Brexit reality bites as stagflation looms


The writer is president of the Peterson Institute for International Economics and a former member of the Bank of England’s Monetary Policy Committee

Sometimes, reality bites. The UK outlook for stagflation of rising prices and slowing economic growth this year and next reflects the realities that Brexit has wrought. 

Of course, the Covid pandemic, the difficulties of reopening the economy, and now energy and food price surges are not caused by Brexit. 

But the UK’s vulnerability to those shocks, and therefore the amplification of their inflation impact, is largely due to Britain’s departure from the EU. This is why the Bank of England will end up having to raise interest rates over the next year more than it forecast this month, and even more than markets have already priced in. Given the very hard Brexit, the Bank of England and the UK economy have been dragged part way back to the 1970s. 

By that, the Bank’s Monetary Policy Committee is no longer able to look past external economic shocks as they did during the 1992 European Exchange Rate Mechanism exit or 2009 sterling depreciation. In these cases, they had the luxury of setting monetary policy solely in terms of hard domestic forecast data. But after Brexit, the MPC would have to worry more about the “spillover” of international events into inflation expectations.

This is due to a combination of the UK being a smaller economy on its own, less buffered by its integration in the EU, and an erosion of trust in UK governments to run disciplined economic policies. Hence, any shocks are likely to result in higher and more lasting inflation than they did before Brexit.

Additionally, because the UK has waged a trade war on itself, Brexit has a direct effect on inflation. There is a down shift in purchasing power — a one-time but significant move that is taking some years to play out as various aspects are implemented. This takes the form of administrative costs and regulatory barriers as well as tariffs and diminished policy choices. 

There also has been a reduction in both the level of labour supply and its elasticity with the effective exclusion of European migrant workers. Labour is a differentiated good with no simple substitution when workers in a given industry, skill set or region are no longer available. Critically, this has meant a growing mismatch of available workers to jobs, as well as the perceived bargaining power of domestic workers in certain sectors. 

The UK avoided the US’s 2021 mistake of distributing too much fiscal stimulus in too brief a period when the economy was recovering but short of labour; if anything, fiscal policy was too austere. The UK, like the EU, also avoided Washington’s error in tying Covid aid to workers laid off or fired, by instead subsidising jobs and furlough schemes. 

Yet, the UK inflation rate is high, similar to US levels, and has been for some time. It is higher than the rate for the eurozone, even though price rises accelerated across the bloc predominantly as a result of Russia’s war in Ukraine. It is Brexit wot done it. Because of the limitations of today’s UK labour market, the British economy faces much the same worker shortages and wage pressures as the US.

UK price rises reflect, in part, the idiosyncrasies of Britain’s natural gas and food markets. However, the lack of sourcing supply options for agricultural labour and fuel made those inflationary effects worse and more persistent. Implementing trade barriers and new standards between the UK and the EU single market only compound the problem.

I do not share the MPC’s assessment that the forecast decline in real incomes and the planned monetary tightening will be sufficient to bring inflation back to target within two to three years. Monetary policy has to be exercised because in a small closing economy with an inflationary trend — similar to Britain in the 1970s — inflation does not self-correct with general movements in demand. 

Wage increases are not keeping up with inflation but this is precisely why monetary policy has to tighten further now, not wait. Preserving the real income for working households is exactly why the Bank should be fulfilling its mandate to maintain stable prices around the 2 per cent target. 

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