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The writer is an external member of the Bank of England’s Monetary Policy Committee
As an American living in London, people regularly tell me England and America are two countries separated by a common language. As an economist, I always want to point out there are many economic factors dividing them as well.
But you wouldn’t guess it looking at the market-implied paths for interest rates in the UK and US, which have closely mirrored one another for the past month. Following surprisingly strong US March CPI inflation, markets now expect the Bank of England will cut rates earlier and by more than the Federal Reserve this year. Macroeconomic fundamentals and inflation dynamics differ in the UK and US, and there’s a greater risk of persistence in the former. The markets are moving rate cut bets in the wrong direction.
The most obvious way the UK economy differs is much more constraint on the supply side. The Monetary Policy Committee (MPC) recently estimated potential growth of 1 per cent this year, rising moderately to 1.3 per cent by 2026. The Congressional Budget Office (CBO) estimates US potential growth of 2.2 per cent over the same period. This means the US can withstand more demand in the economy before it turns inflationary. While the UK has long lagged behind the US in potential growth, the difference became much starker during the pandemic.
Potential growth has two main components — potential productivity growth and labour supply. As I laid out in a recent speech, the UK looks worse on both. Investment is one way to boost productivity growth. But business investment has been essentially flat in the UK between 2016 — the year of the Brexit referendum — and 2020, though it has grown moderately since. Meanwhile, US business investment growth has outstripped that of other advanced economies since 2016.
The difference in labour supply between the two countries is also stark. Overall labour market participation in the UK has not recovered to the pre-pandemic trend. Participation in the US, on the other hand, has exceeded the pre-Covid trend.
Lower UK potential growth means greater inflationary pressures, all else being equal. But all else is not equal. Demand in the UK is far more constrained as well. This is largely thanks to the strength of the US consumer.
Government spending and business investment have also pushed US demand much higher. Investment, both public and private, in green technologies, semiconductors and other strategic sectors has been boosted by the Inflation Reduction Act, Chips and Science Act and Infrastructure Investment and Jobs Act.
With both weaker supply and demand in the UK than the US, we have to look at signs of persistence to compare the inflation dynamics and potential rate paths. I’m worried that second-round effects are having a larger and longer-lasting impact in the UK.
Recent inflationary shocks have been global in nature — a pandemic, worldwide supply chain issues, a war in Europe and energy and food spikes — but have reverberated differently across economies. The Ukrainian war had a far bigger impact on energy costs in the UK than the US. Even as global shocks subside, second-round effects in the UK may take longer to abate.
Following the energy price shock, UK inflation expectations have been more backwards-looking. This amplifies second-round effects, as companies and households are more sensitive to the initial shock. Higher inflation expectations have translated into higher pay growth, by some metrics now between 6-7 per cent in the UK versus 4-5.5 per cent in the US. Such sticky wage growth is a significant component of services inflation. It will need to slow further to see services inflation return sustainably to target-consistent levels. This last mile may prove the hardest. UK services inflation remains much higher than in the US.
The UK economy has faced the double whammy of a very tight labour market and a terms of trade shock from energy prices. Inflation persistence is therefore a greater threat for it than the US. But market pricing for interest rates does not reflect this.
There has been encouraging news on UK wage growth and services inflation in recent months. The risk of inflation persistence is diminishing as these indicators come down in line with the MPC’s forecast. But they remain higher than in other advanced economies, particularly the US. Momentum in the markets has been towards pricing in later rate cuts by the Fed as economic growth remains robust. In my view, rate cuts in the UK should still be a way off as well.