Stagflationary winds — declining growth and rising inflation — are among the trickiest economic challenges that policy makers can face. They reduce the effectiveness of policy instruments and increase the risk of mistakes. And this burden should not be placed primarily on central banks, as is currently happening in the U.K.
After holding up impressively well in the immediate aftermath of the June 2016 Brexit referendum, the U.K. economy is coming under pressure. Economic growth has slowed notably, wages are stagnating and inflation has marched up toward 3 percent, the highest among the major advanced economies.
With this combination in play, it is just a matter of time until the (up-to-now solid) “soft” indicators, including business and household confidence, come under pressure. Consumers would face a further squeeze on their purchasing power caused by both sluggish incomes and rising prices for goods and services. Business investment would be undermined by Brexit uncertainty, including lingering major questions about how the U.K. will interact in the future with its major trading partner, the European Union. And exports, while they face a better outlook due to currency depreciation, would not be large enough to effectively act as a powerful locomotive of growth for the economy as a whole.
Stagflation tendencies also run the risk of triggering unpleasant feedback loops. Think of the exchange-rate channel, for example. The dimmer the growth prospects, the less attractive Britain will be for capital inflows from abroad. This places pressure on the currency, which then spills over into higher inflation, which squeezes consumers, worsening in turn the prospects for aggregate demand and growth.
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