In the UK, full employment is defined by the BoE as being a rate of 4.5 per cent or lower. If unemployment is higher than 4.5 per cent, and inflation is below 2 per cent, then rates are too high.
If unemployment is at the level defined as “full”, but inflation is much higher than the 2 per cent target, then rates are too low.
Unemployment in the UK is presently below the 4.5 per cent level, but inflation is presently at more than twice the 2 per cent target, so using that measure, UK rates have needed to rise for some time.
Robertson says: “It’s really a case of we needed emergency measures when the economy was shut down, but as we normalise, output gaps close and rates rise. Only time will tell if they have got the pace of the rises right.”
A very British problem
Policymakers in the UK have the additional problem, says Bitel, that Brexit has made calculating the trend rate of growth, and consequently the neutral rate of interest, more difficult.
Continuing her example above, she says: “With other countries, you can imagine the growth rate if the pandemic hadn’t happened, and from that calculate where output should be now. But in the UK, it is possible that since 2019, even without the pandemic, the average growth rate would have been lower, and therefore that the long-term trend rate of growth is lower. In such a scenario, the UK would have closed its output gap earlier [because the potential rate of growth is lower] and so rates may have needed to rise earlier.”
Silvia Dall’Angelo, senior economist at Federated Hermes, says: “The inflation we are seeing in the UK right now is a supply shock, partly the result of EU migrants who have not returned, but that could turn into a demand shock if they never return, as that would likely lower spending in the economy.”
In such a scenario, the trend growth rate in the economy would be lower than in recent history, and consequently so should interest rates be over the long-term.
She says the impact of Brexit on the wider economy has, to some extent, been obscured by the pandemic, as the supply-side impacts have hurt every economy, but as those recede globally, the UK could be the outlier in continuing to have supply-side inflationary pressures.
Middle distance
The inflationary pressures in the global economy right now are in deep contrast to how the world looked pre-pandemic, when a consensus had emerged that inflation was structurally low due to the impact of technology, ageing populations and high debt levels.
In such a scenario, inflation, economic growth and interest rates would all peak at a lower level than may historically have been the case.
