- Low potential growth means economies more easily overheat
- But tackling the supply side is easier said than done
In May, Bank of America analysts warned that “the UK has one of the most severe persistent inflation problems among developed market economies”. Two disappointing inflation releases and one ‘double’ interest rate hike later, there is little doubt that they have a point – notwithstanding this week's better-than-expected price growth data.
The analysts say that “the UK economy has an entrenched inflation problem in our view because of weak potential supply growth and modestly de-anchored inflation expectations”. Estimates suggest that the UK’s ‘potential’ growth rate is just 1 per cent a year, which means that it takes only a very low level of ‘actual’ growth to hit full capacity, as the chart below shows. The economy is quick to overheat, and the consequences for inflation are grim.
Analysts think that the UK can either enjoy “modestly positive” growth and persistent inflation, or higher-for-longer interest rates resulting in very weak – or negative – ‘actual’ growth. Both options sound miserable. But is there another way?
In blunt terms, monetary policy works by decreasing demand in the economy until it matches supply. Supply-side policies, on the other hand, can let economies ‘grow out’ of inflation by increasing the rate of potential growth. Policies that improve productivity, competition and innovation all increase the rate of growth that an economy can sustain over the medium term – without generating excess inflation.
Nobel Laureate and Stanford economist Michael Spence argued the case eloquently in an article last year. He said that “trade and investment have long enabled supply to expand rapidly in response to growing global demand”, and advocated investment in digital technology, streamlined regulations and efforts to facilitate trade. Spence warned that if central banks are left to deal with inflation alone, we will see global growth pushed below potential and reduced investment in the energy transition, with “dire consequences for the entire global economy”.
Supply-side policies could also help to address some of the problems caused by tight labour markets in advanced economies. Following their supersized June hike, Bank of England (BoE) rate-setters said that they would closely monitor “the tightness of labour market conditions and the behaviour of wage growth”. Although wages are not rising fast enough to keep pace with inflation, they are rising too fast to be consistent with bringing inflation back down to the 2 per cent target.
Mike Riddell, bond fund manager at Allianz Global Investors, calculates that if long-term productivity growth is only around 1 per cent, any wage growth above 3 per cent will prove inflationary. “If problems on the supply side do not improve, then the BoE will be forced to further reduce demand in order to get wage growth lower”, he said.
But improving the supply side of the economy is hard. Firstly, most policies designed to help are euphemistically described as effective over the ‘medium term’ – limiting their immediate usefulness in the face of an acute inflation problem. The line between fiscal and supply-side policy is also blurred, as the reaction to the short-lived "mini"-Budget showed. What Truss and Kwarteng saw as a “growth plan” full of measures to “help expand the supply side of the economy”, markets and economists saw as unsustainable (and potentially inflationary) government largesse.
But this doesn’t mean that the supply side should be neglected. Clare Lombardelli, OECD chief economist, told the Financial Times last month that while “everyone gets very excited about monetary policy and the short term stuff, what enables economies to grow and what changes people's wellbeing… are these structural things”.
Ruth Gregory, deputy chief UK economist at Capital Economics, is of a similar mindset. She said: “While falling inflation and some pre-election fiscal giveaways may provide scope for some near-term catch-up in the UK, it is the inherently difficult supply-side reforms that need to be addressed if the UK’s current gloomy narrative is going to be changed.”
She added that “as things stand, we are not hearing anything from policymakers to make us significantly more optimistic about the UK’s medium-term outlook”. Although political expediency means we will probably see some tax cuts before the next election, political expediency also means that these will probably be short-lived.
