It’s rare for a central bank governor to outperform even the most negative economic forecasters. Yet Andrew Bailey, the normally dovish Bank of England (BoE) Governor, did just that last week when he hiked interest rates by half a percentage point and presented a surprisingly gloomy outlook for the UK economy.
With inflation rising, the rate hike came as no surprise. Rather, Bailey’s comments on the economy turned markets upside down. His prospects for the UK are apocalyptically bleak and far worse than either the US or the eurozone.
Bailey revealed that the BoE now expects five consecutive quarters of recession to cut GDP by at least 2% from peak to trough virtually until the end of 2023. This likely coincides with the gloomy years of the early 1990s and led to the sharpest fall in household income in 60 years. In a somber statement, he said a painful drop in living standards was now “inevitable” and necessary to bring down inflation. Even if the recovery begins, according to the BoE, growth will be “very weak by historical standards”.
To make matters worse, inflation is set to rise to around 13% by the end of the year. Such a number would have been unimaginable just a few months ago.
Almost more worrying is the complete lack of leadership or political accountability. Despite the worsening economic crisis, Prime Minister Boris Johnson has been conspicuous by his absence in recent weeks. Contemporary historian Sir Anthony Seldon called the end of the Johnson administration “reckless”, with 10 Downing Street a “hive of inaction”. Last week, in the midst of the crisis and the worst summer in 80 years, he went on vacation to an unknown location.
The current lead candidate for the next prime minister, Liz Truss, has blamed the BoE for the poor economy and rising inflation and has promised to reconsider her parliamentary mandate. This could have important consequences for the future of UK currency stability.
At least investors can take comfort in the brutal honesty with which the BoE is handling the situation. No attempt was made to whitewash the dire situation. After the monetary and fiscal easing of the COVID-19 pandemic combined with supply-side cost shocks, restoring monetary stability comes with real economic consequences and trade-offs.
“War has an economic cost. But that won’t stop us from setting monetary policy to bring inflation back towards the 2% target,” Bailey said.
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Such a sentiment could have been conveyed by South Africa’s own ultra-hawk, SA Reserve Bank (Serbian) Governor Lesetja Kaganyago. Just last month he announced the biggest increase in the cost of borrowing in 20 years in a bid to curb rising inflation. Like its emerging-market peers, the Reserve Bank is trying to raise the cost of borrowing beyond developed markets like the US or the UK.
While the Sarb is far more dovish than the BoE, it is likely to hurt the South African economy. The Reserve Bank forecasts the South African economy to grow 2% in 2022 and the consensus forecast says it will grow 1.7% in 2023 and 1.7% in 2024, mainly due to global demand for commodities.
If the BoE is right and the UK, a key part of the global economy, suffers five consecutive quarters of recession, it makes these forecasts absurdly optimistic about a resumption of global growth. Even as Sarab struggles with high food and fuel prices, the economy is essentially stagnant as it is hit by the country’s worst power outage. A global recession would bring with it a mid-sized emerging market like South Africa.
Rate hikes of this magnitude are not a subtle way to reduce inflation by putting the brakes on the economy. They are comparable to pulling on the handbrake in a blind attempt to avoid an accident. Further rate hikes in South Africa will have a strong negative impact on growth and unemployment.
The trade-off is clear: in an inflationary environment, achieving price stability has real short-term economic consequences. In addition, the economy could hardly be less prepared after a decade of stagnation. South Africa must be prepared for the coming serious economic crises. DM/BM