Why inflation figures may have given Labour false confidence

Image of Downing Street

The relief from Downing Street at yesterday’s inflation data – which showed that it dipped to 2.5 per cent in the 12 months to December, down from 2.6 per cent the month before – was palpable. Darren Jones, the Chief Secretary to the Treasury, cast a breezy image as he described his boss, the Chancellor Rachel Reeves, as “brilliant”.

Keir Starmer will now be able to offer his Chancellor more than lukewarm assurances that she is not facing the chop. The news will abate the recent cycle of media criticism and with President Trump’s inauguration next week, focus will soon turn elsewhere. 

Her luck doesn’t end there. In the medium-term, the data will likely justify a further small dip in interest rates by the Bank of England. The resulting increase in disposable incomes might well buy off the political need for an emergency budget.

At least, that’s how the government will choose to see it. But it just might also be a piece of catastrophically damaging false assurance that dooms both Downing Street occupants.

The reality is this: beneath the very modest abatement in inflation, which still sits above the two per cent target, every economic warning light is blinking. Unlike the Westminster news agenda, these are not trends that come or go with a single data point.

Here are the fundamentals. Inflation remains persistently high: 2.5 per cent is too much at the best of times. But this is stagflation. High inflation with no economic growth. These markers reflect decline, not a booming economy.

Asset price inflation is sky high, a reflection of where prospects for ‘growth’ in economic activity are really coming from: cheap credit. Despite the Bank of England’s attempts to wind down Quantitative Easing, money supply grew rapidly last year as banks loaned money they simply didn’t have.

Meanwhile, the gilt markets show little faith in Reeves’s capacity to balance the books. Yields even dwarf those faced by Liz Truss. Servicing this debt will bite into the government’s finances, forcing the Chancellor to countenance unpalatable cuts or further raise taxes.

The result would be obvious: a further, deeper, and harder recession than we are already in. That recession is underpriced as a political event. Whatever their relief today, Starmer’s government will likely conclude its first year in office not just in the midst of a ‘technical recession’ but a full-blown period of economic decline.

Given the choices in the Budget, they will struggle to blame anyone but themselves. Bleakest of all, there is almost nothing they can do to preclude it. Market fundamentals leave this Chancellor almost uniquely powerless.

This mid-year recession, though, is almost the best case scenario for this government. As the Chief Secretary to the Treasury was at pains to remind the public today, the challenges facing the UK economy are not unique.

The world’s major economies are suffering signs of equal sickness. In the United States, as the consequences of Biden’s profligacy come home to roost, gilt rates are equally high. Next week, Donald Trump will enter the White House. That means one thing: disruption.

Trump’s first year in office will be dominated by attempts to correct perceived distortions in global trade. This means tariffs and inevitable retaliatory action, most likely on day one. He has already demonstrated his desire to raise America’s debt ceiling, which will keep borrowing high. Meanwhile, his approach to Russia, China, and Iran is just as likely to send global energy prices soaring as it is to see them fall. Each of those would constitute major economic disruptions in their own right. Together, they could trigger shockwaves that land on our shores.

Therein lies the worst – and perhaps most likely – scenario for this government. For accompanying their relative powerlessness is the extraordinary fragility of our economic and financial system. The blinking indicators of our economic distress are not mere harbingers of the now expected period of recession and decline but warning signs redolent of the kinds of financial collapse we saw in 2008.

Many are, in fact, much worse. Public sector indebtedness is ticking up towards 100 per cent of GDP – two and a half times what it stood at in 2008. Inflation is bad enough but perhaps most troubling is the gap between asset prices and consumer inflation.

The ‘CPIH’ measure – inflation once you include housing costs – sits a full percentage point higher than CPI. This persistent mismatch is increasingly stark, and it points ever more clearly to the obvious: we’re in the midst of a credit driven asset price bubble. When the shocks arrive and the market adjusts, the consequences will be dramatic.

Banks, whose exposure has once more risen, would be deeply vulnerable to a snap in saver confidence. A major shock, or series of them, could see more than one financial institution in trouble. Once the warning of a select few, it is now far from fringe to speculate that a run on banks is foreseeable this year.

Should it occur, the choices facing Reeves and Starmer would be bleak. The menu of options open to this government are not great compared to those available to Gordon Brown. Much of this is not this government’s fault, its indebtedness, for example, is a consequence of Covid and the Ukraine war. But its Budget attacks on growth leave it deeply vulnerable.

For a government elected on promises of restoring economic competence, the political damage would leave a scar requiring more than the dismissal of a Chancellor to heal.

Despite his majority, it would be increasingly hard to see how the Prime Minister survives. Penned in without the capacity to act. The moral case for a General Election would be irresistible. His prospects are limited to say the least. Keir Starmer may come to regret the sliver of good news that stabilised his Chancellor.