Has the UK Economy Broken Down? The Strange Case of Sticky Inflation and low growth

Current Economic Framework of the UK

• The UK economy is currently experiencing a slowdown, characterised by declining GDP and rising inflation, which raises questions about the need for fiscal and economic policy adjustments.
• Government final consumption expenditure has grown exponentially, reaching £599 billion in 2024, a significant increase from £109 billion in 1990, driven by an expanding government workforce and increased demand for public services.

Government Finances and Debt

• The aggregate of National Insurance Contribution (NIC) receivables remained stagnant at around £230.7 billion for both 2023 and 2024. A shortfall of £66 million from 2023 to 2024 likely necessitated an increase in the employer NIC rate from 13.8% to 15% to boost cash flow.
• The UK has experienced a persistent fiscal deficit since 1990, with surpluses only recorded in 1999, 2000, and 2001. These surpluses coincided with technological improvements that enhanced GDP growth and increased tax revenues.
• Since the 2010 Great Financial Crisis, the government has accumulated over £1.75 trillion in deficits, largely due to a prolonged period of zero lower bound interest rates and quantitative easing. This accumulation makes managing public finances challenging as the debt-to-GDP ratio approaches the psychological threshold of 100%.
• The cost of servicing the UK’s public debt has dramatically increased from approximately £30 billion to over £80 billion, primarily due to higher inflation and rising long-duration interest rates.

Inflationary Pressures and Forecasts

• Various forecasts consistently indicate that UK inflation will remain persistent and “sticky,” often above the target 2%.
  • The Consumer Price Index (CPI) is projected to decline to around 2.9-2.6% in the near term, with a potential convergence to 2% by approximately 2027.
  • The CPIH (which includes housing costs) is expected to remain higher, around 4-4.6% in 2025-2026.
  • The Retail Price Index (RPI) is consistently forecast above 3%, with the 12-month RPI around 4.9-4.4%. Rent prices, a significant component, are projected to remain very high, potentially above 8%.

Here is a line chart showing inflation rate forecasts for CPI and CPIH:

• Inflation data shows characteristics of a fat-tail distribution (kurtosis > 3) and autocorrelation for several lags, implying high volatility and correlation with past data.

Labour Market Trends, Productivity and Output Gap

• Forecasts indicate a rising trend in unemployment, expected to reach around 4.6-4.7%, suggesting a weakening aggregate supply in the economy.
• Employment levels are stable around 75%, which is below the pre-2020 peak of 76.4%.
• The simultaneous occurrence of rising unemployment and high inflation creates a challenging economic situation akin to stagflation
• Labour productivity has been slightly negative, indicating sluggishness in the economy’s efficiency.
• The overall output gap is estimated to be flat or slightly negative, meaning the economy is operating below its full potential and faces a risk of stagnation.
• Persistent high inflation negatively impacts the output gap, leading to real GDP growing at a slower rate than its potential.

Monetary and Fiscal Policy Challenges

• The Bank of England faces a significant dilemma: high inflation pressures suggest maintaining or raising interest rates, while a negative output gap and rising unemployment call for rate cuts to stimulate economic activity.
• Globally, monetary policy has been excessively accommodative for too long, contributing to the current inflationary shock and the formation of an asset bubble.
• The Taylor Rule suggests that during periods of high inflation (e.g., 12% inflation), interest rates should have been hiked significantly more (potentially over 10%) to properly price the money supply and constrain excessive government borrowing.
• The UK economy is described as an “overheating engine” due to high input costs and sticky inflation, running at high “RPMs” (high costs) without a corresponding increase in “speed” (economic growth). Businesses respond by reducing “horsepower” and workforce to manage costs.

Policy Simulations and Recommendations

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