Is the Bank of England raising the interest rate the wrong solution to a different problem?
To understand why the Bank of England’s decision to raise interest rates to 1.75% could have perilous consequences, given the multitude of varied economic pressures the UK and its citizens currently face, we must first understand what the ‘Interest Rate’ actually is.
In effect an interest rate refers to the cost of borrowing, so the higher the rate, the more you as the borrower will have to pay back and the higher the rate savers gain. Varying the ‘Bank Rate’ is the mechanism national or reserve banks have used to control inflation and keep their respective economies chugging along, ever since the US abandoned the gold standard in 1933. The Bank of England’s rate specifically refers to the rate at which it – as the UK’s Central Bank – allows commercial banks to borrow from the centre. As such if the Bank of England raises its ‘Bank Rate’ by say 0.5%, then it is more than likely commercial banks will seek to adjust future fixed term loans by at least that margin. They also usually adjust variables like mortgages by whatever rate the Central Bank – in this case the Bank of England – sets as the interest rate.
The best way to explain how such a mechanism impacts the overall health of the economy is to say that when interest rates fall, banks are given incentives to give out loans as they incur less risk due to themselves having to pay less back to the Central Reserve. Thus spending increases as we the public are given better deals on borrowing money and in turn the supply of available money also increases, as more is needed to fulfill the increased volume of loans. Once again when interest rates are low there is less risk. This applies to loans like mortgages or loans utilised to set up businesses or pay off a car.
This all sounds rosy, right? Why not keep interest rates low forever? The answer is “Because of Inflation”.
Inflation
In the UK inflation is currently 10.1% for the 12 months to July 2022, as measured by the Consumer Price Index (CPI). This is above what it was a year ago. Some economists predict 18% inflation by next July so tackling it now is obviously a key priority. There are two major types of inflation: that of Demand-Pull and that of Cost-Push. They kind of say what they are on the tin but understanding them is key to understanding why the Bank of England’s Interest rate rise is in my view an error.
Demand-Pull inflation refers to the kind where too many people want too few goods and thus the increased demand pushes up the prices of the product. Take a house in the middle of a desirable village with a highly rated GP, dentist, in the catchment area of an ‘Excellent’ rated Ofsted school and surrounded by ample job opportunities. Such a house will demand a higher price than one without any of the above-mentioned facilities.
Putting it even more simply: if everyone decided one day that they hated Coca-Cola, then the price of Pepsi would increase because:
- it’s no longer competing for market share and there is no pressure to reduce consumer prices and
- the demand for the product will outstrip supply, thus allowing it to move from a consumer product to a premium product.
Cost-Push inflation, in contrast, is driven by an increase in the costs accrued by a business in the production of their goods. Taking the Pepsi example again. If Pepsi suddenly had to pay its workers 100 times their salary and simultaneously the price of sugar skyrocketed, then the costs to the business would have increased to such a substantial level they will have no choice but to push those costs onto the consumer in terms of the price of the product.
Impact of Covid
Covid-19 stalled the global economy and forced a sharp fall in the majority of nations’ GDP; for the UK GDP fell by 9.4% in 2020; however with the reduction on restrictions and reignition of the economy GDP spiked in 2021 by 7.1%. However, whilst the GDP somewhat recovered, global supply chains, constantly interrupted by the implementation and relaxing of covid restrictions, haven’t. This meant that when the pandemic hit production in many areas ceased either due to the restrictions themselves or because of a lack of demand.
For example, let’s take a trivial example of ‘Meal Deal’ sandwiches. These are suddenly not required because there are no commuters with most people working from home. Thus, production ceases as demand reduces. This would’ve led to layoffs if not for the Furlough scheme. However, not every nation had such a scheme. Foreign producers of sandwich ingredients (lettuce, grain and tomato) may have had to shut down their business and lay workers off. This section of the economy then lies dead. But suddenly thanks to vaccination everyone is back to work sooner than expected, travelling on trains and buying meal deals. Yet the industries cannot reset quickly enough to meet demand, their costs suddenly skyrocket as they now have to purchase a limited supply of grain and lettuce and tomato from the reduced pool of those who still produce it and take on the full costs of those who used to be on Furlough. So, their costs increase which in turn leads to higher prices. Therefore, this narrow section of the economy is hit by two inflationary pressures simultaneously – The Demand-Pull of more commuters competing for too few sandwiches and the Cost-Push of higher costs for the company. Spread this out over the entire economy and you start to build a picture of the troubles faced by post-pandemic recoveries, and that was before the Russian invasion of Ukraine added increased fuel costs as another Cost-Push.
