Inflation and instability

Good morning from New Economy Brief.

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2024 started with businesses optimistic about the UK's economic recovery and hopes that inflation was under control. But last week's figures showed inflation actually rose slightly and economists are warning that the crisis in the Red Sea could ‘shatter hopes of global economic recovery’. 

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This bout of inflation was triggered by Russia’s invasion of Ukraine, and the recovery from it has always been vulnerable to events. UK Prime Minister Rishi Sunak recently warned the world is “the most unstable it has been in decades” as part of his justification for airstrikes on Houthi targets in Yemen, and others say we are entering a new era of geopolitical instability and that macroeconomic models still haven’t caught up to this new reality.

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This week’s New Economy Brief looks at what happens to economic modelling and monetary policy institutions in a world where geopolitics and climate change create new challenges and regular supply shocks. Or in other words, how should policy adapt to a new world of permanent instability and higher inflation? 

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Hopes of recovery? Last week The Times reported a renewed sense of optimism in the UK’s economic recovery after over a year of record inflation and stagnant growth, with financial markets expecting interest rates to fall from a 15-year high of 5.25%. Some are even predicting inflation to drop back to the BoE’s 2% target by April. However, the latest figures showed inflation rose slightly to 4% rather than falling as expected. Financial markets now expect this to move down to 2% later in Spring.

• A longer-term outlook on inflation. Debates about whether or not the economy will have a “softer landing” from high rates of inflation are perhaps too focused on the short term. Often, the debate assumes that the global economy is stable and returns to ‘equilibrium’ after localised supply shocks have a chance to move through the system and markets restabilise. But many experts believe we are entering a new period of instability and will regularly face fresh bouts of higher inflation. 

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Geopolitical instability and supply shocks. Experts at Brookings argue that “geopolitical tensions have become the single most important risk confronting the global economy” in 2024, with wars in “two regions critical to the world’s food and energy supply”. Conflict in the Red Sea has already led to supply shortages and trade frictions in the Suez Canal, which accounts for 30% of global shipping container traffic. These developments again show that inflation can arise from unpredictable external events over which institutions like the BoE have little control. Can our institutions respond to this new inflationary environment? 

• Climate change and inflation. Evidence from the Climate Change Committee shows that the UK economy is “already experiencing disruption to domestic supply chains from floods, droughts, high temperatures and other extreme weather”, with nearly half of respondents to a recent survey from the Business Continuity Institute saying their supply chains had been disrupted by extreme weather. James Meadway’s recent substack explains how "The simultaneous foul-up of the Panama Canal, hit by drought, and the Suez Canal, targeted for hijackings linked to Israel’s assault on Gaza, neatly encapsulates the polycrisis and its impacts and costs". (Read Chatham House’s 2021 Climate Change Risk Assessment for an overview of the ‘cascading systemic risks’ climate change poses for the global economy, in the form of trade disruption, mass migration and more.)
• War and global trade frictions. Part of Rishi Sunak’s justification for the recent military intervention in the Red Sea was explicitly economic, arguing that “It is also about economic security, because of the impact of the Red Sea attacks on the prices people pay at home. We have already seen that in the impact on oil prices of the Russian invasion of Ukraine.” Rising geopolitical tensions are leading some governments to adopt more interventionist approaches to secure supplies of energy and critical commodities. US President Biden's National Security Advisor Jake Sullivan warned that “Clean-energy supply chains are at risk of being weaponized in the same way as oil in the 1970s, or natural gas in Europe in 2022.” The Biden Administration has attempted to overcome partisan dividing lines over climate action by framing green industrial policy as an “essential element of United States… national security”. (Laurie Laybourn and Joseph Evans’ paper in IPPR’s Progressive Review explains how the CHIPS Act, IRA and other pioneering pieces of US climate policy fuse productivist economics with decarbonisation and geopolitical strategy.)

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UK institutions haven’t adapted to new instabilities. The Bank of England is mandated to increase interest rates and constrain economic activity when inflation is higher than its 2% target. The question of when and how to act largely turns on your view of whether the inflation is ‘transitory’ or ‘persistent’- i.e. is high inflation just a temporary shock that will resolve itself, or is it so embedded within the economy that more determined action is needed? Much of the economic debate over how to respond to inflation has focused on this question, with (very crudely) Team Persistent arguing for higher rate rises to crush core inflation, while Team Transitory called for price caps and other strategies to contain the impact of high energy prices and stop it spreading to other areas of the economy. 

