The spectre of stagflation could return to haunt Britain very soon

If country’s Q3 GDP data due out Thursday comes in softer than the 0.3pc gain expected, it would be less than half the rate notched up in the previous quarter

PUBLISHED : Monday, 24 October, 2016, 10:19am
UPDATED : Monday, 24 October, 2016, 10:41pm

Remember the days of slowcoach growth, hyper-inflation, surging property prices and unemployment heading higher. Does it ring any bells?

It may sound rash to say stagflation is returning to Britain after four decades, but it would be unwise to rule it out entirely.

For the UK economy, over-loaded with QE money and excessively low interest rates, signs of rising inflation makes a sea-change in policy thinking imperative in the next few months.

It is still unclear how badly the UK economy has been affected by June’s shock poll favouring Britain quitting the European Union. But one thing is certain – UK inflation is heading higher, making it a mistake for Britain to cut rates again or to print any more QE money in this cycle.

Official UK GDP data due out this week could throw better light on the matter when Britain publishes its first full quarter of economic growth data since June’s Brexit vote.

Despite all the doom and gloom about Britain sinking into recession due to Brexit, recent economic data and surveys have shown the economy looking remarkably resilient. But this is not set in stone.

Britain’s major banks are also set to report stronger-than-expected results this week, confounding expectations that political and economic upheaval caused by the vote to quit the European Union would immediately squeeze profits.

If Thursday’s third quarter UK GDP data comes in softer than the 0.3 per cent gain expected by market polls, it would be less than half the 0.7 per cent rate notched up in the previous quarter. Stagflation was the curse of Britain’s ailing economy back in the 1970s, so any signs of UK growth faltering while inflation is bouncing back would be a shock for UK markets and policymakers.

If so, UK monetary policy will need a vital shift from deflation-fighting to inflation-prevention without damaging growth prospects at the same time – a complex task at the best of times.

Adding to the Bank of England’s problems will be gauging how much UK inflation is set to rise after sterling’s recent currency collapse, especially while import costs are being driven higher by a recovery in global commodity prices.

The UK inflation outlook is clearly in a state of flux right now. September’s jump in headline inflation to 1 per cent and the rise in the core CPI rate (excluding food and energy) to 1.5 per cent confirm that UK deflation dangers are over. It means, at some stage, the BOE will need to intervene, unwind its monetary over-accommodation and stop inflation from bolting higher.

Even through headline inflation will probably be breaking the BOE’s 2 per cent target in early 2017 and possibly tracking up to 3 per cent next year, there is little reason for panic just yet.

Weakness in the UK pound may be stoking up higher cost-push inflation risks, but the UK is a far cry from the demand-pull pressures usually associated with excessive over-heating risks.

However, the BOE will still be anxious that monetary policy is tilted too much towards super-stimulus, with interest rates effectively at zero. Sterling’s 25 per cent collapse over the last year is the equivalent of a 6 per cent drop in short term interest rates, strengthening arguments that the economy is getting too much of a good thing and is in urgent need of some pre-emptive tightening before too long, especially now the government is easing back on fiscal austerity.

UK policymakers should also be concerned about other associated symptoms of over-heating, not least in the financial and property markets. Thanks to QE and zero interest rates, the glut of cheap money is continuing to pump up bubbles in the UK’s equity and debt markets and keeping British property prices super-heated at the same time. The weak pound is making the problem worse as overseas investors continue to snap up apparently ‘cheap’ UK financial assets.

Risks to UK financial stability are not going unnoticed in the markets. Mainstream investors are already beginning to fret about the threat of a hard landing should market euphoria eventually take a dive. UK asset managers are quietly scaling back equity exposure in favour of safe haven government bonds and ultra secure cash in a move to minimise risk.

The BOE’s overriding priority is to ensure economic sustainability and protect financial stability going forward. UK markets have already been primed for a possible rate cut in November if the outlook for growth deteriorates. But another rate cut is the last thing the UK economy needs right now.

It may be easier to respond to weaker growth signals in the short term, but the BOE would be braver to tackle inflation before it is too late.