9 November 2022

Britain’s big squeeze

A new era of higher interest rates and lower wages threatens another lost decade for living standards.

The economic forecasts released by the Bank of England in August were perhaps the grimmest set it had unveiled since gaining independence from the government in 1997. The November update, which accompanied the 0.75 point rise in interest rates, was, if anything, even worse. The UK, the Bank said, had already fallen into recession and the downturn is expected to last until at least mid-2024. That would make for the longest recession in at least a century and raises the prospect of an economic contraction that spans Rishi Sunak’s entire premiership. To enhance the gloom, even the forecast recovery is expected to proceed at a sluggish pace.

The news will have come as no surprise to British households. Economists have a poor record of spotting downturns in advance. Both the 2008 recession and that of the early 1990s were several months old before most forecasters realised that they were happening. Surveys of consumer confidence were far more accurate predictors than the views of professional economists. The same seems to have happened this time around. The market research company GfK’s monthly measure of consumer confidence – one of the oldest in Britain, dating back to 1974 – has been hitting record lows since late spring.

Video produced & edited by Phil Clarke-Hill

This is hardly breaking news. While UK GDP fell by 0.3 per cent in August, for most people the past six months have felt like a recession. Household living standards are enduring what is expected to be the biggest fall since the 1950s. Annual average wage growth of around 5 per cent may be the fastest in cash terms for almost two decades but inflation now stands at 10.1 per cent.

Rather than supporting the economy, policymakers are adding to the pain. The Bank of England has increased interest rates from just 0.1 per cent last December to 3 per cent, the fastest pace of monetary tightening in 30 years. With price rises at a 40-year high, the Monetary Policy Committee (MPC) has concluded that tough medicine is required to return inflation to the 2 per cent target.

While the MPC can do little to combat high global energy prices or supply chains disrupted by the Covid-19 pandemic, it worries that a tight domestic labour market – with more advertised job vacancies than unemployed workers – is adding to inflationary pressure and requires cooling. In plainer English, the Bank is raising interest rates in order to increase borrowing costs, tighten financial conditions and slow down firms’ hiring and investment decisions. The pain felt by borrowers – the average tracker mortgage has increased by £3,410 since last year – is a feature, not a bug, of the policy.

The Bank of England is far from alone in reaching this conclusion. The US Federal Reserve has tightened policy to an even greater degree (its benchmark interest rate is now 3.75 to 4 per cent) and the European Central Bank is moving in the same direction (it has raised rates to 1.5 per cent, the highest level since 2009). In the UK, however, tighter monetary policy has an unpleasant twin: tighter fiscal policy.

Less than two months ago, in late September, the short-lived Truss government launched its equally short-lived “dash for growth”. The centrepiece of the mini-Budget on 23 September was tax cuts worth £45bn a year, the largest since the Tory chancellor Anthony Barber’s ill-fated 1972 budget. After 12 years of preaching fiscal rectitude, the Conservatives wholly abandoned budgetary discipline and bet the house on tax cuts. The bet did not pay off.

The negative market reaction forced not only a change in policy but a change in prime minister. Rishi Sunak now appears ready to overcompensate. Ahead of Jeremy Hunt’s Autumn Statement on 17 November, Sunak has warned of “tough choices” – code for a new era of austerity. The visit paid by George Osborne to the new chancellor at Downing Street on 27 October symbolised as much. Hunt has appointed Rupert Harrison, Osborne’s former chief of staff and now a Blackrock portfolio manager, to a new economic advisory council.

But loose talk of a “£60bn fiscal black hole” should not be accepted unquestioningly. The figure is a result of the fiscal rules chosen by the government (in this case, to reduce the national debt as a share of GDP over the next three years). Such edicts have been changed frequently over the past decade and could easily be changed again. As a general principle, any set of rules that calls for tax rises and spending cuts as consumers are squeezed and firms begin to cut jobs and investment is ill-judged.

Even leaving aside the immediate economic implications, the impact on public services of a return to austerity would be severe. Outside of health and defence, government departments could be facing budget cuts of 10 to 15 per cent. After a decade of tight spending settlements, there is no fat left to trim. Cutting the infrastructure budget – a usual favourite of chancellors seeking savings – risks damaging growth prospects well into the future.

It is important to understand that the vicious market reaction to the mini-Budget had two distinct but related drivers. On one level the response was straightforward: investors rightly concluded that if the government added to inflation via tax cuts then the Bank would be pushed into even steeper interest rate rises. This led to a corresponding fall in the price of British government bonds, known as gilts. The price of bonds falls as the yield, or interest rate on them, rises.

But alongside this predictable shift, there was another factor. Many defined-benefit pension funds, it transpired, had deployed a great deal of borrowing as part of their investment strategies and pledged gilts as collateral for their loans. As gilt prices fell, the funds were forced to sell their gilts to meet immediate demands for payment, adding to downward pressure on their prices. This was the “fire-sale dynamic” that pushed the Bank of England to intervene to prevent a financial crisis.

