Rishi Sunak or Liz Truss? Whoever wins faces a bleak economic outlook | Larry Elliott

Britain has a chequered economic past so it is not exactly unusual for new prime ministers to take over at times of crisis. It is hard, though, to think of a premiership in recent times that has begun with the skies as dark as they are today.

Liz or Rishi? Tax cuts now or later? In a sense, it doesn’t really matter because whoever takes over from Boris Johnson will be handed one heap of problems.

Harold Wilson took up the reins in 1974 when the country was on a three-day week and inflation was rife. Wilson handed over to Jim Callaghan in 1976 just as a sterling crisis was about to erupt. When Margaret Thatcher defeated Callaghan three years later, it was in the aftermath of the winter of discontent and with inflation on the rise.

Liz Truss or Rishi Sunak will be confronted with a mix of all these problems. Inflation is high and rising. Energy bills will rise sharply for a second time this year in October. A summer of strikes has only just begun. Sterling looks vulnerable on the currency markets.

Wilson and Thatcher at least had the comfort of knowing they had a full parliamentary term to straighten things out. Truss or Sunak will not have that luxury. One or other of them will take over in mid-term, with living standards crashing and not much time to impart a feelgood factor.

The economy is not exactly in recession, at least in the technical sense of experiencing two successive quarters of negative growth, but is showing all the classic signs of heading for a downturn over the coming months.

Retail sales are down almost 6% year on year. Consumer confidence is at its lowest in almost half a century. The latest purchasing managers’ index last week showed manufacturing output contracting and the service sector expanding at its slowest rate since early 2021. The PMIs are not a particularly good guide to the precise state of the economy but they do provide some clues as to its direction of travel.

None of this is a surprise because real pay – wages adjusted for prices – is falling at a record pace, and the squeeze will intensify as the annual inflation rate rises from its current 9.4% to around 12% in October.

Usually, the Bank of England would respond to a weakening economy by cutting interest rates but it will do the opposite this time. Borrowing costs look set to go up by half a percentage point to 1.75% when Threadneedle Street’s monetary policy committee announces its latest decision early next month. Not since the mid-1970s have interest rates gone up when the economy was in recession.

The Bank is under fire for first stoking inflation and then failing to act quickly enough when price pressures started to surface. Truss has said she wants to look at Threadneedle Street’s mandate – the duty to hit the government’s inflation target – to make sure it is tough enough.

But the Bank’s actions need to be put in context. When the pandemic arrived in early 2020 and the country was locked down, it was right for the Bank to cut interest rates and pump money into the economy. At the time, the fear was of a second great depression.

Similarly, until the Russian invasion of Ukraine it was reasonable to assume inflationary pressures would be temporary and the result – mainly – of global factors beyond its control. A year ago there was concern the end of the government’s furlough scheme would lead to higher unemployment. It didn’t but the Bank was not to know that.

Vladimir Putin’s actions have resulted in the Bank of England becoming more hawkish. Russia’s invasion was a classic black swan event: something that comes as a shock, has a dramatic impact, and which in retrospect everybody admits they should have seen coming. The Bank was not alone in failing to spot what the Kremlin was planning, and is being unfairly scapegoated.

Attempts to dragoon the Bank into aggressive interest rate increases are unwise because the economy is in a state of extreme fragility and there is a risk of making the looming recession longer and deeper than it need be. There are signs – especially from lower commodity prices – that global price pressures are easing, which should feed through into sharply lower UK inflation next year.

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For now, there is the possibility that the recession will be short and shallow. In part, that’s because unemployment is below 4% and record vacancies mean there are plenty of jobs available. In part, it’s because better-off households are able to live off the excess savings they accumulated while spending opportunities were limited during the various lockdowns. In part, it’s because the property market has been defying gravity and owner-occupiers feel less gloomy when house prices are rising.

Clearly, that could change. Demand for labour might fall as activity weakens. Rising interest rates could be the trigger for a marked slowdown in the housing market. If people are forced to sell their homes at a discount because they have lost their jobs, then Britain will be back in the negative equity crisis of the early 1990s. For either Truss or Sunak, this is the nightmare scenario.

As the foreign secretary has correctly reminded voters, Britain’s economic performance has been rotten since the Tories won the 2010 general election. Attacks on the previous Labour government for failing to mend the roof while the sun was shining ring even more hollow now than they did at the time, because Britain is ill-prepared for the testing times that are to come. Whoever wins the race for 10 Downing Street is going to have the briefest of honeymoons.

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