At the end of January, the Governor of the Bank of England, Andrew Bailey, voiced his “great concern” regarding inflationary pressure in the UK economy. His remarks came just hours after the latest official inflation figure, the Consumer Prices Index, reached its highest level for 30 years. Anxieties around the future path of inflation are high: the current inflationary pressures are in stark contrast to the low inflation economy we have become accustomed to.
In this article, the first in a series we intend to release on this and other topics, we look at the history of inflation in the UK, the causes of it and what it meant for the economy. The impact of anti-inflationary policies varies and the extent of the long term scars remain widely contested. However, what is in little doubt is that western governments and central banks will not tolerate persistently high levels of inflation. As we digest the Bank of England’s most recent forecast of 7% by Spring 2022, this brief history offers useful context to the UK’s current position.
Post-War Recovery
Shortly after the end of the Second World War UK government debt peaked at around 270% of GDP. The US wanted a return on the £2.2bn they had loaned us, and the new Labour Government nationalisation policy did not come cheap. It was, in the words of John Maynard Keynes, Britain’s ‘Financial Dunkirk’. What followed the war, however, was almost thirty years of strong growth. This was fuelled by the repair of war damage, investment catch-up and people moving from the country into cities. Excluding the period of the Korean War (1950-3), inflation was relatively stable throughout this period of regeneration.
The ‘Sick Man of Europe’
Synonymous with economic turmoil, the 70s saw record rates of inflation. The post-war economic growth began to slow, and productivity began to lapse. The Arab world’s oil embargo of the West in the wake of the Yom Kippur War of 1973, and the Iranian revolution, led to an eightfold increase in the oil price. Inflation rates soared, averaging 12% a year and peaking at 24% in 1975. Great Britain became the ‘Sick Man of Europe’. The remedies offered by the Labour Government included a severe incomes policy and restrictive fiscal and monetary policies. Wages and output responded positively.
Mrs. Thatcher took these ‘monetarist’ ideas further, wholeheartedly committing to a ‘medium term financial strategy.’ According to the Conservative Party 1979 Election Manifesto, inflation was close to “destroying our political and social stability”. The manifesto proposed this be addressed through “proper monetary discipline” and “publicly stated targets for the rate of growth of the money supply.” This resulted in a 5-year plan involving targets for the growth of the money supply and the budget deficit. Through this, Thatcher’s government continued the trend of lower inflation, though at the heavy cost of increasing unemployment.
The Lawson Boom
From the late 80s, the UK welcomed a ‘boom’ period. Consumer confidence skyrocketed as tax cuts, a reluctance to increase interest rates and Nigel Lawson’s optimism got the economy roaring. Growth averaged 4.3% from 1985-88. Lawson boasted his “plain fact” that the British economy had been “transformed”. In addition, the 1980s saw a boom in the housing market. By the end of 1988, house prices had risen by 30% annually. This rapid increase led to an increase in consumer wealth and consumer spending.
As the boom progressed, so too did inflation and the current account deficit (the difference between the value of exports and imports). Despite this, Lawson refused to apply the brakes. The Chancellor continued to pursue his beloved “unofficial exchange rate” and as such interest rates became compromised. As Britain entered a new decade, the inflation of old was beginning to creep up, reaching 8% in 1990.
Crashing back to Reality: The 1990s
In 1990, the UK joined the Exchange Rate Mechanism with hopes of bringing inflation under control. It proved incredibly difficult to keep the value of the Pound at its exchange rate target. In response, the government increased interest rates. In September 1992, interest rates were 10%, stratospherically high by the standards of the last decade. The high interest rates made mortgage payments expensive, lowering disposable income and household spending. Despite these efforts, the government failed to support Sterling and on 16th September 1992, the UK left the ERM. The following day, Black Wednesday, saw the value of the pound by plummet by 20%. This was the product of high-interest rates, falling house prices and an overvalued exchange rate. The 1991-2 recession ensued.
Inflation Targeting
In October 1992, inflation targeting was introduced in response to the high-inflation period and the exhausting efforts to get “inflation down again”. The framework, first improvised by the Conservative Chancellor of the Exchequer, Norman Lamont, was strengthened by Gordon Brown through the Bank of England Act 1998. The law confirmed that the objectives of the Bank of England were “(a) to maintain price stability and (b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.” To realise these objectives, the Bank established the Monetary Policy Committee (MPC), enjoying complete operational independence in “formulating monetary policy”.
In short, the Bank of England was assigned the responsibility for setting short-term interest rates with the goal of hitting the predetermined inflation target. This policy drew criticism from the business community and public alike who were concerned that inflation targeting diminished the role of GDP and unemployment as determinants of inflation. Yet, from the 2000s onwards Britain enjoyed low inflation and steady growth.
The Financial Crisis and Inflation
From 1992, the size of the UK economy had grown every quarter. However, in 2008 this positive trend halted as the Great Financial Crisis swept across the world. Having shrunk by more than 6% between early 2008 and mid 2009, the UK economy took five years to get back to its pre-recession level.
The Base Rate was cut aggressively between December 2007 and March 2009. This pattern was repeated across the other central banks. By March 2009, the Bank of England had brought interest rates down to 0.5%. The Bank was forced to accept that interest-rate manipulation could no longer stimulate the economy. From March 2009, the Bank of England began buying bonds through what became known as Quantitative Easing.
By the end of 2011, approximately 2.7 million people were looking for work. Real wages were falling, as the public sector introduced a pay freeze (from 2011) and pay cap (from 2013). In the private sector wage growth equally lagged inflation. Deflation was the concern rather than inflation. Many analysts predicted a rampant return of inflation. As a result of ultra low interest rates, however, it took a decade for inflation to raise its head again.
Conclusion
This article has looked at how inflation contributed and responded to times of crises. Attempting to explain what causes inflation and its impact is a study that goes far beyond this brief article. Our next piece will seek to address how inflation impacts investors.
As we enter a new era for our global economy, how will inflation respond? And what are the consequences for investors? We invite you to contact us to find out how inflation influences our advice to our clients.