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 recession and high inflation have led to fears that the UK may be on the way to a period of ‘stagflation’ – something the country has not faced since the 1970s.
But what exactly does this term mean, why is it bad – and how can it be solved?
What is stagflation?
Stagflation is an economic term used to describe a period of high inflation, relatively high unemployment and low demand for products.
It doesn’t necessarily happen in that order.
Stagflation was a major problem for the UK in the 1970s, but think tank National Institute of Economic and Social Research (NIESR) has warned it could be back on track.
In his latest UK Economic Outlook reportit forecasts that GDP growth will slow from 3.5% in 2022 and 0.5% in 2023, while unemployment will rise to over 5% – currently 3.8%.
It also forecast a further rise in inflation and a 2.5% fall in real consumer purchasing power.
Currently, the UK already sees high inflation – 9.4% in June 2022 – while the Bank of England forecasts a recession is imminent from the last quarter of 2022.
What causes stagflation?
A sudden shock in the supply of goods can lead to a rapid rise in prices.
This has been seen since the start of the energy crisis in autumn 2021, when a gas shortage caused wholesale prices to skyrocket and many UK suppliers struggled to break even.
There are other examples elsewhere where the slowdown in manufacturing is more acute, where production has increased only modestly over the last 12 months due to severe supply chain disruptions and slowing demand.
Why is stagflation bad?
Stagflation is a period when demand for products is disrupted, high inflation and higher unemployment.
Ultimately – when the economy slows, demand falls and more people become unemployed – the private sector is less willing or unable to invest in the UK economy and the government cannot generate as much money from taxes.
Less revenue for government means public spending could be reduced – leading to cuts in public services and public sector wages, as well as a lack of fiscal space to raise the cost of living.
This leaves the UK’s next prime minister – either Liz Truss or Rishi Sunak – with tough decisions to make on how to get the economy back on track.
For example, high inflation and weak demand have caused the Purchasing Managers’ Index (PMI) – a measure of confidence in manufacturing – to fall to a 25-month low of 52.1 in July 2022.
“Increasing market uncertainty, the cost-of-living crisis, war in Ukraine, ongoing supply concerns and inflationary pressures are simultaneously weighing on demand for goods, while ongoing post-Brexit issues and the slowdown in the global economy are hampering exports,” said Rob Dobson, director at S&P Global Market Intelligence – a financial analysis company.
“As the Bank of England continues to hike interest rates to fight inflation, there are downside risks to the outlook. Against this background, the persistently low level of optimism among manufacturers is not surprising.”
However, Mr Dobson added that there was a silver lining as inflation and supply chain disruption appear to have peaked.
How can stagflation be solved?
Once stagflation sets in, it can be difficult to stop, as policymakers must reduce inflation and unemployment at the same time.
It is assumed that a long-term reduction in inflation usually leads to an increase in unemployment in the short-term. Likewise, a short-term reduction in unemployment increases inflation in the long-term.
In its report, NIESR called on the government to tackle the problem by introducing more targeted support for vulnerable households, increasing public sector wages and lowering trade barriers with Britain’s biggest trading partner – the EU.
On the latter front, she warned against provoking a trade war with the EU over the Northern Ireland Protocol.