Interest Rate Rise
So where does the Bank of England’s interest rate rise fit into this? I hear you screaming. Think about it from a business point of view. You are struggling to absorb the rising energy costs and the costs of reintegrating your workforce, despite in many cases having generated no income during the pandemic beyond government backed loans. Then add increased fuel bills for your vehicles and the cost of competing for limited resources, plus an interest rate rise of 0.5% onto your existing loans. By my understanding you’ll find inflation will not reduce but increase as businesses seek to recoup some of their costs by increasing prices for the consumers. That’s if the businesses survive at all.
However, for the general public, these interest rate rises will pinch the purse of many at a time when they don’t have any spare cash. As Martin Lewis, the ‘Money Saving Expert’, said: people like him are “virtually out of tools” to help people. Think of house owners on variable mortgages who will likely have their rate increased by a minimum of the Bank of England’s rate. Think too of renters whose landlords will raise the rent to cover their increased mortgage payments. Then there are those with personal loans who will see their repayments jump.
The perception that a rise in interest rates will reduce spending and so reduce inflation – the Demand-Pull – is wrong. As explained above, the majority of current inflation is not happening because the average consumer is splashing their money about, trying to buy luxury items in short supply. It is because people are attempting to purchase the basics like bread and baked beans in the wake of a Cost-Push resulting from the pandemic and fuel costs that interest rate rises will only exacerbate not solve.
We are in a Cost-of-Living Crisis. Inflation is rising. Wages are not. Profits are rising. Supply isn’t growing fast enough.
Options
The government therefore has at its disposal three options.
To do nothing. Allow inflation to run free and hope it comes under control soon and hope too it doesn’t destroy too the small businesses which make up the backbone of our economy and, if they do fail, hope everything corrects so we don’t fall into a long-term recession.
Raise interest rates. Push interest rates so high and limit monetary supply so harshly that they plunge the economy into a purposeful recession causing misery to millions in the hope excess unemployment will reduce demand – this is unlikely to work due to the issue being the supply of basics. No matter how poor someone is, they will still need to eat something.
Intervention and Support – My preferred option. The government intervenes to limit price rises in the basics by securing consensus across all major supermarkets and their producers. The cost of this intervention could be funded by introducing a tax on the banking sector’s profits, so they can start to repay the costs to the taxpayer of bailing them out in 2008. Secure a unified pay rise across sectors as part of a wider inflation reduction strategy and minimise price rises by incentivising businesses to accept slightly smaller profits.
The government should nationalise the failed energy supply company, Bulb, to provide a public option for energy cap maximum of £2,000. It should impose a Windfall Tax on oil and gas companies and use the proceeds to provide the smallest businesses with an energy cap. Reintroduce the £20 a week Universal Credit uplift so people can afford the basics. Enact an industrial strategy on re-securing international supply lines of the basics as well as subsidising British farmers to produce grains and other basics considering the ongoing situation in Ukraine.
Conclusion
This radical solution would:
- Avoid a recession,
- Limit inflation,
- Increase supply,
- Steady demand and
- Protect the most vulnerable.
It is not good enough to do nothing. It is not good enough to lower taxes on the wealthiest. It is not good enough to increase interest rates by 0.5% and assume everything will be fixed. The costs of this crisis shouldn’t be placed upon the most vulnerable in society or the smallest businesses that keep our country going.
We are faced with an existential problem and the blunt instrument of an interest rate rise is too simplistic a solution. What is needed is radical overhaul of our utilities and taxation to protect the vulnerable.
If this government won’t act, it’s about time we got a new one.
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