates on equivalent assets rose to 4%, the market price of the bond would fall to £50, as £2 per annum is 4% of £50. This percentage of the market price (as opposed to the face value) is known as the ‘yield’. With worries about the rise in government borrowing, bond prices fell and yields correspondingly rose. Investors were demanding much higher interest rates to lend to the UK government.

The Investment Director at JM Finn compared investing in government bonds to sloths, they’re low risk and typically don’t move. This is because lending to the UK is usually considered as an ultra-safe bet. However, some bonds fell in price by 20% in two days (26–28 September).

There was concern that the mini-Budget threatened the financial health of Britain’s biggest pensions and insurance companies, which together manage trillions of pounds of people’s cash. These companies hold large amounts of UK government bonds and the fall in their price was significantly reducing the value of their assets.

The Bank of England thus announced that it would step in to calm markets, warning that continued volatility would be a ‘material risk to UK financial stability’. The Bank would start buying government bonds at an ‘urgent pace’ to help push their price back up and restore orderly market conditions. It would set aside £65bn to buy bonds over 13 working days. It is hoped that the Bank’s action will now ease the pressure on pension funds and insurance companies.

But the purchase of bonds increases money supply. This was the process by which money supply was increased during periods of quantitative easing (QE). Increasing money supply, while helping to dampen the rise in interest rates and stabilise the financial markets, is likely to lead to higher inflation. The Bank of England had previously planned to do the opposite: to engage in quantitative tightening (QT), which involves selling some of the stock of (old) bonds which the Bank had accumulated during the various rounds of QE.

Despite the Bank of England’s action which helped to curb the fall in the sterling exchange rate, some analysts warned it could fall further and could even reach parity with the dollar. There are concerns that the Bank is simply firefighting, rather than being able to solve the wider problems. There is now growing pressure on the government to make clear the financial cost of its tax cuts and spending plans.

Criticism from the IMF

There has been widespread criticism of the government’s plan, with the International Monetary Fund warning on Tuesday 27 September that the measures were likely to fuel the cost-of-living crisis and increase inequality. The stinging rebuke from the IMF arrived at the worst moment for the UK government. The IMF works to stabilise the global economy and one of its key roles is to act as an early economic warning system. It said it understood the package aimed to boost growth, but it warned that the cuts could speed up the pace of price rises, which the UK’s central bank is trying to bring down. In an unusually outspoken statement, the IMF said the proposal was likely to increase inequality and add to pressures pushing up prices.

Mark Carney, the former Governor of the Bank of England also criticised the government, accusing them of ‘undercutting’ the UK’s key economic institutions. Mr Carney said that while the government was right to want to boost economic growth, ‘There is a lag between today and when that growth might come.’ He also criticised the government for undercutting various institutions that underpin the overall approach, including not having an OBR forecast.

What is next for the economy?

Before the announcement, the Bank had expected the economy to shrink in the last three months of 2022 and keep shrinking until the end of 2023. However, some economists believe the UK could already be in recession. The impacts of the mini-Budget have so far not alleviated fears of the UK diving into recession. However, the Governor of the Bank of England, Andrew Bailey, also warned that little could be done to stop the UK falling into a recession this year as the war in Ukraine continued. He added that it would ‘overwhelmingly be caused by the actions of Russia and the impact on energy prices’.

Despite the external pressures on the economy, it is clear that recent market activity has damaged confidence. The Bank has already said it will ‘not hesitate’ to hike interest rates to try to protect the pound and stem surging prices. Some economists have predicted the Bank of England will raise the interest rate from the current 2.25% to 5.75% by next spring.

The Bank’s action of emergency bond purchases helped provide Kwarteng with some respite from the financial markets after three days of turmoil, which included strong criticism of the mini-Budget from the International Monetary Fund, about 1000 mortgage products pulled and interest rates on UK government bonds hitting their highest level since 2008.

On 3 October, at the start of the Conservative Party annual conference, Kwarteng announced that the planned cut in the top rate of income tax from 45% to 40% would not go ahead. This showed that the government would change course if pressure was strong enough. That day, the sterling exchange rate against the dollar appreciated by around 0.5% to around $1.12.

