Lessons for today’s investors from the UK in the 1970s

It’s the last day of the Fed today, and we may well see another rate cut today to round out the year. But as the political pressure on the Fed to cut interest rates remains high, it is worth looking at an analysis of the UK and the Bank of England in the 1970s by Michael Bordo, Oliver Rush, and Ryland Thomas.

Like so many studies of the period, they emphasise the role of inflation expectations, which became increasingly unanchored in the face of external shocks and policy mistakes. External commodity shocks like the OPEC oil shocks pushed inflation expectations higher. This is in itself not too different from the inflation shock of 2022. Still, back in the 1970s, the government at the time made things worse by adopting fiscal policies that focused on preserving jobs and promising higher wages to workers to compensate them for the inflation shock from commodities.

There is a crucial difference to today, where wages don’t see the same upward pressure in the US or in the UK as during the 1970s, thanks in no small part to the fact that labour unions are much weaker today than they were back then.

However, the White House in the US is once again embarking on a fiscal policy that increases fiscal deficits. In the UK in the 1970s, this fiscal deficit came from higher government spending for wages and other fiscal stimulus measures. In the US today, it comes from tax cuts that are supposed to stimulate consumer demand.

In the UK, this fiscal stimulus increased inflation pressures in the UK, all the while the Bank of England sat on its hands, unsure how to deal with the economic developments and the fiscal measures of the government. This uncertainty was understandable to some degree, given that it had only recently moved into a world of flexible exchange rates after the end of Bretton Woods.

The conventional wisdom at the time was that the UK economy could afford the large deficits because it would soon start receiving revenues from the sale of North Sea oil, which was being developed at the time. And the international imbalances of the UK would resolve themselves thanks to a devaluation of Sterling. Inflation would just be temporary and transient, they thought.

In the end, it wasn’t, and the Bank of England’s inactivity made the situation worse because it kept interest rates well below the level suggested by a simple Taylor Rule (not that back then they had any concept of such a thing as the Taylor Rule).

Policy rates in the UK vs. the Taylor Rule

Source: Bordo et al. (2022)

The chart below shows the different contributions to UK inflation during the period of high inflation. Note that the initial increase in inflation in the early 1970s came from cost-push inflation (grey bars). But this inflation push was then made worse by government measures to boost aggregate supply (brown bars) and monetary policy that remained too accommodative (orange bars).

Decomposition of UK inflation in the 1970s

Source: Bordo et al. (2022)

If we look at the situation in the US today, we also had a cost-push inflation shock in 2022 and 2023 that we are still digesting (remember that we never went back to 2% inflation in the US). Now, the US government is trying to create a supply shock by cutting taxes (while at the same time creating another cost-push inflation shock from tariffs). And it pressures the Fed to keep interest rates artificially low to boost demand even more.

And guess what: In 2026, it might well work. It might create a nice sugar rush of stronger growth and demand from consumers. But the history of the UK in the 1970s tells us where this could lead to in 2027 or 2028.

To quote from a newer paper by the same authors: “Our empirical evidence suggests that fiscal policy was at the heart of many of the problems in the UK during the Great Inflation. In contrast to most of British history, it was not used to stabilise the public finances. Instead, it was used to keep unemployment down and growth up, to subsidise losers from terms of trade shocks and to secure deals with the unions.”