PM Sunak is facing increasing challenges as the country wraps up the year. Strikes have been going on for months in different sectors, but they are getting particularly intense of late, as workers struggle with higher cost of living. But, this opens up another problem that could be a headache for the BOE: a cost-wage spiral. Which could be made worse as the UK moves from stagflation into a full-blown recession.
A wage-price spiral can lead to hyperinflation and destabilize the economy, and is feared by central bankers. That’s when prices rise, prompting workers to demand higher pay, which means goods and services cost more to produce, pushing up inflation, and the cycle repeats. Unions striking so far have managed to reach agreements on pay rises that at least match or are more than the annual inflation rate. While this helps the workers deal with the cost of living crisis, it puts additional strain on the country’s finances.
Something’s got to give
According to the most recent CBI report, UK business investment is still down 9% when compared to pre-pandemic levels. The report also predicted that productivity would remain below 2019 levels well into 2024. Inflation is the mismatch between too much money and/or too little production. While the BOE can deal with inflation by reducing the money supply with higher rates and QT, that inflation could remain persistent if productivity doesn’t kick into gear.
But, given the macro uncertainty (BOE policy, government’s finances, disputes with the EU, energy costs) businesses are hesitant to invest. And those who do invest, are finding it increasingly more expensive to get funding as the BOE raises interest rates. If the strikes succeed, and wages increase leading to even more price increases, then the BOE might have to be even more aggressive in tightening. Which in turn makes businesses less willing to invest.
A bright spot in the gloom
The scenario is of stagflation, according to the CBI, which was a little more optimistic than the BOE which said the UK was in recession. To meet the technical definition of a recession, two quarters of negative growth are required. So far, Q3 has been negative, meaning that if Q4 is negative, then the UK would meet the technical definition.
The UK will report its rolling three month to October GDP figures which are expected at 0.4%, substantially better than the -0.6% prior. This would be the first positive reading in two months, suggesting that at least the first of the three months of the fourth quarter is doing relatively better.
The underlying data
However, the growth in GDP is expected to be driven by a drop in imports, which means a smaller trade deficit. And the bulk of that is likely due to lower cost to import fuel, since October started to see Brent prices come down.
Meaning that even though there is an improvement, it isn’t in any of the underlying factors that are troubling the economy and giving reason to forecast gloom for the pound. With inflation still in the double digits (and rising), spread in real interest rates in cable is likely to keep widening, putting downward pressure on the charts.