But this was not enough. The pressure was still on the government. There were urgent calls from the House of Commons Treasury Select Committee to bring forward the government’s financial statement, which was not due until 23 November, by at least a month. The government was urged to publish growth forecasts as soon as possible to help calm the markets. In response, on 4 October the government agreed to bring the financial statement forward to late October along with the forecasts of its impacts from the OBR.

However, Truss and Kwarteng have so far resisted this pressure to bring analysis of their tax plans forward. They have refused independent analysis of their plans until more than six weeks after receiving them, despite more calls from Tory MPs for Downing Street to reassure the markets. The Prime Minister and Chancellor said they would only publish the independent forecasts on 23 November alongside a fiscal statement, despite them being ready on 7 October.

Longer term impacts

Amongst all the activity in the week following the mini-Budget, there are real concerns of the longer-term impacts the budget will have on the economy. Some experts predict that the lasting effects of the ‘mini’ Budget will be felt far beyond the trading floors. Large tax cuts the government claimed would boost growth have instead convinced markets the UK’s entire macroeconomic framework is under threat. Although this turmoil has been the short-term result, it’s important to step back and think about how the effects of this abrupt shift in economic policy will be felt far beyond the trading floors.

Sterling’s partial recovery a few days after the mini-Budget reflects an increased confidence that there will be a large interest rate rise coming on November 3. However, the bleak economic outlook has removed any fiscal headroom the government may have had. The largest tax cuts in five decades need funding, while spooking the markets means another £12.5bn a year added to the debt interest bill. However, Kwarteng remains committed to debt falling eventually.

It is estimated that there needs to be a fiscal tightening of around £37–£47bn by 2026/27. Even more could be required to ensure that tax revenues cover day-to-day spending or for even a small margin for error. Many have therefore called for a U-turn on the measures announced in the mini-Budget beyond abolishing the cut to the top rate of income tax. Performing a U-turn on some of the tax cuts would make the fiscal tightening much more achievable. However, it could be politically detrimental. Much lower taxes will mean less public spending. Some suggest that this trade-off was ignored when those tax cuts were announced, but market pressure has now put it centre stage.

The Prime Minister has since admitted that mistakes were made in the controversial ‘mini’ Budget that sparked market turmoil in the last week of September. However, a day before reversing the cut in the top rate of income tax, she said she would not retreat on her plan to deliver £45bn of unfunded tax cuts, insisting it would help deliver growth, but admitted: ‘We should have laid the ground better and I have learned from that.’

Articles

Questions

  1. Explain how the announced tax cut will stimulate economic growth.
  2. What is the impact of the weakened pound on UK households and businesses?
  3. Draw a diagram illustrating the way in which the $/£ exchange rate is determined.
  4. How is UK inflation likely to be affected by a depreciation of sterling?
  5. Are there any advantages of having a lower pound?
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A confluence of calamities

World politicians, business leaders, charities and pressure groups are meeting in Davos at the 2022 World Economic Forum. Normally this event takes place in January each year, but it was postponed to this May because of Covid-19 and is the first face-to-face meeting since January 2020.

The meeting takes place amid a series of crises facing the world economy. The IMF’s Managing Director, Kristalina Georgieva, described the current situation as a ‘confluence of calamities’. Problems include:

  • Continuing hangovers from Covid have caused economic difficulties in many countries.
  • The bounceback from Covid has led to demand outpacing supply. The world is suffering from a range of supply-chain problems and shortages of key materials and components, such as computer chips.
  • The war in Ukraine has not only caused suffering in Ukraine itself, but has led to huge energy and food price increases as a result of sanctions and the difficulties in exporting wheat, sunflower oil and other foodstuffs.
  • Supply shocks have led to rising global inflation. This will feed into higher inflationary expectations, which will compound the problem if they result in higher prices and wages in response to higher costs.
  • Central banks have responded by raising interest rates. These dampen an already weakened global economy and could push the world into recession.
  • Global inequality is rising rapidly, both within countries and between countries, as Covid disruptions and higher food and energy prices hit the poor disproportionately. Poor people and countries also have a higher proportion of debt and are thus hit especially hard by higher interest rates.
  • Global warming is having increasing effects, with a growing incidence of floods, droughts and hurricanes. These lead to crop failures and the displacement of people.
  • Countries are increasingly resorting to trade restrictions as they seek to protect their own economies. These slow economic growth.

