Are we heading for a 1980s-style inflation spike?
What lessons should policymakers from the Lawson Boom and subsequent recession? Asks Daniel Mahoney
High inflation, unreliable data and a government banking on growth. While this sounds familiar, it was also the situation at the end of the 1980s – the “Lawson Boom”. We know what happened next; inflation soared further and was only eventually brought down by recession. But this was not inevitable. As the government finalises its November Budget, are there lessons to be learned from events almost 40 years ago? More importantly, can we avoid another inflation spike – or a recession?
It is true we saw runaway inflation in 2022, but this was initially driven by externalities – the Covid aftermath and the effects of the Ukraine war. Inflation in the late 1980s, by contrast, was sparked by credit growth arising from financial liberalisation. And there are disturbing parallels today.
Currently we are in the middle of an interest-rate-cutting cycle, despite inflation being notably above the Bank of England’s target, at a time of elevated consumer inflation expectations. Should we be worried, given what happened in the late 1980s? The base rate fell around six percentage points from 1985 to 1988 – before having to be dramatically hiked to tackle what was, by then, exploding inflation. So why did policymakers back then feel they could loosen monetary policy?
Inaccurate data
The first challenge was inaccurate data. Statistics provided to policymakers at the time underestimated growth by 2.5 percentage points for 1987, an enormous error given this mismeasurement effectively amounted to the entire productive potential of the economy. This tricked policymakers into thinking economic conditions were not overheating. Today’s policymakers, then, might exercise caution given current issues with data reliability: for example, the labour force survey continues to face significant problems, and major revisions to historical savings data have recently been announced. Moreover, compared to the 1980s, the UK is a more service-orientated economy – notoriously harder to measure.
The second mistake was overestimating supply-side improvements, or how quickly they would take effect. Back then this referred to tax reforms and the effects of privatisation – both of which did eventually improve the supply side of the economy, but not nearly as fast as anticipated. Again, we see contemporary parallels. The government makes much of its planning reforms, and they should potentially drive growth. But OBR forecasts seem wildly optimistic; nearly all construction experts agree we will not meet national home-building targets.
The government also hopes AI will deliver a technological boost, driving efficiencies and transform the workplace. This too will happen – eventually. But although almost 70 per cent of Britons use AI in some form, this falls to 44 per cent in a professional setting. Meanwhile, use at “high-intensity” remains rock-bottom; the OECD suggests just 2-6 per cent of firms are in this category across the developed world. AI-adoption has great potential to boost productivity, but it may take the best part of a decade to reach scale.
Can we avoid a recession?
It is also worth remembering that major historical inflationary episodes – for example, in the late 1970s and 1980s – only ended after recession. Can we avoid that this time? The Taylor Rule for setting interest rates – proposed by John Taylor in the 1990s – suggests interest rates should currently sit around 5.5 per cent, notably above the current level of four per cent. Taylor’s key insight was that interest rates must rise by more than inflation to ensure real rates increase in times of higher inflation. This rule is not strictly adhered to currently because inflation expectations have been broadly anchored since Bank of England independence. But does this still hold true in a post-pandemic era? Continuing the rate-cutting cycle, as markets currently expect, appears the most sensible approach given current data, but we cannot rule out the possibility that monetary policy mistakes are being made.
There is one lesson we can learn. Prior to 1997, monetary policy was not set independently by the Bank of England, but by the Treasury. Political control of interest rates helped catalyse decisions that were not in Britain’s longer-term economic interests. Since 1997, there has been broad agreement in developed economies on central bank independence, but we can see this consensus fraying. In the United States, President Trump repeatedly challenges the Fed’s independence, while even here there has been growing criticism of the principle of Bank of England independence from figures of various political persuasions. One outcome of the Lawson Boom is crystal clear: monetary policy that underpins macroeconomic stability is best formed independently from short-term political concerns. In other words, if we want to avoid a recession – or another spike in inflation – we may need those independent experts after all.
Daniel Mahoney is UK economist at Handelsbanken