Raising interest rates won’t fix inflation and could harm the recovery

Author: Danisha Kazi

October 26, 2021

The standard tools for controlling inflation will do nothing to address the current sources of rising costs.  These are rooted in global factors from supply chain turmoil to continued upheaval as we learn to live with COVID-19.  We need a fairer approach to inflation that supports those at the sharp end of the squeeze on living standards, and delivers targeted public investment to build a more resilient economy. 

Inflation has dominated the headlines in recent weeks, from rising energy and commodity prices to growing labour shortages.  While the UK’s inflation rate has dropped slightly from last month to 3.1% in September, inflation is expected to rise to 4% by the end of this year, well above the Bank of England’s target of 2%. Headline inflation in the US has also risen above target, reaching 5.4% in September.  

There is an ongoing debate between those that see these inflation spikes as temporary while the post-lockdown economy adjusts, and others that warn of 1970s-esque inflationary spiral making a comeback. Moving beyond this debate, we must fundamentally rethink how we respond to inflationary pressures, especially where it hits the most vulnerable hardest — for example, with rising energy prices. 

The global factors currently feeding into inflationary pressures are varied and complex.  They include supply chain disruptions, volatile fossil fuel prices, and the mismatch in supply and demand as countries emerge from lockdowns. Wholesale energy prices have soared by 250% since January, partly due to a colder winter last year which depleted the world’s stockpile of stored natural gas. This is having knock-on effects on energy-intensive businesses and UK energy suppliers, which will invariably impact the prices consumers face.  The underlying problem of this kind of inflation is the UK’s overdependence on imported fossil fuels, and slow progress towards developing robust alternatives, such as domestic renewable energy infrastructure and better home insulation to improve energy efficiency.  

At the same time, international supply chains are facing ongoing disruptions. Since January, 584 container ships have been stranded outside ports and shipping costs are now 3 times higher.  A mix of extreme weather events, warehouse backlogs, factory stoppages due to COVID-19 and labour shortages have deepened supply bottlenecks and caused prices of certain goods to rise. This has exposed our economy’s structural reliance on fragile ‘just-in-time’ supply chains, for delivering goods directly to our homes quickly and at low cost.

Another factor is the mismatch in supply and demand as the lockdown ended.  As some industries are unable to raise production to meet renewed demand.  Semiconductor shortages slowed the production and supply of new cars, which has led to the prices of second hand cars rising by 21.8% between April and September 2021.  Transport costs made the largest contribution to inflation in September due to rising petrol prices, which have now hit a decade high.  However, these problems are related to goods and commodities that have experienced supply chain disruptions. Currently higher inflation figures are also the result of how they are measured — by comparing current prices to those in the previous year. As highlighted by the Office for National Statistics (ONS), these ‘base effects’ distort data during periods of economic disruption. For example, restaurant and hotel prices pushed headline inflation higher in August due to very low prices the same time last year when the government’s Eat Out to Help Out scheme was in place.

The standard tools the Bank of England has for controlling inflation are not well suited to address these underlying global factors. The monetary policy toolkit we have was shaped by monetarist theory, which makes the reductive assertion that inflation is always the result of an expansion in the money supply — in the words of monetarist economist Milton Friedman: “Inflation is always and everywhere a monetary phenomenon”.  The typical response is to tighten monetary policy by raising the Bank’s base rate.  This will cause other interest rates in the economy to rise and make borrowing more expensive for households and businesses. The desired effect is to reduce demand in the economy where supply is constrained and ease upward price pressures.  The Bank of England’s Governor, Andrew Bailey, has already signalled that the Monetary Policy Committee (MPC) is ready to take action. However, Bailey also admitted this will have no impact on the current sources of inflation, which are driven by supply side factors.  More worryingly, higher interest rates will choke off any signs of a recovery and reinforce supply chain difficulties.  As investment becomes more expensive, businesses will hold back expanding production, hiring more workers, spending on new machinery and building new factories or warehouses.  

Far from excessive fiscal and monetary expansion, the government’s various measures in response to pandemic (such as the furlough scheme) have been vital to support the economy, maintain people’s incomes, and keep businesses afloat. By February 2021, the total cost of the UK government’s support measures had reached £370 billion.  This has been supported by £450 billion of Quantitative Easing (QE) by the Bank of England since March 2020, which has kept government borrowing costs at historic lows. So far, there is little evidence that such measures have led to excess money driving higher prices we see today.  The £200 billion households have saved during the pandemic have been concentrated amongst higher income households, while lower income households have been forced to take on more debt.  The economic outlook is also worsening and consumer confidence is sliding.  Recent data indicates retailers are facing the longest slump in sales since 1996.  While the Bank of England expects household spending to remain below pre-pandemic levels due to uncertainty over the impact of COVID-19 on the economy.  

Eagerness to raise rates are rooted in fears that workers will start to demand higher wages and inflation will become more entrenched.  Again, the evidence here suggests caution.  Labour shortages, such as with HGV drivers leading to wage rises, are still confined to certain sectors. Annual wage growth figures have also been distorted by the pandemic.  The ONS suggests that wage growth is between 4.1-5.6% once base effects are stripped out.  Some modest inflation below the rise in money wages would be welcome after a decade of stagnant real wages. 

The government and the Bank of England must rethink their approach to inflation and work together to build a more resilient economy.  Raising rates at a time when the economic recovery is faltering is a blunt tool that will do nothing to solve the real causes of inflation we see today.  In the immediate future, this means supporting those at the sharp end of the squeeze on living standards by ensuring essential goods, housing, and energy remain affordable.  We also need targeted public investment and redistributive policies to shift the economy away from fossil fuels towards renewables, and away from our dependence on cheap labour and exploitative supply chains. 

Danisha Kazi is the Senior Economist for Positive Money.