World leaders at Davos will be debating what can be done. One approach is to use fiscal policy. Indeed, Kristalina Georgieva said that her ‘main message is to recognise that the world must spend the billions necessary to contain Covid in order to gain trillions in output as a result’. But unless the increased expenditure is aimed specifically at tackling supply shortages and bottlenecks, it could simply add to rising inflation. Increasing aggregate demand in the context of supply shortages is not the solution.

In the long run, supply bottlenecks can be overcome with appropriate investment. This may require both greater globalisation and greater localisation, with investment in supply chains that use both local and international sources.

International sources can be widened with greater investment in manufacturing in some of the poorer developing countries. This would also help to tackle global inequality. Greater localisation for some inputs, especially heavier or more bulky ones, would help to reduce transport costs and the consumption of fuel.

With severe supply shocks, there are no simple solutions. With less supply, the world produces less and becomes poorer – at least temporarily until supply can increase again.

Articles

Discussion (video)

Report

Questions

  1. Draw an aggregate demand and supply diagram (AD/AS or DAD/DAS) to illustrate the effect of a supply shock on output and prices.
  2. Give some examples of supply-side policies that could help in the current situation.
  3. What are the arguments for and against countries using protectionist policies at the current time?
  4. What policies could countries adopt to alleviate rapid rises in the cost of living for people on low incomes? What problems do these policies pose?
  5. What are the arguments for and against imposing a windfall tax on energy companies and using the money to support poor people?
  6. If the world slips into recession, should central banks and governments use expansionary monetary and fiscal policies?
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The economic fallout from war

The suffering inflicted on the Ukrainian people by the Russian invasion is immense. But, at a much lower level, the war will also inflict costs on people in countries around the world. There will be significant costs to households in the form of even higher energy and food price inflation and a possible economic slowdown. The reactions of governments and central banks could put a further squeeze on living standards. Stock markets could fall further and investment could decline as firms lose confidence.

Russia is the world’s second largest oil supplier and any disruption to supplies will drive up the price of oil significantly. Ahead of the invasion, oil prices were rising. At the beginning of February, Brent crude was around $90 per barrel. With the invasion, it rose above $100 per barrel.

Russia is also a major producer of natural gas. The EU is particularly dependent on Russia, which supplies 40% of its natural gas. With Germany halting approval of the major new gas pipeline under the Baltic from Russia to Germany, Nord Stream 2, the price of gas has rocketed. On the day of the invasion, European gas prices rose by over 50%.

Nevertheless, with the USA deciding not to extend sanctions to Russia’s energy sector, the price of gas fell back by 32% the next day. It remains to be seen just how much the supplies of oil and gas from Russia will be disrupted over the coming weeks.

Both Russia and Ukraine are major suppliers of wheat and maize, between them responsible for 14% of global wheat production and 30% of global wheat exports. A significant rise in the price of wheat and other grains will exacerbate the current rise in food price inflation.

Russia is also a significant supplier of metals, such as copper, platinum, aluminium and nickel, which are used in a wide variety of products. A rise in their price has begun and will further add to inflationary pressures and supply-chain problems which have followed the pandemic.

The effect of these supply shocks can be illustrated in a simple aggregate demand and supply diagram (see Figure 1), which shows a representative economy that imports energy, grain and other resources. Aggregate demand and short-run aggregate supply are initially given by AD0 and SRAS0. Equilibrium is at point a, with real national income (real GDP) of Y0 and a price index of P0.

The supply shock shifts short-run aggregate supply to SRAS1. Equilibrium moves to point b. The price index rises to P1 and real national income falls to Y1. If it is a ‘one-off’ cost increase, then the price index will settle at the new higher level and GDP at the new lower level provided that real aggregate demand remains the same. Inflation will be temporary. If, however, the SRAS curve continues to shift upwards to the left, then cost-push inflation will continue.

