Stephen King: Why is UK growth not rising as impressively as inflation?

A lot depends on which side of the Atlantic you're on. No, this is not an article about the wisdom of war and the philosophical nuances of Messrs Bush and Chirac. Instead, I'm thinking about inflation, more specifically inflation in the UK and the US.

As the left-hand chart shows, UK and US experiences on inflation have begun to diverge rather dramatically. Excluding the volatile food and energy components, the rate of consumer price inflation in the US fell to just 1.7 per cent in February, the lowest rate for – wait for it – 37 years. Meanwhile, in the UK, inflation on a similar "core" measure (using HSBC calculations) stood at 3.3 per cent.

Inflation in the US and the UK has also been heading off in different directions. In the second half of 2001 and the beginning of 2002, inflation in the two countries was broadly convergent. No longer: since then, inflation has headed up rapidly in the UK but headed down rapidly in the US.

These differences are rather remarkable in other ways. Both countries have responded to the post-bubble environment in similar fashion: interest rates have come down (more so in the US), fiscal policy has been loosened (again, more so in the US) and currencies have declined. If anything, you'd have thought that inflation would be picking up rather more quickly in the US than in the UK.

So, while the Federal Reserve can have sleepless nights about deflation, the Bank of England perhaps should be getting rather worried about inflation. All this despite a similar global environment, despite a similar policy approach and despite a shared reliance on the consumer to keep economic growth ticking along. What's more, the UK's higher inflation rate has been accompanied by a slower growth rate: last year, the US economy managed to expand by more than 2 per cent whereas the UK economy grew by less than 2 per cent.

One difference appears to be the impact of the housing market. House price inflation has been strong in some parts of the US – notably in some of the prime locations on the eastern and western seaboards – but the UK has managed to achieve a much higher rate of house price inflation at the national level. There may be quite a few worries about the UK housing market today but last year's buoyancy undoubtedly pushed the UK inflation numbers higher: indeed, the HSBC inflation measure used in the chart would show an inflation rate about 0.9 per cent lower were it not for the impact of rapidly rising house prices. On this basis, softer housing this year should automatically lead to a much lower overall inflation rate as the UK heads towards 2004.

But I suspect that the key factors go beyond the housing market. One of the most commonly cited differences between the US and UK economies in recent years has been productivity. The US has been through a productivity miracle whereas, in the UK, productivity growth has struggled to make any sort of reasonable impression. This may simply mean that the long-term "trend" rate of growth – determined by supply factors – is lower in the UK than in the US. That, of course, implies that an identical growth rate in the two countries might be associated with falling inflation in the US but rising inflation in the UK.

There's nothing particularly controversial about this view: many people in the US argue that trend growth over there is in a range between 3 and 3.5 per cent whereas the Treasury argues that trend growth in the UK is running at 2.75 per cent per year. The trouble with this, however, is that UK growth is a lot lower than 2.75 per cent yet inflation is still surprising on the upside. At least the US is behaving itself: growth is lower than trend and inflation is coming down.

For the UK, how can we square the circle? How can we explain the rise in inflation against a background of disappointing growth? Apart from housing, I would make the following key observations.

First, governments always tend to have an overly optimistic assessment of trend growth. This is hardly surprising. The higher trend growth is, the more the government can claim that the economy will expand without hitting an inflation constraint and the more the government can spend without bumping into a borrowing constraint. As the right-hand chart shows, however, the history of trend growth in the UK has not been encouraging. Taking the average annual growth rate through each economic cycle in the UK over the past 40 years, the UK hasn't been close to the Government's 2.75 per cent target for a good 30 years or so. In real terms, growth slowed from 2.7 per cent per year in the 1960s – when the global economy was growing a lot faster than it is today – to roughly 2.2-2.3 per cent ever since.

Second, trend growth is typically calculated on the basis of various supply "inputs" including productivity – which will reflect technological change and quality of management – hours worked, changes in the "structural" rate of unemployment and the growth rate of the population of working age. If we tot up the contributions from these inputs since the mid-1990s, it looks as though productivity on average added about 1.9 per cent to growth per year, hours worked knocked off 0.2 per cent, changes in the structural rate of unemployment added about 0.4 per cent and the growth rate of the population of working age added a further 0.4 per cent, giving a trend growth rate of roughly 2.5 per cent.

And here comes the catch. The 0.4 per cent added to growth per year from a drop in the structural rate of unemployment is sustainable only so long as the unemployment rate can continue to fall. But what if we reach full employment? Desirable in itself, of course, but once we get there, the economy simply will not be able to expand at the previous rate. So, on the assumption that we now are at roughly full employment – a triumph for the Government in many ways – there is a price to be paid: other things being equal, we ought to lop 0.4 per cent off our estimate of trend growth, leaving the UK struggling to grow much faster than 2 per cent per annum over the medium term.

Third, to maintain growth at the rate seen over the past few years, a series of potentially unsustainable factors has been at work. The strength of sterling may have helped suppress inflationary pressures in the short term but has left a legacy of low profits and, possibly, a much weaker environment for capital spending. The desire to improve public services may have kept the labour market tighter than expected given the weakness of global economic activity. That, in turn, may have reduced the ability of companies to rebuild profits. The fall in share prices over recent years and the legacy of high debt in the corporate sector may also have blunted both the willingness and ability of companies to invest.

Faced with all these factors, it may simply be the case that the UK economy cannot expand as quickly as the authorities would like to see. Attempts to keep the economy growing at 2.75 per cent per year simply through demand management policies may ultimately end in failure, with inflation remaining too high. And for the Government, a lower trend growth rate can mean only one thing: public spending plans that seemed to be affordable may no longer be so, unless the Chancellor is prepared to run bigger and bigger budget deficits.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com