1990s Lesson: Recession Is The Price of Curbing U.K. Inflation

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By Philip Aldrick

(Bloomberg) —

“Rising unemployment and the recession have been the price that we have had to pay to get inflation down. That price is well worth paying.” 

It was May 16, 1991 when Norman Lamont, then finance minister in John Major’s Conservative government, uttered his infamous words as the consumer prices index of inflation peaked at over 8%.

Thirty one years later, uncomfortable parallels are emerging. The Bank of England expects CPI to hit 7.25% in April and policy makers face similar dilemmas. Will inflation become entrenched, how much pain can households absorb, how severe will the interest-rate squeeze be, might tackling it require a recession?

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The comparisons are not precise but, for Lamont, 79, who now sits in the House of Lords, the lessons are clear. “You have to give priority to reducing inflation,” he said in an interview with Bloomberg. “Because a lot of time has passed, and people have got used to stable prices, they have forgotten the horrors of compound inflation. It is always a danger.”

In 1991, memories of the 1970s — when prices were spiralling upwards at annual rates above 20% and the U.K.’s stagnating economy was falling behind European peers — were still vivid. Margaret Thatcher’s Tory government raised interest rates above 15% to address the problem, after which growth, productivity and business investment recovered. But the cost of success was a recession in 1980.

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“Having gone through that, people were worried it had all been for nothing,” said Douglas McWilliams, then chief economic adviser at the Confederation of British Industry who now runs the Centre for Economic and Business Research consultancy.

Ben Broadbent, deputy governor for monetary policy at the BOE, acknowledged this month that tackling inflation involves a trade-off. The central bank could “have pushed inflation down” by raising rates earlier but that “would have involved much lower wage growth and higher unemployment,” he said.

The BOE has raised its benchmark rate from 0.1% to 0.5% since December and markets expect close to 2% by the end of the year, while the central bank begins to unwind its 875 billion pounds ($1.19 trillion) of quantitative easing, the fastest pace of monetary tightening in the Group of Seven. 

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But Lamont fears “today’s leaders lack the courage to douse the inflationary fire.”

‘Hideous Dilemma’

“With QE, the bank has become much more a driver of demand than before, which leaves it with the hideous dilemma: ‘Will we kill the recovery?’ Under the previous regime [before QE] they would have been much more focused on inflation. Do we have the determination to beat it now?”

The Thatcher government took a drastic step to curb inflation. In October 1990, Britain joined Europe’s Exchange Rate Mechanism, tying sterling to a tight range around Germany’s Deutsche mark. But the rigor came at a cost to exporters, which struggled to compete on global markets. By the end of the year, the U.K. was back in recession.  

On Black Wednesday in September 1992, the U.K. crashed out of the ERM in a moment of national humiliation because it could not afford to defend the pound. But, by then, inflation was under control. “Did membership of the ERM prolong the recession? I think it did,” Lamont said. “But it did reduce inflation. Judged by that, it did deliver its objective.”

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The big difference between the 1990s and today is that the trade-off then was between inflation and unemployment, whereas today the problem is a cost of living squeeze as pay settlements fail to keep up with soaring prices. In 1992, unemployment jumped above 10% but real wages never declined. Those in work were protected. The hit, as McWilliams remembers, came from high interest rates for mortgage borrowers, which ate up “much of mine and my wife’s income.” 

One in 12 borrowers were two months or more in arrears in 1991. Today, following the huge build-up of mortgage debt since before the 2008 financial crisis, roughly one-in-50 households will be at risk of repayment difficulties if rates rise to just 1.5%, according to the BOE, in line with pre-financial crisis averages when rates were far higher at around 6%.

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Should rates climb much above market expectations of 2%, household vulnerability will edge toward its pre-2008 peak, BOE analysis shows. This time, though, four-in-five mortgages are fixed, providing protection for a period. In the 1990s, everyone was on floating rates.

There can be no escape from the trade-off required to dampen inflation today, Lamont believes, because much of the price impact is being imported -– through energy and commodity prices. 

“All the commentary is about what the government can do to protect people from inflation,” he said. “What is not being recognized is that this is a terms of trade shock and that means a drop in living standards. You can’t do anything about it. Adjusting to a lower inflation regime will require a fall in living standards,” Lamont said.

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Rishi Sunak, the current chancellor of the exchequer, does not appear to agree. The government is providing 10 billion pounds of support for households to help with the 54% increase in energy bills from April and Sunak’s budget in October was stimulatory, to bolster the recovery.

Lamont expressed sympathy for BOE Governor Andrew Bailey over his remark that workers should not ask for big pay rises to compensate them for high inflation. 

“He got it in the neck, but he will be terrified that inflation gets embedded,” Lamont said. In February 1991, as chancellor, Lamont made a similar plea, telling companies that “if they are to prosper, they will agree realistic, affordable wage settlements. If costs are held down, the downturn will be shorter and less severe and the level at which unemployment will peak will be lower.”

McWilliams draws one final, bleak comparison. “To get rid of inflation in the 1990s, interest rates had to go up and that created a recession,” he said. “Today rates at 4%-5% may be enough to sort out inflation, but that may bring the economy into a slight recession.”

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