These supply-side shocks make the resulting inflation hard for policymakers to deal with. When the problem lies on the demand side, where the inflation is accompanied by an unsustainable boom, a contractionary fiscal and monetary policy can stabilise the economy and reduce inflation. But the inflationary problem today is not demand-pull inflation; it’s cost-push inflation. Disruptions to supply are both driving up prices and causing an economic slowdown – a situation of ‘stagflation’, or even an inflationary recession.

An expansionary policy, such as increasing bond purchases (quantitative easing) or increasing government spending, may help to avoid recession (at least temporarily), but will only exacerbate inflation. In Figure 2, aggregate demand shifts to AD2. Equilibrium moves to point c. Real GDP returns to Y0 (at least temporarily) but the price level rises further, to P2. (Click here for a PowerPoint of the diagram.)

A contractionary policy, such as raising interest rates or taxes, may help to reduce inflation but will make the slowdown worse and could lead to recession. In the diagram, aggregate demand shifts to AD3. Equilibrium moves to point d. The price level returns to P0 (at least temporarily) but real income falls further, to Y3.

In other words, you cannot tackle both the slowdown/recession and the inflation simultaneously by the use of demand-side policy. One requires an expansionary fiscal and/or monetary policy; the other requires fiscal and/or monetary tightening.

Then there are other likely economic stresses. If NATO countries respond by increasing defence expenditure, this will put further strain on public finances.

Sentiment is a key driver of the economy and prices. Expectations tend to be self-fulfilling. So if the war in Ukraine undermines confidence in stock markets and the real economy and further raises inflationary expectations, this pessimistic mood will tend in itself to drive down share prices, drive up inflation and drive down investment and economic growth.

Articles

Questions

  1. If there is a negative supply shock, what will determine the size of the resulting increase in the price level and the rate of inflation over the next one or two years?
  2. How may expectations affect (a) the size of the increase in the price level; (b) future prices of gas and oil?
  3. Why did stock markets rise on the day after the invasion of Ukraine?
  4. Argue the case for and against relaxing monetary policy and delaying tax rises in the light of the economic consequences of the war in Ukraine.
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Rise in the cost of living
Part 1: What are the distributional consequences?

Households are expected to see further rises in the cost of living after the annual inflation rate climbed for a 13th month to its highest point in almost 30 years. This will put further pressure on already stretched household budgets. The increase reflects a bounceback in demand for goods and services after lockdowns, when prices fell sharply. It also reflects the impact of supply-chain disruptions as Covid-19 hit factory production and global trade.

The biggest concern, however, is the impact it will have on those already hard-pressed families across the UK. According to official figures, prices are rising at similar rates for richer and poorer households. However, household income levels will determine personal experiences of inflation. Poorer households find it harder to cope than richer families as essentials, such as energy and food, form a larger proportion of their shopping basket than discretionary items. On average the lowest-income families spend twice as much proportionately on food and housing bills as the richest. So low-income households, if they are already spending mainly on essentials, will struggle to find where to cut back as prices rise.

Latest Inflation figures

Latest figures from the ONS show that the Consumer Prices Index (CPI) rose by 5.5% in the year to January 2022, with further increases in the rate expected over the next couple of months. In measuring inflation, the ONS takes a so-called ‘basket of goods, which is frequently updated to reflect changes in spending patterns. For example, in 2021, hand sanitiser and men’s loungewear bottoms were added, but sandwiches bought at work were removed.

Annual CPI inflation is announced each month, showing how much the weighted average of these prices has risen since the same date last year. The weighted average is expressed as an index, with the index set at 100 in the base year, which is currently 2015.

Consumers would not normally notice price rises from month to month. However, prices are now rising so quickly that it is clear for everyone to see. What is more, average pay is not keeping up. There are workers in a few sectors, such as lorry drivers, who are in high demand, and therefore their wages are rising faster than prices. But the majority of workers won’t see such increases in pay. In the 12 months to January, prices rose by 5.5% on average, but regular pay, excluding bonuses, on average rose by only 4.7%, meaning that they fell by 0.8% in real terms.

