David Gauke is a former Justice Secretary, and was an independent candidate in South-West Hertfordshire at the 2019 general election.
Last week, inflation in the US hit 7.5 per cent, the highest for nearly 40 years. In the UK, inflation is expected to hit seven per cent in the spring, the highest level since 1991.
There are clearly some temporary factors in play as the world economy returns to a new normality after two years of a pandemic causing major disruption. The transition will inevitably be bumpy and, the optimists argue, as long as we do not allow ourselves to assume that inflation is here to stay (which could result in a wage price spiral), high inflation should be a relatively short term phenomenon, as the spike in energy costs pass through the system.
The more pessimistic view is that there is a more fundamental over-heating of the economy. We have had years of quantitative easing and low interest rates, unemployment is remarkably low and labour shortages (caused predominantly by older workers retiring earlier) are likely to persist, and energy prices look set to remain high. We cannot assume, say the pessimists, that the current inflation is largely transitory. This latter view is gaining ground, including in the Monetary Policy Committee which has voted for two increases in interest rates in recent weeks, with a minority of members wanting to go further.
Whichever view is correct, inflation and its consequences will be the big domestic issue affecting people’s lives in the next few months. Most obviously, we will see a squeeze in living standards that is going to be very painful for many households.
The Bank of England is forecasting the weakest growth in real post-tax labour incomes in more than 70 years. This will have negative political implications for the Governmen,t with the local elections in May likely to be very difficult for the Conservatives, whoever is their leader at that point.
All of this will increase pressure on the Government to assist households facing higher costs. We have already seen an announcement of a loan scheme for energy costs, but there will be plenty of calls for more action, whether that is dropping or postponing the national insurance increases, cutting VAT on domestic fuel or increasing Universal Credit.
The Treasury will rightly worry about affordability and credibility. On affordability, the public finances are performing better than was predicted by the Office for Budget Responsibility at the time of last year’s October Budget, but the Chancellor will not want to get into the habit of spending all the proceeds of an improved forecast as a matter of course. Scrapping the National Insurance increase would also raise questions of credibility and suggest to the markets that the Government – with an 80 seat majority – is too weak to put up taxes. That is not a good signal to send.
A further problem is that if fiscal policy is being used to soften the consequences of inflation by putting more money into people’s pockets, the Bank of England might be compelled to move further and faster on interest rates. Mortgage holders may find that tax cuts are accompanied by interest rate rises.
The issue of pay rises is already proving to be contentious. The Governor of the Bank of England, Andrew Bailey, attracted criticism for his remarks that workers should not chase pay increases that match inflation.
These words – although well-intentioned – were unfortunate. Putting aside the inevitable criticism that he is in a position than most to afford a pay freeze, it could be interpreted that he was advocating a return to an incomes policy where the man in Whitehall (or, in this case, Threadneedle Street) told everyone else how much they should be paid. Private sector pay should be a matter for the market which can reflect changes in the labour supply and consumer choices.
Bailey was not really advocating a return to incomes policies, even though it sounded a little like that. His point was that large pay rises will make the process of getting inflation under control all the more painful with interest rates potentially having to go higher than would otherwise be the case and workers finding themselves priced out of a job. The higher cost of global commodities is going to have to be absorbed somewhere, and ultimately this will result in a fall in people’s real term income.
Pay rises in the public sector will be a contentious issue. Again, the issue is not really about controlling inflation (at least, only indirectly), but about the public finances. Big increases in public sector pay will place further pressure on spending and, understandably, the Chief Secretary to the Treasury, Simon Clarke, is calling for restraint. Controlling public spending, ensuring that public sector pay is sufficient to recruit, retain and motivate the workforce and avoiding a summer of disputes with the public sector unions will be no easy task.
There are measures that the Government can take to protect people from the squeeze in living standards, but the fundamental problem is that costs are going up faster than we are getting more productive. We can smooth the pain of a short term spike in energy costs – if that is what it is – but in the end these costs will have to be paid by real people, whether taxpayers or consumers.
If this all sounds somewhat fatalistic about the short term, that is true. Ultimately, our standard of living will be affected by factors such as global commodity prices as well as our own productivity. For multiple and complex reasons, many negative factors are coming to a head this spring.
The immediate focus of the debate will be distributional – who we should protect and how we should do it. Such a debate is understandable, and there is a very strong case for protecting the most vulnerable who will struggle to pay their bills.
But if the response to the cost of living pressures is cut taxes or spend more to protect the bulk of the population, we just end up borrowing more and passing on costs to future generations. Such an approach is unsustainable.
The reality is that our national living standards depend upon our success in delivering a highly productive, strong economy. Even in those circumstances, we will always be vulnerable to being buffeted by high commodity prices, but we are more exposed because of a relatively weak currency and low productivity growth.
The predictions made by the Prime Minister as recently as last autumn that we are about to enter a period of high wage growth now ring hollow as, in real terms, wages are falling. There is a risk that both the Government and Opposition focus their energies on short term solutions – often involving borrowing more money – without addressing the fundamentals.
Our living standards reflect the strength of the economy. It has faced a number of difficulties in recent years – some unavoidable, some self-inflicted – and this will have consequences. The challenge for policy-makers, about which we hear too little, is how we deliver that strong economy for the future.