This is Armchair Economics with Hamish McRae, a subscriber-only newsletter from The i Paper. If you’d like to get this direct to your inbox, every single week, you can sign up here.
Inflation is climbing again – and will climb further next year. One month’s figures are only one month’s figures, but the rise in the Consumer Prices Index (CPI) in November to 2.6 per cent has scuppered any remaining chance that the Bank of England might cut interest rates tomorrow.
If owner-occupied housing costs are factored in, as in the CPIH, inflation is also rising, at 3.5 per cent. As for longer term rates, the yield on 10-year gilts rose well above 4.5 per cent to the highest it has been this year.
The most troubling aspect of the inflation numbers is that there is no sign of any let-up in the months ahead. This is partly because of Government policy – the rise in tobacco duties, for instance, pushed up the index for November. Putting VAT on private school fees will increase the index in January, and the rise in vehicle excise duties will show through in April. The fact that many contracts are linked to the Retail Prices Index, up 3.6 per cent in November, will add further pressure.
But the strongest driver of inflation will be what happens to service sector prices. They are rising by 5 per cent a year. The service sector is huge and labour intensive. So the latest pay figures showing that average wages are up 5 per cent year on year will make it very hard for that chunk of the economy to hold prices down in 2025.
One forecaster, Pantheon Macroeconomics, estimates that the CPI will hit 3.1 per cent in April and stay at or above 3 per cent through to October. If that happens, the pressure will be on the Bank to slow down any cuts in interest rates.
High prices, or job losses
The great unknown is how employers will react to the forthcoming increase in national insurance contributions (NIC), which takes effect in April. There will be some combination of higher prices and lower employment, but no one really knows what the balance between those two will be.
If higher prices are passed onto consumers, that slows any decline in interest rates. If there are job cuts, then quite aside from the social and human damage of rising unemployment, that slows the economy – flat at the moment – even more.
So it is a difficult outlook. There are two further factors that will complicate matters even more. Both come from the US. The fiscal plans of the incoming Trump administration are unclear, but there is real concern that the country’s fiscal deficit, which is running around 6 per cent of GDP, will rise still further. That will push up bond yields everywhere, including in the UK – if the US government has to pay more to borrow, so too will our government.
Tariff tit-for-tat
The other is what the tariffs proposed by Donald Trump may do to goods prices worldwide. Will there be retaliation, with other countries putting tariffs up too? Most economists think that any impact on prices will likely be felt in 2026 rather than next year, and that may be so.
It may be that the UK, unlike the EU, will be spared from any trade barriers. That would be mostly because two-thirds of our exports to the US are services rather than goods, and there are no plans to restrict trade in services. But if the European economies are hit by US action, that would have a knock-on effect by reducing demand for our exports.
So there are huge uncertainties. Yet this is nothing like the blow that struck the world economy during the pandemic, nor the damage done by the banking crash of 2008-09. The problem, though, is that it is hard to see any significant positive aspects for 2025.
It’s not all bad
Inflation will be above the 2 per cent target. Interest rates may come down a bit, but not much. Large companies will be cautious. Small businesses will be squeezed. Taxes overall will go up, either directly, with things like vehicle excise duty, or indirectly, with inflation pulling more and more people into higher tax brackets.
The outlook is not totally negative. House prices have held up this year, and that gives stability to the economy more generally. Unemployment has not risen as sharply as many feared. But the best hopes for inflation come from the international front.
Just as the Russian invasion of Ukraine pushed up global food and energy prices, some sort of ceasefire would help to hold them down. A calmer Middle East would of course be enormously welcome for a host of different reasons. However, the big lesson of the past few months, as far as inflation is concerned, is that once it shoots up, it is very hard to grind it back down.
The crisis is past, and that is a relief. But as these latest numbers remind us, the dragon of inflation is not yet safely back in its cage.
Need to know
There is, I am afraid, one set of circumstances that would really stamp on inflation, and that would be a recession. Pay would be held down, some people would lose their jobs and companies would be forced to hold down prices wherever they could.
But no one should want that. Far, far better to allow rising productivity to work its way through the economic system, so that most people keep their jobs and employers find ways to contain their costs without downsizing their staff. While it is easy to say that, it is very hard to do.
What we do know, however, is that just about every small or medium-sized business in the land is trying to figure out how to contain costs when the rise in NICs hits in April. Viewed objectively there should be scope for gains in efficiency. Our service sector, like so many aspects of the economy, is uneven. The best of it is wonderful, but there is a long tail of underperformers.
There is a thorough study of the issues from Cambridge University here, the gist of which is that high-productivity sectors such as manufacturing and mining have declined vis-à-vis lower productivity branches such as construction and services. Within service sectors, productivity in finance has fallen from the high levels from the 1990s to the banking crash – though I think a lot of that growth was actually very damaging.
A lot of the activity was lending money to borrowers that didn’t pay back. Lord Adair Turner, the then chair of the Financial Services Authority, famously described a lot of financial transactions as “socially useless”.
So you have to be careful in measuring productivity in service industries. But what I hope is that we will learn something positive from the imposition of higher NICs. Maybe there are simpler ways of doing things that will help hold down costs.
The good news is that at least we are aware of the issue, and there is a lot of work going on from organisations including The Productivity Institute to try to lift performance. There is a National Productivity Week at the end of January, and let’s see what emerges. But just as curbing inflation will be a huge slog, so too will be lifting the efficiency of the economy.
Whisper it low, but I have a sneaking feeling that the rise in NICs will trigger some surprising outcomes.
This is Armchair Economics with Hamish McRae, a subscriber-only newsletter from The i Paper. If you’d like to get this direct to your inbox, every single week, you can sign up here.
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