The cost of living seems to be one of the most talked about subjects, particularly during the last few weeks with the debate over who should be the next prime minister developing. We are now in an environment where higher-than-expected inflation is eroding the real value of money; thus, the current debates have been rooted in how either Rishi or Liz may attempt to plug the gap whilst not damaging the long-term outlook for our economy.
It is important to note that inflation itself is not the issue, the monetary figure on one’s shopping trolley does not become a problem unless the income one receives does not cover one’s needs and, to some extent, wants.
Economists typically attempt to understand inflation and identifying the contributors to it is key to understanding which tool can be used to tackle this rising beast. With higher inflation the first place we look is the Bank of England (BoE), to reach into its toolbox of economic instruments to save the day. Central banks are now responding to inflation as a threat even greater than debt. The Federal Reserve has been particularly hawkish in its response to rate hikes in comparison to the European central bank which has been conservative in comparison. How much central banks can raise rates and how useful it will be is dependent on its individual circumstances which are determined by geopolitics and factors within their own economies.
Interest rate hikes have historically been a tool which allows the central banks to control the availability of money circulating within the system and tend to have an inverse relationship with inflation. It is important to understand that this tool tends to not be effective immediately and raising rates to combat high inflation often takes time to filter through.
As the BoE explains on its website, it is important for inflation to be stable and not too high. If it fluctuates too often or goes up too much, it makes it difficult for businesses to set prices for things – like the cost of a new car for example. It also makes it hard for people to plan how to spend their money.
For the past few years savers have been lamenting the low-interest rates on offer while most central banks have kept rates at historically low levels. Borrowers and companies have rejoiced and borrowed money for all sorts of endeavours, which has been a tailwind to the growth and innovation story we have experienced over the last 10 years.
2022 has seen a substantial change in our global and local environment. We are still navigating BREXIT and the journey out of a global pandemic all whilst there is a rush to become more independent in terms of supply. Problems with the global supply chain restrict the availability of some products and component parts of others. Supply chain issues have a huge plethora of factors, some of the biggest being the zero policy COVID crackdowns in China and the Russia-Ukraine conflict.
So, the question is posed, can Andrew Bailey (Governor of the BoE) and Jerome Powell (Chairman of the Federal Reserve) realistically influence inflation by raising rates? Raising interest will inevitably bring down inflation in the future, however as well as domestic considerations, there are things impacting global energy prices that central banks have minimal to no control over. Gas and energy prices are a core component of the inflation measurement in many countries and with supply issues continuing to weigh heavy – primarily as a result of the conflict in Ukraine – the price has remained high.
A quote from Andrew Bailey when questioned on what the BoE is doing about interest rates does seem to suggest that the rising rates will help however is not the only tool which needs to be implemented. He said, “80 per cent of these rises are due to international phenomena that are out of domestic control”.
Governments and central banks can influence other contributors of inflation such as tight labour markets, or consumer spending. Government policy will be key to how we move forward and herein lies the current theme that has run through all of our recent articles. Respond and deal with events as they arise – as much as you can do. And the overriding message has always been maintaining focus on the long term to navigate the short-term uncertainty.
Milton Friedman, the noted American economist once mused that “inflation is taxation without legislation.” It is not just savers who feel the pain of high inflation and rising interest rates, but government and corporate bond holders who are receiving fixed levels of interest are also suffering. We are all in this together, however although interest rates have increased and inflation is taking its toll, a positive thing that comes out of this is the discipline which governments and corporations will now need to practise when spending money. The hope is that, if money is more expensive to borrow, the things that any given party will spend on will need to be worth the cost, R&D will be more targeted, the throw away culture may stumble to pave a way for more long-term quality solutions which is where we navigate through the noise.