The Bank of England has warned that CPI inflation could rise to 7% this year and some economists are forecasting that it could be almost 8% in April.

Why are costs rising?

From the weekly food shop, to filling up cars, to heating our homes, the cost of living is rising sharply around the world. Global inflation is at its highest since 2008. Some of the reasons why include:

  • Rising energy and petrol prices
    Oil prices slumped at the start of the pandemic, but demand has rocketed back since, and oil prices have hit a seven-year high. The price of gas has also shot up, leaving people around the world with eye-watering central heating bills. Home energy bills in the UK are set to rise by 54% in April when Ofgem, the energy regulator, raises the price cap.
  • Goods shortages
    During the pandemic, prices of everyday consumer goods increased. Consumers spent more on household goods and home improvements because they were stuck at home, couldn’t go out to eat or go on holiday. Manufacturers in places such as Asia have struggled to keep up with the demand. This has led to shortages of materials such as plastic, concrete and steel, driving up prices. Timber cost as much as 80% more than usual in 2021 in the UK.
  • Shipping costs
    Global shipping companies have been overwhelmed by surging demand after the pandemic and have responded by raising shipping charges. Retailers are now having to pay a lot more to get goods into stores. These prices are now being passed on to consumers. Air freight fees have also increased, having been made worse by a lorry driver shortage in Europe.
  • Rising wages
    During the pandemic many people changed jobs, or even quit the workforce – a problem exacerbated in the UK by Brexit as many European workers returned to their home countries. Firms are now having problems recruiting staff such as drivers, food processors and restaurant waiters. This has resulted in companies putting up wages to attract and retain staff. Those extra costs to employers are again being passed on to consumers.
  • Extreme weather impact
    Extreme weather in many parts of the world has contributed to inflation. Global oil supplies took a hit from hurricanes which damaged US oil infrastructure. Fierce storms in Texas also worsened the problems in meeting the demand for microchips. The cost of coffee has also jumped after Brazil had a poor harvest following its most severe drought in almost a century.
  • Trade barriers
    More costly imports are also contributing to higher prices. New post-Brexit trading rules are estimated to have reduced imports from the EU to the UK by about a quarter in the first half of 2021. In the USA, import tariffs on Chinese goods have almost entirely been passed on to US customers in the form of higher prices. Chinese telecoms giant Huawei said last year that sanctions imposed on the company by the USA in 2019 were affecting US suppliers and global customers.
  • The end of pandemic support
    Governments are ending the support given to businesses during the pandemic. Public spending and borrowing increased across the world leading to tax rises. This has contributed to rises in the cost-of-living, while most people’s wages have lagged behind.

Main concerns for the UK inflation

With rapidly rising prices, the economic decisions people will have to make are much harder. The main concerns for UK households include increases in energy costs, food prices, rent and interest rates on borrowing. All of these concerns come at a time when the government prepares to increase national insurance contributions for workers in April. There has been some pressure from MPs to scrap the tax rise so as to ease the pressure on living costs. It can be argued that there are fairer ways to increase taxes than through national insurance. However, the plan is relatively progressive, and scrapping the rise could be a badly targeted way of helping the poorest households with their energy bills.

Energy Bills
Electricity and gas bills for a typical household are expected to increase on average by £693 a year in April, which, as we have seen, is a 54% increase. Around 18 million households on standard tariffs will see an average increase from £1277 to £1971 per year. And around 4.5 million prepayment customers will see an average increase of £708 – from £1309 to £2017. Energy bills won’t rise immediately for customers on fixed rates, but many are likely to see a significant increase when their deal ends.

Bills are going up because the energy price cap is being raised. The energy price cap is an example of a maximum price being imposed on the market; it is the maximum price suppliers in England, Wales and Scotland can charge households for their energy. Energy firms can increase bills by 54% when the new cap is introduced in April. The price cap is currently reviewed every 6 months and it is expected that that prices will rise again in October.

