Yet again, the Chancellor’s Spring Statement turned into a Spring Budget. Expectations were that the Government would intervene to alleviate the impact of higher fuel and food prices on household income. Whilst fuel duty was cut by 5p a litre for 12 months and the National Insurance threshold raised, for many, those expectations weren’t met, and pressure on both the Government and the Bank of England to do something to help remained high.
Despite monthly UK GDP data in January 2022 surpassing its previous peak in February 2020, the economy is heading for a challenging period. For now, the consensus view is there will still be solid growth over the year, but forecasts vary widely on how much.
And that’s because of the levels of uncertainty within the global economy, particularly considering new outbreaks of the COVID virus in China and, crucially, the effects of the war in Ukraine. Unfortunately, some of the downside risks to growth envisaged last year – from geopolitical events and lingering fallout from COVID-19 – have materialised.
Policy discussions are therefore focused on limiting the damage to growth. The problem is that any policy response is hamstrung by the need to rein in inflation, which is close to 30-to-40-year highs in many advanced economies, including the US and UK. Reducing fiscal deficits, expanded considerably to protect jobs and businesses during the lockdown, is a priority. Therefore, cutting interest rates and easing fiscal policy indiscriminately as a way out is not an option for policymakers.
Indications of tighter policy
To illustrate this – despite the gathering of global economic storm clouds – the Bank of England raised interest rates for the third time in consecutive meetings in March, taking the Bank rate to 0.75%. And it is not alone; the US Fed raised interest rates on 16 March, and the ECB continues to monitor inflation. Quantitative easing is being reined back in the UK, with maturing bonds under the scheme no longer being reissued, the same effect as withdrawing their stimulatory effects on liquidity. The Fed has announced a programme selling $95bn of its $10 trillion stock of securities a month in the US.
In the UK, with National Insurance contributions increased to 1.25% in April, VAT to return on fuel, and freezing of tax allowances in cash terms, fiscal policy is being tightened by about 2% of GDP or close to £40bn over the next few years. At the same time, a combination of rising inflation and rising interest rates will squeeze consumer spending, creating what the Institute of Fiscal Studies and the Resolution Foundation describe as one of the biggest reductions in household income in real – or inflation-adjusted terms – since the 1980s.
Managing the fear
As we can see in Chart 1, a world price shock stemming solely from the conflict in Ukraine will raise inflation in the UK, possibly by another one to two percentage points more than was expected. While government policy cannot prevent this, pressure to slow the fiscal and monetary tightening pace will undoubtedly mount. In the UK, the Bank of England will look at the low unemployment rate (3.8%) and an annual inflation rate of 7% and possibly 10% in a few months and be worried that their inaction will lead to a rise in inflation expectations. Thus, it is raising interest rates even at the risk of further weakening the economy, as it signals that it is unwilling to tolerate faster-rising prices.
Their fear is grounded in the risk that high inflation could become embedded into the fabric of the UK economy. They would want to avoid that at all costs, even at the risk of an economic downturn. And they are not alone in that fear – similar observations and concerns feature heavily in the US.
Further increases in interest rates are very likely even as the crisis unfolds in Ukraine. However, fiscal policy may well respond before the year is out with other offsetting measures such as increases in energy allowances, VAT cuts on essential items, and targeted efforts to help the most vulnerable within an envelope of fiscal tightening in the medium term.
Economic shocks – the new norm?
In the past 12 years, we’ve encountered two one-in-one-hundred-year economic shocks; the global financial crisis and a pandemic. To that list, we can now add the largest ground war in Europe since 1945 and some after-effects from the pandemic with a surge in new cases in Hong Kong and China. The consequences of these shocks are higher global oil and other commodity prices, which will reduce the income of net oil importers. Weaker economic growth will stem from greater volatility, less investment and weaker consumer spending as inflation-adjusted pay growth falls.
The hidden impact of the war in Ukraine
On the surface, the economic effect of the Russian invasion of Ukraine seems small. Together both countries amount to about 2% of the global economy expressed at market prices in nominal US dollar terms. The figure for total trade – imports and exports – are similarly about 2% of the worldwide total. The World Trade Organization (WTO) estimates their share of direct investment flows in 2020 at a maximum of 1.5% of the world total. Bank for International Settlements (BIS) data shows that lending to residents in Russia and Ukraine is under 0.5% of international claims on banks in Q3 of last year.
However, the gross numbers paint a misleading picture. Both countries are significant exporters of critical raw materials. Together, they account for 30% of wheat exports and 20% for natural gas, fertilisers, and corn. Russia’s share of global oil exports stands at 10%. In addition, Russia is a significant exporter of ‘rare earth’ metals used in batteries, catalytic converters, and electric cars. At the global level, these translate into impacts on prices, meaning inflation, and production capacity –representing economic growth, see Chart 2.
The impact on individual countries will depend on how much of these commodities they import and their proximity to the conflict itself. But there is also the second-round effect to consider, which is the impact on the world economy and what effect that will, in turn, have on individual countries. For instance, the US has a relatively small exposure to Russia for either wheat or oil. Under 1% of oil imports for the US – and the UK, incidentally – come from Russia. But the impact on the world economy and global markets of the conflict in Ukraine will still affect them. Simulations, for example, done on the worst-case scenario of all energy supplies to Europe being cut off, show that such an eventuality would trigger a eurozone recession. Comments from the UK Treasury suggest that if that happened to the EU economy, it would cut UK GDP by 3%. Since UK growth is assumed to be around 3 to 4% this year, this would mean that the UK will see little or no expansion in 2022, or approximately £70bn of lost output.
Against this backdrop of continued uncertainty, the global and domestic economy will continue to walk a tightrope to recovery and growth, with the risk of stagflation never far away.