Ashleay: Welcome to the “In Your Interest!” podcast from iA Financial Group, where we discuss your need-to-know economic news and how it affects your finances. All this in under 10 minutes. The UK Government has been the talk of the town in the recent weeks. Sébastien, what should we know and what should we learn from this? It feels as if they're hitting the brakes and the gas pedal at the same time. My name is Ashleay. I'm here with my colleague Sébastien Mc Mahon, our Chief Strategist and Senior Economist here at iA Financial Group. Hi, Sébastien.
Sébastien: Hello, Ashleay.
Ashleay: All right. So, there's been a lot of talk in the UK government. Can you tell us more about the current situation?
Sébastien: Sure. So, the UK is facing the inflation issue just like here, just like in the U.S., just like pretty much everywhere else in the world. And you know, the UK being a part of Europe, they are facing an energy crisis right now, which is something that we have been fortunate enough to avoid here, here in North America. But the commonalities are wide because the Bank of England, so the central bank of the UK, just like the Bank of Canada here and the Federal Reserve in the U.S., they've been pretty clear that they will be raising interest rates enough to bring inflation back to target. And the Bank of England in fact was one of the most, the most clear of the central banks, the most transparent of the central banks, because it was saying that we will bring inflation down and this will likely cause a recession. So, they were hiking as they were forecasting that there would be a recession by the end of the year. So, the energy situation in the UK and in Europe is making things worse than here because mostly of the heavy dependence on natural gas to produce electricity. So, of course everyone knows that Russia has invaded Ukraine early in 2022. That has pushed the price of natural gas and oil higher and this is creating even worse inflation over there than here. And the estimation is that it's about a loss of 8% of purchasing power for the citizens of the UK, which means that if a household with a net income of $100,000 is facing an $8,000 increase in their energy bill directly coming from this situation.
Ashleay: Right. Can you put us maybe just into context just to compare, do we have any other countries that we have an example of the inflation rate?
Sébastien: Yeah, well, I'd love to have an estimate of the hit from the energy situation in other countries because, of course, in Canada our electricity is produced much less through oil and through natural gas. But the UK is hit harder than other European countries because, for example, the figure in Germany is 4% of the loss of purchasing power compared to 8% in the UK. So, there's that. And there is also, of course, just like here, the effects of cost increases on producers of goods and services, who then pass on the bill to consumers. So, some measures were put in place. The government in the UK introduced a two-year price cap on household energy bill, energy bills at a cost of over £100 billion. So, that's a lot of money that needs to be borrowed by the government to finance this. But now the situation in the UK, you can say that it's one of the most difficult out there and the government is really in a difficult situation.
Ashleay: Absolutely. And so, where does it get even more complicated? I feel like there's the central bank that kind of has its foot firmly on the brake and then we have consumers, we have plenty of. Can you explain a little bit more about that?
Sébastien: Yeah, sure. So, the central bank has both feet on the brakes, just like here in Canada and in the U.S., hiking very, very quickly, raising interest rates to slow the economy down, to be able to bring inflation back towards its 2% target. So, the central banks, their mandate is to keep inflation under control, so it cannot afford to let inflation run wild. It needs to act with vigour given the magnitude of the task at hand, and it has been very clear about its intentions and the consequences of its actions. So, maybe just a bit of history before looking at the fiscal side. You know, before the early 1900s, central banks were not as common. The Bank of England is the oldest in the world, but central banks were not common. An inflation target was not common before the early 1990s. So, that's way recent in history. Even if the story of existence of central banks and inflation is clearly a tax on living standards. So, I get asked a lot of questions about inflation, not that many questions about recessions or the odds of recessions, because everyone's been through recessions over the last few years. But inflation, you need to go back to the 1970s or early 1980s to remember what that was. That's a tax on living standards. And when inflation is volatile, the ability of households and the ability of businesses to plan their next move, their next investments is hampered quite a bit. So, you have some issues coming from inflation that are hard to swallow, that are hard on the population at large, and even more so those with lesser income. When you have inflation from food, from the price of energy, and it's a huge part of your budget that is impacted by that. So, this is why inflation is an issue and why central banks are acting like that. Now, on the other hand, you have the government with its fiscal policy that, faced with these economic challenges, decides to go in the opposite direction and stimulate the economy, thus fostering more inflation. And when we're talking about that, we heard the UK discuss tax cuts for the rich. Other measures to help the population. But it was mostly concentrated in the higher part of the distribution of income. So, there's a lot of push back that have been had from that because you help, you send more money towards the rich to help stimulate the economy at the same time as the central bank is trying to put on the brakes. So, at the end of the day, if one force goes against the other, where do you end up? You have quite a mess on your hands. And it's difficult for any investor, any households to understand where this is headed.
Ashleay: Right. And in your view, in your professional opinion, which force will win? Will we be talking more about the fiscal policy or are we talking more monetary? How would you see that?
Sébastien: Well, at first it was difficult to see who would win. But now, we have a better idea that monetary policy is very strong. It impacts everyone through the move in interest rates. So, monetary policy is key. The fiscal policy, the package I just described was modified very quickly. They needed to walk back some of those promises and they were criticized by economists, by investors, but also by the International Monetary Fund because of the lack of fiscal prudence. And, you know, the original plan benefitting the rich, it was a big part of that. But also, there was some backlash from the markets. And when a government has to borrow a lot of money to finance some public policy, if the market is confident that it will help the country grow some more, then that means that the markets can be confident that they will be repaid on the money that is being borrowed by the government. But in a situation like that, when you have the monetary policy headed one way, the fiscal policy headed the other, you have a lot of uncertainty that is surrounding this. And we had some big pension funds in the UK that were under a lot of pressure because the value of their bonds just fell because interest rates were higher. And then you had some issues where the central bank needed to step in. So, on the one hand the central bank is putting on the brakes, but on the other one, they needed to inject liquidity to avoid market reactions that would be too negative. So, lots of inconsistencies in all of this story. And now we know that monetary policy likely is the force here that will win in such an instance. But it clearly mostly shows the importance of coordination. So, what we have in the UK right now, it's an important theatre of the reality that many countries will face in the future. And it's very important that all levels of government work together, not one against the other.
Ashleay: Right. And so, no matter who prevails, can this affect us directly here in Canada, let's say in the short term?
Sébastien: Well, probably yes, because the global economy, I always describe it as a tripod; you have China's economy, you have the European economy and the U.S. These three are the most important economic regions. And typically, when you have two out of three that are holding together, you're on strong footing. Right now, China is hurting because of its COVID zero policy. The European economy is likely in a recession and in the U.S., the odds of a recession until the end of 2023, we estimate them at about 70%. So, the picture is not rosy and Canada being a small open economy, of course, it will be impacted by that. But most importantly, I think the message needs to be received by all levels of government—federal, provincial government—that when you have the central bank, like the Bank of Canada here acting strongly to keep inflation under control, acting to slow down the economy, if you try to go against that with fiscal policy, you might lose the confidence of the markets. You might have unexpected results. And in the end, where do we end up? You need to pick one target, focus on that target. And right now, the target is clearly inflation.
Ashleay: Got it. Thank you so much, Sébastien. That was very clear. And we will keep an eye on this in the coming weeks. Love this podcast? Want to know more about economic news? Follow our “In Your Interest!” podcast available on all platforms, visit the economic news page on ia.ca, or follow us on social media.