UK: At the Crossroads of Growth and Inflation

There are two big questions about Britain’s economy this year. One is whether inflation will come down after yet another “temporary” blip. The other is whether the recovery can survive both tax increases and spending cuts.

On Tuesday Vat will rise to its highest level in Britain’s history, 20%. Back in the 1970s, when the tax replaced the old purchase tax, there was a standard rate of 8% and a 12.5% rate for luxury goods.

These were combined into a single, higher rate of 15% in Sir Geoffrey Howe’s first budget under Margaret Thatcher in 1979, followed by the increase to 17.5% by Norman Lamont in 1991. You will notice that every Vat increase has been by Conservative chancellors.

In theory, Tuesday’s VAT hike to 20% should be neutral for inflation. This time last year, Labour reversed its temporary cut in Vat to 15%, restoring the rate to 17.5%. So, while the Vat hike raises the level of prices – by 2.13% if you do the arithmetic – it should not add to inflation.

In the real world, however, things are a bit more complicated. Evidence from the Office for National Statistics and the Bank of England’s agents suggests that while the effect of the temporary cut and subsequent hike in Vat in 2008-10 was partial – many companies did not pass it through in their prices – the permanent Vat hike to 20% will have a bigger impact, close to full pass-through. It could even be beyond full pass-through if, as is possible, firms use the Vat hike as cover for other price hikes. If you wanted to be optimistic, on the other hand, you might conclude that firms have already begun to anticipate the Vat hike in their prices. You may remember those record November price hikes in furniture and clothing.

Vat is not the only headache for the Bank. Ross Walker of Royal Bank of Scotland has a grim list which includes utility price rises of 7%-9%, 6% rail fare increases and continued high food price inflation. Though he does not expect inflation to hit 4%, as many do, he thinks it will be above 3.5% for most of the year.

This is exactly what the Bank’s monetary policy committee (MPC) does not want. When fiscal policy is being tightened, the understanding is that monetary policy stays loose. That is what the government is assuming. If that assumption is wrong, this will be a tricky year for the economy.

I am assuming that the MPC will move heaven and earth to “look through” the inflation overshoot, as before. So we either get no change in Bank rate or at most a gentle move up to 1%. We need inflation to be back below 3% by the end of the year and falling, which is what I expect, but this is a risk.

If the Bank were forced to raise rates more sharply, it would add to the impact of the government’s fiscal tightening. John Philpott, chief economist at the Chartered Institute of Personnel and Development (CIPD) predicts 120,000 public sector job losses this year, and an additional 80,000 in the private sector, pushing unemployment on the wider measure up from its current 2.5m to 2.7m, 9% of the workforce.

This is a big uncertainty. In 2010 private sector job creation was strong, as in the 1990s when public sector jobs were cut. But the momentum appears to have weakened towards the end of the year.

Households look set for a double whammy of below-inflation pay increases and the threat of unemployment. I would expect some rise in unemployment in the short-term, pushing the narrower claimant count up to 1.55m by the end of the year.

As for overall growth in the economy, Britain needs a substantial contribution from investment and net trade; exports minus imports. Recent news on business investment has been encouraging, net trade less so.

I would expect that to come through during 2011, with the current account deficit falling from more than £30 billion to £15 billion on its way to balance. Investment should continue to pick up, giving overall economic growth of about 2%. That’s unexciting but not bad in the circumstances. Growth could surprise on the upside again.

Looking back on what I expected for 2010, I was a little pessimistic on growth (1% versus a likely 1.7% outturn) and unemployment (1.75m), too optimistic on inflation (2%) and the current account (a deficit of £10 billion versus a likely £30 billion-plus) and wrong to expect a small rise in Bank rate to 1%.

Whether the mistakes this year are on the optimistic or pessimistic side remains to be seen, but 2011 will certainly be fascinating.

My regular column is available to subscribers on – this is an excerpt.

Originally published at David Smith’s EconomicsUK and reproduced here with permission.