Therese Raphael: Dan, we’re not hearing the word “transitory” bandied about these days, but there are signs inflation has peaked. The annual CPI price index fell to 10.7% in November from a peak of 11.1% in June. What will disinflation look like over the next year?
Dan Hanson: Inflation in the UK is likely to fall back next year. A lot of that will be arithmetic — that is, the big price gains this year, particularly in energy and core goods prices, are unlikely to be repeated in 2023. That effect will be enough get inflation down to between 4% and 5%, we think. The challenge will be the final two to three percentage points which reflects services inflation and the tightness of the labor market. Central banks won’t think about easing until there is significant progress towards their 2% target in the services side of the economy. That’s unlikely to come until 2024.
TR: Over the past year, it’s consumers who have borne the brunt of rising inflation. Will 2023 be the year higher producer prices hit business margins, and do you see credit spreads (a measure of the risk premium on corporate debt) widening?
DH: High inflation is partly a reflection of businesses protecting their margins as cost pressure rises. The extent to which they can do that is linked to the circumstances at the time. If demand is strong and everyone is raising prices, the risk of a loss of market share is far lower. I think that will change next year as demand softens.
Remember, too, that about 70% of corporate debt is floating rather than fixed rate. So rising borrowing costs are being felt by many businesses already. Against a backdrop of weaker growth and profitability, you would expect spreads to widen. Taking it all together, it could be that low business investment contributes just as much as slowing consumption to the weakness in activity in 2023.
TR: It feels like there are a lot of mixed signals, with some restoration of business confidence and more positive PMI figures, but also consumers showing restraint in retail purchases. Are we crab-crawling sideways in ’23 in the UK?
DH: We still think there is going to be a recession, just one that is shallower compared to downturns in recent memory — we expect a peak-to-trough fall in GDP of 1.5%. The thing to remember, though, is that if the economy does hold up and that prevents the job market loosening, the Bank of England will almost certainly push rates higher to choke inflation out of the system. So a recession feels inevitable — the question is how far does output need to fall for inflation to come back under control?
TR: Certainly, Prime Minister Rishi Sunak seems determined not to feed into inflation by giving into strikers’ demands. Of course, we talked last time about the dangers of the new government overcorrecting for the mistake of Liz Truss’s September budget. What’s your verdict on the current fiscal policy mix?
DH: It feels like Chancellor of the Exchequer Jeremy Hunt got the balance about right: He is supporting households and businesses in the near term with the energy price shock and backloaded the consolidation plan that was needed to put the public finances on a sustainable footing and restore market confidence. The missing piece of the jigsaw continues to be a serious “growth plan.” Dealing with weak productivity growth (where low business investment is part of the story) and the fall in labor supply since the pandemic are both key issues that need to be addressed.
TR: This will sound like a trick question, but which of these three things do you think will have the biggest impact on consumer sentiment and the economy in 2023: worker strikes, falling house prices or NHS wait lists.
DH: I would say falling house prices. They have the ability to shift sentiment quickly as homeowners feel poorer. A negative confidence shock on top of everything else would be very unhelpful. In the context of already weak labor supply, rising NHS waitlists could mean the labor market stays tighter for longer (though there’s mixed evidence on the reasons that inactivity has gone up). At the margins, that could mean interest rates have to rise further to take the heat out of the jobs market.
The strikes, although inconvenient for many, are manageable from an economic perspective as long as they don’t become more widespread.
TR: Speaking of overcorrection, how concerned are you that central banks will overdo tightening and we get a bad recession? Or do you think a soft landing for the economy and jobs market is more likely?
DH: Central banks might break things on the way up, but they now have lots of policy space to reverse course if things go bad and lower inflation allows them to. I think the more likely path to a deep monetary policy-induced recession is if inflation proves far more persistent than central banks are expecting. If that happens, they will have no choice but to hit the brakes even harder and generate a severe downturn and an even sharp rise in unemployment.
Even in a relatively benign scenario, some rise in joblessness is likely. What’s worrying central banks is that a tight labor markets will interact with high inflation to raise expectations of future price gains among firms and workers. One way to break that dynamic (or the risk of it developing) is to hit demand with higher rates and hope that it pushes up on the jobless rate. If unemployment is rising, workers will feel far less confident asking for a pay rise because they know there are others willing to take their place at a lower wage. That, in turn, should mean inflation falls faster back to 2%.
TR: Economists largely missed the biggest surge in inflation since the 1980s. Was the cause of the historically high inflation too much stimulus or rates too low for too long? I also wonder your thoughts on the lessons of the past year or so.
DH: I have to put my hands up and say I was one of those who underestimated the scale of the problem. But I think those who say central banks should have been faster to deal with the inflation we have today also need to be honest about what that would have entailed. It would have required them to predict that a war would break out in Ukraine, that supply disruptions would linger after the pandemic and that labour demand would recover quickly as supply fell.
Having predicted each of those things they would have had to start tightening policy 18-24 months ago (since that’s the lag involved in policy). In other words, they would’ve had to jack up rates during the height of the pandemic and exacerbate the downturn.
The main lesson for me is that institutions matter. We can debate whether the BOE was late raising interest rates, but we should all be glad that central banks’ hands are freed of political influence to get on with bringing inflation down. The UK’s experience in recent months is a timely reminder of how much worse things can get when institutions are subject to interference or sidelined.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Therese Raphael is a columnist for Bloomberg Opinion covering health care and British politics. Previously, she was editorial page editor of the Wall Street Journal Europe.
Dan Hanson covers the U.K. for Bloomberg Economics in London. He previously spent seven years at HM Treasury working on a variety of U.K. macroeconomic issues.
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