With the risk of a global recession looming, Costas Milas examines several implications for UK monetary and fiscal policy.
Talk to The Financial Times Speaking on condition of anonymity, a cabinet minister said: ‘We’re heading for a *** storm – we better pick someone who knows what they’re doing’. The anonymous cabinet minister raised a very good point. Inflation in the UK is expected to reach (or even exceed) 11% and the Bank of England predicts a recession. The global outlook is also darkening rapidly. With US inflation hitting 9.1% in June 2022, the biggest rise since 1981, there is a good chance that the Fed will soon raise its key rate by a minimum of 75 basis points to 2.5%. Meanwhile, IMF chief Kristalina Georgieva warns that the world faces a growing risk of recession over the next 12 months.
All of the above has implications for UK monetary and fiscal policy. As Bank of England officials consider further interest rate hikes above the Bank’s current benchmark rate of 1.25%, they need to consider a number of factors, foremost including the significant knock-on effects of US monetary tightening on the rest of the world. Between April and June 2022, the Fed raised its policy rate by a total of 1.25 percentage points. Such an increase lowers the GDP of advanced economies by up to 0.6% over a three-year horizon. This overall effect will put further downward pressure on UK GDP, but will also slow UK inflation sooner rather than later.
The second factor is the possible interference of the next leader of the Conservative Party and Prime Minister in British monetary policy. Penny Mordaunt raised eyebrows by declaring: “my monetary policy will be to control inflation”. It is highly likely that this very statement indicates some ignorance about who is in charge of monetary policy rather than an intentional desire to interfere with the independent Bank of England. Nonetheless, the point here, as the Minister said above, is that we need someone with solid economic knowledge to weather the (ongoing) economic storm.
Third, the possible impact of all these tax cuts promised by the Tory leadership candidates on the British economy. The tax cuts represent a fiscal expansion that, in theory, should stimulate demand and therefore reduce the risk of recession. At the same time, however, the tax cuts risk pushing UK inflation even higher. Consequently, the Bank of England will have no choice but to raise interest rates even more rapidly to bring inflation back towards the 2% target.
The main problem, of course, is that leadership candidates talk about tax cuts without providing a detailed account of how those tax cuts will be funded. Worse still, there is no real discussion of how efficient these tax cuts will prove to be in boosting the UK economy. The main question therefore remains: can tax cuts stimulate investment and growth in the UK? Take, for example, the popular promise to cut the UK corporate tax rate. At 19%, our corporate tax rate is 4 percentage points lower than the average rate for OECD economies. In fact, as shown in Figure 1, the UK corporate tax rate has been lower than that of OECD economies for the past ten years. Despite this, UK business investment grew by only 2.5% per year, on average, over the same period.
Put simply, further cuts in the corporate tax rate may not turn out to be as effective as leadership hopefuls (wish to) believe. Indeed, the growth of business investment depends not only on business policy, but also on other economic drivers. The first is economic policy uncertainty. No surprise here. Growing economic policy uncertainty makes UK businesses less willing to invest and/or delay investment decisions until the fog of uncertainty is lifted. In fact, my own co-authored research finds that growing economic policy uncertainty in the UK is hurting GDP growth up to 12 months later. Needless to say, the (rushed) economic statements made by UK policymakers are not always helpful. Take, for example, the new Chancellor of the Exchequer Nadhim Zahawi who declared that “nothing is on the table”. This very statement is the classic definition of huge uncertainty in forward-looking economic policy.
The second driver of business investment is the quality of governance. According to World Bank data, the UK has moved from the top 2% of 214 countries in 2010 to the top 8% ten years later in terms of the Regulatory Quality Index (the latter monitoring the ease of business creation and bureaucratic efficiency). In other words, there is so much to talk about and deal with when it comes to boosting business investment and growth in the UK. The next prime minister must address these issues before promising any tax cuts.
About the Author
Costas Milas is Professor of Finance at the University of Liverpool.
Photo by Dan Cristian Pădureț on Unsplash.