When growth slows, cutting rates is the go-to response for central banks around the world, while raising them in response to quickening inflation has also become the standard. What to do then when both happen at the same time?
That's the dilemma potentially facing Bank of England Governor Mark Carney should the U.K. crash out of the European Union without a deal on Oct. 31 and predictions of collapsing growth coupled with a slump in the pound come to pass.
He wouldn't be the first U.K. policy maker to deal with so-called stagflation, a term first coined by British politician Iain Macleod in 1965 to describe the phenomenon of concurrent stagnant growth and high inflation. In the 1970s, a combination of soaring oil prices thanks to the Arab oil embargo and policy missteps that looked to stimulate growth while spurring inflation, afflicted much of the developed world, particularly the U.S.
This time, the main culprit is Brexit, specifically the risk of a no-deal scenario that would see tariffs between the U.K. and many of its largest trading partners revert to World Trade Organization norms, raising the cost of imports and exports and introducing non-tariff barriers such as new regulations. Concern about the impending disruption helped the U.K. economy to a second-quarter contraction and contributed heavily to the biggest slump in U.K. manufacturing for seven years in August.
The pound has also suffered, falling 16% since the June 2016 referendum and reaching $1.2033 on Aug. 9, the lowest close since 1985. It fell as low as $1.1957 on Sept. 3, the weakest intraday level since October 2016.
The sudden decline in the days and weeks following the vote saw inflation surge from 0.8% to a peak of 2.8% in September 2017. Having dropped back down to 1.8% in January 2019, inflation is picking up again, reaching 2.0% in July.
"We certainly expect a recession and higher inflation, caused by a depreciation in sterling" in the event of a no-deal Brexit, said Azad Zangana, senior European economist at Schroders.
Should Carney cut rates in the wake of a no-deal Brexit, it could weaken the pound further, spurring even higher inflation than would otherwise be the case. If he chooses to raise rates to prop up sterling, it would add to pressure on the struggling economy.
Growth will be the BoE's primary concern, according to Bill Diviney, senior economist at ABN Amro.
"I am quite convinced the BoE would not raise rates, but would ease policy to counter the confidence hit from no-deal — at least in the short-term," he said in an interview. "Once the dust has settled, assuming it does, and if inflation is still on the high side, then I would expect higher rates. But not as a first reaction."
That strategy may face some resistance from those who have a more narrow view of the central bank's remit.
In a February address to a parliamentary committee, Carney made clear that the likely inflationary impact of Brexit will limit the extent to which the central bank will be able to stimulate the economy.
"We'll provide what support we can but, ultimately, the remit given to us by parliament — and for the right reasons — is to return inflation to the 2% level in a timely fashion."
Carney also noted that the imposition of tariffs, likely depreciation of the currency and reduction of supply to the economy will be inflationary.
The U.K. ended its last bout of stagflation by embracing monetarism under Margaret Thatcher. Prior to her election victory in May 1979, the then Labour government had been incrementally raising interest rates, climbing from 5% in October 1977 to 12%. The Thatcher government went further. Inspired by the economist Milton Friedman, Thatcher raised rates to a peak of 17% in November 1979 and maintained double digit rates for most of the remainder of her 11-year premiership.
The high rate, tightened fiscal policy and subsequent appreciation in sterling tipped the U.K. into recession from 1980 to 1981, and unemployment climbed above 10%. But having peaked at 21.9% in May 1980, by June 1983 RPI inflation was down to 3.7%.
In the U.S., Paul Volcker, Federal Reserve Chairman from 1979 to 1987 under Jimmy Carter and Ronald Reagan, faced persistently high inflation of between 8.9% and 14.8% in 1979-1981. Volcker applied the same formula as seen in the U.K., raising the federal funds rate to a peak of 19.1% in June 1981.
Carney may be helped this time by the fact that the developed world is collectively struggling to keep prices rising at a satisfactory pace at the moment thanks to anemic economic growth and high levels of government debt. So long as the pound was to stabilize at a lower level, the pass-through to higher prices would be a one-off phenomenon.
"Once a recession become more visible, we expect the [BoE] to cut rates to almost zero," said Schroders' Zangana. "The spike up in inflation will be seen as temporary, but the weakness in growth could become more protracted without stimulus."