Foreward: Sailing in Treacherous Seas

The British economy is suffering, once again, from a shortage of options in the face of shocks. The injections of monetary and fiscal demand during the Covid-19 lockdowns were still swilling around the system when supply chains started to fail and energy and food costs rose, first in line with a world economic recovery and then from the consequences of Russia's invasion of Ukraine. The inflationary impulse from food and energy costs has fallen more on the expenditure baskets of the poorest households and is acting to drag demand lower, as well as exacerbate income inequalities. It is quite clear that fiscal policy could be used to smooth the income shock in aggregate but also across the distribution. And if it did so, aggregate demand would be supported in such a manner as to allow the Bank of England to raise interest rates more decisively. But our policymakers may be lacking some collective courage to do the right thing and continue to wish to hide behind arbitrary fiscal rules. In our fiscal space, the narrative says 'There Is No Alternative' but there certainly is. I am forced to ask: when will this game end? Time and again we have been told that there is little room for manoeuvre when the weather turns unpleasant and, as a result, we find that the economy underperforms its peers. Since the financial crisis of 2008, the monetary and fiscal settlement has asked too much of the Bank of England. It has had to stoke up sufficient levels of demand to meet the inflation target. Fiscal policy has been set on too constricted a course, in a world of tighter financial regulations and considerable scarring in the real economy, with insufficient attention paid to supporting the supply side. The result is that excess demand in the shadow of Covid-19 has produced the largest spike in inflation for 30 years. While bringing inflation back to levels consistent with price stability is the main immediate macroeconomic priority, it would be a significantly easier task if HM Treasury provided an appropriate cushion for the poorest households, who have also been the ones to suffer most during Covid-19. Equity alone demands that we pay attention but efficiency makes the siren call. Let me focus on the supply side. The well documented poor performance in UK productivity is just another way of writing that we are not generating sufficient prosperity across the country and that real wages have tended to stagnate. Our track record makes the current adjustment in real wages, where they have to fall in response to the external terms of trade shock, even harder to bear, as the impact falls disproportionately on households with lower incomes. Actually, we estimate that the impact on those households could easily be reduced with no deterioration in the medium-term sustainability of our fiscal position. And so this is an example of where the politics and economics ought to be closely aligned. Perhaps an even better example of why a fiscal rule can also lead to pro-cyclical rather than countercyclical policy. The right response to a temporary negative income shock is to smooth it with more debt borrowed from our better off futures. Indeed, the inflation shock has, on balance, ameliorated our overall fiscal position as nominal tax revenues have increased relative to fixed cash expenditures. There is money to help steady the ship. It is though critical that inflation does not persist and is not expected to persist, as that would raise public borrowing costs and pose much more of a problem for fiscal sustainability. And here we turn to the question of the Bank of England. Rightly we should celebrate the 25th anniversary of the central bank's independence, as the Monetary Policy Committee has hit its objective over its lifetime with inflation at around 2 per cent. But it is now set to face its most difficult task, even with the insulation of reputation. How to drain excess demand from the economy, including the liquidity generated by huge asset purchases under quantitative easing, without sinking an economy that is facing the ragged edge of Brexit, a compression in trade and a lack of direction. It can only do so if it continues to be charged with the sole mandate of reaching the safe port of price stability. It does not need a broader remit or to be charged with further objectives, though more dialogue and discussion on complex trade-offs would help us understand better the choices that are faced at every meeting. Indeed, fiscal policy could learn very well from adopting a measure of wellbeing for its own objective and remembering that deficits are an instrument and not a target of policy. NIESR warned in 1998 that co-ordination problems between monetary and fiscal policy may become rife without a mechanism to ensure the right mix of the two and increasingly this seems to be the case. We will need to work together and not drift apart if we are to avoid being smashed on the rocks.