Energy price rises are likely to hit Britain’s poorest households the hardest as they spend proportionately more of their income on energy, a problem exacerbated by many living in poorly insulated homes. More people are thus expected to find themselves facing fuel poverty. This means that they spend a disproportionate amount of their income on energy and cannot afford to heat their homes adequately. According to the Resolution Foundation, the poorest will see their energy spend rise from 8.5% to 12% of their total household budget, three times the percentage for the richest.

The way fuel poverty is measured varies around the UK. In Scotland, a household is in fuel poverty if more than 10% of its income is spent on fuel and its remaining income isn’t enough to maintain an adequate standard of living. It is expected that the number of homes facing ‘fuel stress’ across the UK will treble to 6.3 million after April. It will, however, have the greatest impact on pensioners, people in local authority housing and low-income single-adult households who on average could be forced to spend over 50% of their income on gas and electricity. The Resolution Foundation thinktank has warned that UK households are facing a ‘cost of living catastrophe’.

Food
Low-income households also spend a larger proportion than average on food and will therefore be relatively more affected by increases in food prices. Food and non-alcoholic drink prices were up by 4.2% in the year to December 2021. The Monetary Policy Committee has stated that food price inflation is expected to increase in coming months, given higher input costs. It has been estimated by the thinktank, Food Foundation, that 4.7m Britons, equivalent to 8.8% of the population, are struggling to feed themselves and are regularly going a day without eating.

Supermarkets have also raised their concerns about future increases. Tesco’s chairman John Allan has predicted that the worst is yet to come, pointing to 5% as a likely figure for food price inflation by the spring. He cited high energy prices, both for Tesco and its suppliers, as a key factor behind the expected rise.

It has been observed that the Smart Price, Basics and Value range products offered by supermarkets as lower-cost alternatives are stealthily being extinguished from the shelves. This is leaving shoppers with no choice but to ‘level up’ to the supermarkets’ own better-quality branded goods – usually in smaller quantities at larger prices. The managing director of Iceland, Richard Walker, has stated that his stores are not losing customers to other competitors or to better offers, but to food banks and to hunger. This is a highly concerning statement given that 2.5m citizens were forced by an array of desperate circumstances to use food banks over the past year.

Rent
Private rents are also rising at their fastest rate in five years, intensifying the increase in the cost of living for millions of households. Data from the ONS reveal that the average cost of renting in the UK rose by 2% in 2021. This was the largest annual increase since 2017. The East Midlands had the biggest increase in average rental prices, with tenants paying 3.6% more than a year earlier. However, due to falling demand for city flats during lockdown, as people favoured working from home, London had the smallest increase at 0.1%. Nevertheless, as Covid restrictions are removed, renters, including office workers and students, are now returning back to cities. This is now pushing up rental prices with demand outpacing supply.

The property website Zoopla found newly advertised rental prices were rising much faster across the UK. It said the average rent jumped 8.3% in the final three months of 2021 to £969 a month. This increase in rental prices, combined with the general rise in prices will place additional pressure on the government to increase support for vulnerable families. The housing charity, Shelter, has reported an increase in people who are struggling to pay their rent and even pay their electricity. With Covid-era protections having ended, if people struggle to pay, they are faced with eviction or even homelessness. There are calls for the government to support such people by reversing welfare cuts.

Insurer, Legal & General, has announced an additional investment over the next 5 years of £2.5bn on its ‘build to rent’ schemes. The aim is to provide more than 7000 purpose-built rental homes in UK towns and cities. L&G claims that the additional homes are part of the solution to the rental problem, with rent increases being capped at 5% for five years. However, sceptics claim the company is simply trying to cash in on the booming market and there are calls for further government action. The Joseph Rowntree Foundation claim that renters will struggle as rents in some areas have risen as much as 8%. Despite this, housing benefit has been frozen for two years and therefore there are calls for government to urgently relink housing benefit to the real cost of renting.

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Questions

  1. What other measures of inflation are used beside CPI inflation? How do they differ?
  2. If all consumers are facing approximately the same price increases for any given good or service, why are poor people being disproportionately hit by rising prices?
  3. For what reasons might the rate of inflation (a) rise further; (b) begin to fall?
  4. Examine a developed country other than the UK and find out how inflation is affecting its population. Is its experience similar to that in the UK? Does it differ in any way?