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The stagflation threat

Yes, the UK does face the threat of stagflation. Some of the sources of this threat are temporary, but one other is not.

Stagflation is an ugly word for an ugly thing – a combination of slow growth and higher inflation. It’s what happens when it becomes more difficult or expensive for firms to produce goods and services with the result that they raise prices or cut production or both.

And production is becoming more difficult and expensive. One reason for this is the quadrupling of gas prices this year. This adds to the costs of production, as well as squeezing our real incomes and hence our spending. But it is only the most spectacular example of a wider phenomenon: commodity prices generally (as measured by the GSCI) have risen more than 35 per cent so far this year.

A less functional labour market is another source of stagflation. The problem here is not that demand for labour generally is soaring; that would be inflationary not stagflationary. If this were the case, we’d be seeing low unemployment and rising real wages. But we are not. If we add together the officially unemployed and those outside the labour force wanting a job, there are over three million out of work. And real wages have actually fallen so far this year. Instead, what we’re seeing are mismatches: shortages in a few sectors such as lorry-driving existing alongside unemployment.

The ending of the furlough scheme is also stagflationary. It ends a subsidy to employers, thus raising their costs.

Some of these threats, though, are temporary. Labour market mismatches should fade as firms recruit and train new staff – at higher wages for some. And higher prices naturally cause people to economise, which will force prices down: commodity prices, remember, are cyclical. It is only if rising prices lead to higher inflation expectations and hence to further price rises that inflation will become entrenched. So far, though, there is little firm evidence of this.

And, in fact, some other developments will reduce inflation. The £20 a week cut in Universal Credit will cut aggregate demand and, at the margin, therefore help force down inflation.

Yes, inflation will rise in the next few months. But I fear weak activity is a bigger danger. The fact that bond yields are still so low suggests that markets agree with me – rather more strongly than I am comfortable with.

We must not, however, think that all the causes of stagflation are new or temporary. One of them is longstanding. I mean, of course, the flatlining of productivity. In the last 14 years this has grown just 0.3 per cent per year compared with 2.3 per cent a year in the previous 30. This is a sign that companies are finding efficiency gains more difficult than they used to. That makes it harder to increase output without raising prices, which means we are more vulnerable to the threat of weak growth and higher inflation than we used to be.

Now, the thing about stagflation is that the Bank of England can do little about it: higher rates cut the flation but worsen the stag. Instead, the cure lies in anything that improves the supply-side of the economy – be it lower commodity prices, technical progress or whatever. We should hope that such improvements come from the operation of market forces – because there’s little evidence  that they’ll come from policy makers.