How Trump’s Iran war could derail the economy – and the Labour government
TThe Bank of England’s monetary policy committee (MPC) voted to keep interest rates steady at 3.75 per cent. This is no shock, given the uncertainties created by the Iran war, but until Operation Epic Fury was launched, almost everyone thought the Bank would take another baby step and cut interest rates again by 0.25 percentage points. The change shows how policymakers, investors, businesses and households are holding their breath right now, and that such uncertainty could weaken the economy even in the short term.
What was the vote?
The decision to keep rates constant was passed unanimously 9-0, indicating a firm decision to keep the decision. (This is actually unfair, because it represents necessary caution until the situation becomes clear.)
Why did they do this?
Before the Iran war, the outlook for inflation returning to the MPC’s 2 percent target was relatively positive. You could say that the worst of Trump’s tariff chaos is over, economic growth is fragile but gradual, and wage settlements are slowly declining.
Now everything depends on how long the war lasts. If this process ends quickly and oil, gas and financial markets return to normal levels, then interest rate cuts are likely to continue. If the war drags on and causes even more disruption and leaves energy costs higher, a pervasive force in every economy, then some more difficult decisions will have to be made.
What’s the worst case scenario?
Stagflation: Stagnant economic activity combined with rising inflation. This would be particularly worrying if the rise in energy and fuel costs triggered a new domestic inflation crisis driven by inflation expectations that pushed wages higher; Experience with the impact of Putin’s invasion of Ukraine will have taught the Bank not to become too complacent about how easily inflation can spiral out of control. Indeed, the fact that consumers are now more “inflation conscious” due to recent traumatic experiences means that the risk of a price-wage spiral is higher and rates need to be higher than normally set.
What’s the best case?
Even if things don’t get worse, the Bank faces the challenge of whether to “review” the recent pressure on inflation on a one-off basis and tolerate a move away from the 2 percent target as the economy readjusts, or to make an announcement by pushing rates up firmly.
If MPC members remain concerned about labor and skills shortages in the UK and think businesses can raise prices, they will be forced to make the painful decision to keep rates steady or even raise them again. (A technical alternative would be “monetary tightening – selling UK government bonds to take money out of the system”).
Investors are pricing in a few rate hikes this year, but it still depends on when the war ends. Many people hope that the Taco doctrine (which Trump always shy away from) will prevail again.
What will all this do to the housing market?
This will overwhelm it, driving down values and slowing sales. Mortgage deals are already fewer and more expensive. Those using trackers will be deprived of many of the windfalls they’ve come to expect from MPC, and there’s even a chance rates could rise. This, together with low earnings growth, makes for a bleak picture but perhaps presents opportunities for first-time buyers.
What about politics?
Fortunately, the Treasury under Rachel Reeves is implementing complementary fiscal and monetary policies to gradually reduce inflation while trying to stimulate growth. So the policy will at least be coordinated. The more Reeves spends on emergency subsidy programs, the less the Bank will seek a rate cut.
Interest rate rises or further delays in cuts would make servicing Britain’s huge national debt more costly and narrow the scope for increased public spending or tax cuts. The government is also facing calls for help with energy bills for households and consumers, but it is harder to protect people from the full force of a rise in inflation when debt is this high.
In other words, the cost of living crisis may become even more severe; Bad news for the ruling party. It’s hard to blame Reeves and the government, but what voters will want is a sense that ministers are sympathetic and competent. Any misstep now would mean the end of Reeves’ career and have dire consequences for the first Labor government elected since 2005.