The government lit a fire in the gilt market, but it turned out that the structure of the market itself had provided plenty of kindling. Had that kindling not been present, the price moves would have been painful but would not have taken the UK to the edge of a crisis. Regulators have belatedly woken up to the problem and a direct repeat of the episode is unlikely.

In other words, the markets are not a Damoclean sword hanging over the government, waiting to fall if “the black hole” is not filled quickly. While £45bn of unfunded tax cuts risked overheating an economy that already had an inflation problem, £60bn of tax rises and spending cuts risks intensifying an already grim recession. The fiscal shower dial has swung from too hot to too cold with no attempt to find a warm middle ground.

Sadly, inappropriately austere policy is nothing new for Britain – it has prevailed for most of the Conservatives’ 12 years in office. The new element is higher interest rates. Past rounds of Tory austerity have been offset by what Osborne called “monetary activism” (the Bank’s base rate was below 1 per cent from March 2009 until May this year). The return of interest rates to something approaching a more historically normal level will have a profound impact on British politics and society.

Despite real wages stagnating since the 2008 financial crisis, the Conservative Party has increased its share of the popular vote at every general election over that period. In part, this reflects the Tories’ formidable strength among the over-65s (who have been duly rewarded with the protection of the state pension “triple lock”). But even amid the UK’s anaemic post-crash growth, there has been a substantial cohort of working-age voters for whom economic reality has not been too tough. As in the 1930s and the 1980s, the 2010s were a decade of economic pain during which an incumbent Conservative-led government was consistently re-elected. And as in those decades, the key to understanding this is to remember that provided the economy is creating enough relative winners, a government can assemble a sufficiently large coalition of voters.

Ultra-low interest rates were one of the key reasons Conservative support rose even as the state shrank. The most obvious impact was on the housing market. It was low rates that drove much of the near 40 per cent rise in house prices between 2010 and 2020. But it was also low rates that kept mortgages affordable even as prices surged. According to Zoopla, an online estate agent, the typical monthly mortgage payment – in cash terms – flatlined from 2010 to 2020 and was actually lower in 2020 than in 2008. Meanwhile, private rents rose by almost 30 per cent in the same period. Homeowners won in two regards: not only were their monthly housing costs lower than those of renters, their wealth rose as the value of their home increased.

The impact of cheap money could also be seen on Britain’s driveways and in its garages. Rather than buying a new car with cash, consumers started paying a deposit and taking a low-cost loan from the vendor. Less than half of new car purchases were financed in this way in the mid-2000s, compared with more than nine in ten by 2019. As cars became cheaper they also became fancier, with more Audis and BMWs filling up the roads.

Much ink has been spilled on Boris Johnson’s conquest of the Red Wall: the 50 or so Conservative gains from Labour in Wales, the Midlands and the north of England in 2019. While the Brexit deadlock and Jeremy Corbyn were crucial factors, behind these transitory aspects was a structural economic shift. In these seats, low interest rates often meant lower housing costs, rising wealth and a better, cheaper car. It is notable that the Red Wall seats have higher rates of home ownership than their Labour-voting neighbours and that most of their workers commute by car.

In 2019, 57 per cent of owner-occupiers and 43 per cent of mortgage-holders voted Tory (against just 22 per cent and 33 per cent for Labour). Of the 365 seats won by the Conservatives, 315 have home ownership levels above the UK average of 64 per cent, compared with just 53 of the 202 won by Labour.

In the “Barratt Britain” – named after Britain’s biggest home construction company, Barratt Developments – of estates built over the past three decades, ultra-low rates meant that a couple with a combined income of around the national household median of £31,400 after tax could, via savings or family help with the deposit, afford not only a house but two cars and often two holidays. Income growth might have been weak but the actual experience of day-to-day living was far better than the numbers imply. In short, the middle-class lifestyle idealised by the Conservatives was, in many parts of Britain, attainable to those of relatively modest means.

This world looks rather different in an era of 3 per cent-plus interest rates. For a typical couple who bought their first property in the 2010s, a 2 per cent increase in rates amounts to an extra £350 a month on the house alone. The second car will go and the first may have to be downgraded. A return to more normal interest rates means the imbalance between stagnant wages and actual living standards will end.

[See also: The rise of high-tax Britain]

Though some Conservative supporters are nostalgic for higher rates – 57 per cent of people who owned their homes outright voted Conservative in 2019 – conditions today are radically different to the 1980s: house prices have risen by more than 1,100 per cent since 1980 and the government no longer provides mortgage interest tax relief. Owing to higher mortgage debt, interest rates of 3 per cent are today equivalent to 14 per cent in 1980 when defined by affordability.

The Truss government’s promise was one of higher growth and lower taxes. But the UK now faces one of the most unpalatable economic cocktails in memory: lower growth, higher taxes, lower public spending, higher interest rates. That is an economic disaster for the UK. But it is also a political disaster for the Conservatives. A party can preside over tough times and still be re-elected as long as it creates the right amount of relative winners. In the big squeeze, there simply will not be enough of them.