• Modelling shocks. It matters a lot how we model these external shocks. Geopolitical instability and climate-induced disruption to the economy both drive inflation up by restricting trade and reducing the supply of goods. Conventional economic models view these events as temporary external shocks which will eventually tend back towards an ‘equilibrium’, under the assumption of efficient, stable markets that allocate resources efficiently. 
• But what if the shocks are not one-off events at all? James Meadway covers this in a recent substack on Inflation and the Anthropocene, and asks a poignant question: “In a world subject to repeated, consistent shocks, deriving from the same source, what use is a model that can only say they are “external” deviations from the economy’s growth path?” His answer is to suggest we are entering a period of consistent external shocks, and that economic models need to adapt accordingly.

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Rising UK interest rates won’t solve global problems. And yet, the BoE’s price stability mandate encourages it to increase interest rates whenever inflation rises over 2%. Increasing interest rates makes borrowing more expensive, limiting both public and private investment. As explained above, across the world, many countries are accelerating investments in industrial policy to ease supply bottlenecks, but conventional monetary policy is pulling in the opposite direction.

• Green investment suffers in particular. Higher interest rates is especially harmful for investment in the green transition – the exact kind needed to wean the economy off the supply chains most threatened by geopolitical instability. Projects such as offshore wind farms save money in the longer term, but they  often have high upfront capital costs. This has put new construction under increasing strain as borrowing has become more expensive. The irony of this is that the Bank’s aim of price stability is being further hindered by its own blunt tool of monetary tightening. Green investment can make the UK economy less vulnerable to future bouts of ‘fossilflation’ - inflation that was primarily caused by sudden increases in fossil fuel prices – e.g. by financing more building retrofits and clean energy projects. (See our previous explainer on how green credit guidance – offering a lower interest rate for green investments – can help.)
• But: “inflation is a sign that more investment is needed”. IPPR’s Carsten Jung argues that the Bank of England increased interest rates too much because they put “too little focus on supply side mechanisms & too much attention on wage earners.” Economists at German insurer Allianz concluded that 55% of the disinflation seen in the US can be attributed to the healing of supply chains, with just 20% stemming from monetary tightening and the way it constrained demand. Alex Williams from Employ America writes in IPPR’s latest Progressive Review that adopting a ‘macroprudential fiscal policy’ approach to inflation – essentially using industrial strategy to ease supply bottlenecks – provides “a critical alternative to interest-rate hikes as the main tool by which inflation can be reduced”. This approach conceives of inflation as a signal to invest more in sectors suffering from supply shortages, rather than a sign that people need to be made poorer by tightening monetary policy. (Read other articles in this edition for more on how the UK can learn from US green industrial policy.)

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Anti-inflationary policy for an unstable global economy. Christine Lagarde, President of the European Central Bank, argued in a speech at last year’s Jackson Hole Economic Symposium on Policymaking in an age of shifts and breaks that “we will have to establish new frameworks geared towards robust policymaking under uncertainty”. If instability is now the norm, perhaps it is time to rethink our monetary policy institutions and how economies respond to bouts of inflation and supply-shocks?

• Reviewing central bank independence. Some experts think central bank independence should be reviewed to help macroeconomic institutions work together to achieve multiple policy goals, rather than against each other. Peter Sedgwick of the Official Monetary and Financial Institutions Forum suggests that, whoever wins the next general election, “it will be time to review the institutional arrangements for monetary and fiscal policy.” He offers various suggestions for reforming how the Treasury and BoE cooperate “even if this alters the Bank’s operational independence”, with the aim of  ensuring that “the burden of reducing inflation, when necessary, does not fall disproportionately on those of working age with mortgages.” ‍
• Fiscal and monetary coordination. A recent pamphlet from the Fabian Society proposed that “a new economic policy coordinating committee should be set up to bring together the Treasury, the business department and the Bank of England, alongside the devolved governments and arms-length bodies responsible for climate change, public finance, infrastructure and low pay” to share analysis and coordinate policy to reach several goals. Its authors argue that both public spending policies (such as the energy price cap) and tax changes (such as cutting VAT) should be used to reduce the pain that inflation inflicts on lower income households.