Britain faces stagflation threat: what the grim prognosis means

THE ailing British economy is heading for a triple-dip recession and faces an ominous new threat in the form of "stagflation", the Financial Times says. Here's what this grim prognosis means:

Why is a triple-dip recession likely? The British economy has continued to flatline in the first two months of 2013, according to the National Institute of Economic and Social Research. Economists were hoping an increase in manufacturing production would help avert a third period of economic contraction, but they were disappointed. Output fell 1.5 per cent between December and January, a performance described as "awful" by analysts HIS Global Insight. A triple-dip recession – a period in which the economy falls into recession three times without returning to a period of robust growth in between – now seems firmly on the cards.

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So, what’s stagflation? Under normal circumstances, inflation falls in a recession because wages are squeezed and there's less demand for goods and services. Stagflation is different. It's "a toxic cocktail of stagnating growth and rising prices that leaves policy-makers unable to tackle one problem without making the other worse," says the Daily Telegraph. "Households suffer, as the weak labour market means wages do not keep pace with wider price rises in the economy." The term is generally attributed to the Tory minister Iain McLeod, who coined the phrase in a speech to Parliament in 1965. "We now have the worst of both worlds – not just inflation on the one side or stagnation on the other, but both of them together," he told the Commons. "We have a sort of 'stagflation' situation."

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So, it's happened before? Absolutely. After the mid-60s, it happened again when the 1973 OPEC oil embargo triggered the worst period of stagflation in both the UK and the US. The soaring price of fuel choked economic output and simultaneously pushed up the cost of goods and services, causing high wage demands and triggering spiralling inflation. As a result, people often use the phrase "1970s-style stagflation".

How do we know inflation is going to rise this time? The strongest indicator that prices are going to rise sharply has come from investors, the FT says. They have "priced in" an inflation rise that would see it reach its highest level in almost five years. "Inflation expectations, as measured by the difference between nominal and inflation-linked bond yields, ticked up to near 3.3 per cent yesterday, levels not seen since September 2008," the paper said today.

What can be done to avert stagflation? Most analysts say the first step is to get the economy moving again. Citigroup's Valentin Marinov told the FT there is "an urgent need for policy steps to revive the economy" ahead of the 2013 Budget next Wednesday. In his Daily Telegraph column, finance journalist Alister Heath says Chancellor George Osborne needs to deliver "shock-and-awe tax cuts" if a 1970s-style disaster is to be averted. "The Government's problem is that people are getting poorer, as inflation munches into incomes, and the economy is stagnating," he writes. "Unless that changes visibly, and quickly, how can the Tories hope to win in 2015?"