The inflation trap

Governments and central banks across most advanced economies are battling to put a lid on consumer price inflation. At the beginning of the year, UK prime minister Rishi Sunak outlined his five key priorities – halving inflation was at the top. With UK inflation still far above the Bank of England’s two per cent target, its Monetary Policy Committee (MPC) once again decided last week to increase short-term interest rates by a further quarter of a per cent.

The focus on tackling inflation makes sense on the surface. After all, high consumer inflation – say, above five per cent per year – is always a problem. Rising prices of goods and services make it harder for people to make ends meet. But the latest unexpected burst of inflation has been compounded by pre-existing hardships, which are not getting the attention they deserve. This is especially true in Britain, which has suffered over a decade of income stagnation following the 2008 financial crisis.

Moreover, raising interest rates in response to inflation creates its own problems. Those who have been coping with the recent cost-of-living pressures through low-cost borrowing are now finding that the cost of servicing their debts is soaring. Those who are paying off mortgages – about 6.5million people, or a quarter of Britain’s 23million households – are also finding that their monthly repayments are going up. Four out of five mortgages may currently be on fixed-term deals, but many of those will expire by the end of next year, when interest rates will likely still be high. This is likely to affect over three million households.

Some will recall that double-digit mortgage rates were the norm until the early 1990s. But because they were normal, people budgeted accordingly. Moreover, house prices relative to incomes were much lower then, too, meaning that people were borrowing far less.

Whatever the immediate trigger, higher inflation is invariably a symptom of deeper problems in the economy and in society. For instance, the return of high inflation in the 1970s was a symptom of a drop in corporate profitability. Businesses pushed up their prices to compensate for this. The political context was important, too. During the 1970s and early 1980s, there were high levels of trade-union and worker activism. The political class’ battle to crush inflation provided a framework for its crusade against the labour movement. This culminated in Margaret Thatcher’s government cutting inflation through mass unemployment, and by destroying trade-union organisation.

High inflation today is a symptom of deeper economic and political problems specific to our present moment. Bosses may still be increasing prices to alleviate their own financial strains. But the political conditions are very different to those of the 1970s. Back then, workers were strong enough initially to secure inflation-level wage increases – indeed, over the course of the 1970s, real wages grew by about 30 per cent. Today’s labour movement is much weaker. The pressure exerted by the current wave of public-sector strike action is nothing compared with that exerted by trade unions in the past.

The key factor behind today’s economic problems is the post-2008 productivity slump. This was the cause of the wage stagnation during the 2010s. It also underlies the economic fragility that has made it much harder for Britain to cope with the supply disruptions of the past three years, caused first by the pandemic lockdowns and then the war in Ukraine.

Indeed, the lockdown-related interruptions to imported supplies were what initially set off the jump in consumer prices in Western countries. Britain was affected more than other advanced economies because our internal productive capacities have been more hollowed out from deindustrialisation. The UK’s dependence on imported goods means there is much less domestic scope to compensate for foreign supply shortages.

Most parts of developing Asia have been better able to offset the supply bottlenecks arising from the global shutdowns and reopenings. Many of these countries are in the midst of building up, not eroding, their domestic productiveness. This gives them more adaptability in the face of global disruptions. As a result, consumer prices in lots of Asian countries have not risen by as much as they have in the West. This shows why a narrow focus on inflation levels is unhelpful. It is a distraction from the real cause of people’s hardships – namely, protracted and anaemic growth in the UK and the West.

The obsession with reducing inflation also places a lot of pressure on central bankers. The trouble is that tweaks to monetary policy can’t fix the productivity slump that underlies our cost-of-living crisis. Quite the opposite, in fact. Central banks’ loose monetary policies, from 2008 through to 2021, have served to camouflage and entrench productive decay. Cheap and accessible borrowing has kept less-productive businesses afloat, clogging up the whole economy.

At some unknowable point, the illusion of stability generated by monetary easing is going to run up against reality. That’s the prospect troubling central bankers today. In response to rising inflation, the Bank of England has steadily increased its base interest rate from near zero at the end of 2021 to 4.5 per cent this week. These are the fastest increases undertaken since 1988, and rates are higher than they have been since before the 2008 financial crash.

Last week’s decision to raise interest rates again shows that the increases thus far have not done enough to dampen the economy and neutralise inflationary pressures. Many observers do not think the Bank of England will stop here, either. They predict that rates could reach a peak of five per cent later in the summer.

Of course, central banks are having to make these tough monetary decisions because Western governments have empowered them to do so. From the late 1980s on, governments delegated responsibility for national economic policymaking to these supposedly independent state banks. As a result, central banks have become responsible for ensuring the overall stability of the economy, from price stability to the stability of the financial system. This has posed ever-greater challenges, not least as these goals can sometimes be at odds with each other – for instance, aggressive interest-rate hikes, designed to get inflation under control, could prove recessionary or destabilising to the financial system.

None of this is to absolve central bankers of blame for our economic travails. It was they who pumped masses of liquidity into the economy, creating all sorts of asset-price bubbles and encouraging the take-up of crippling levels of debt. It was they who responded to the pandemic shutdowns by effectively creating the money to fund governments’ huge pandemic handouts. (Ironically, this injection of money enabled individuals and businesses to pay the higher prices that have fuelled the rises in inflation.)

However, central bankers should not be scapegoated for the failure of successive governments to take responsibility for the economy. The real problem is that elected politicians have wilfully distanced themselves from economic policymaking. They have turned it into a technocratic exercise and dodged all democratic accountability.

Ultimately, governments are to blame for our economic turmoil. They have tolerated decades of low productivity growth and the rise of zombie businesses. They have cut back on public research spending and investments. They have failed to ensure cheap and reliable energy supplies. They have allowed transport systems to remain broken and expensive. They have accepted inadequate house-building rates, and so much more besides.

The inflationary spike has now brought the consequences of this long-term failure to the surface. It has exposed the underlying economic problems, and left many families struggling to pay their bills.

It has also revealed the near exhaustion of conventional economic policies. Just as the stagflation of the 1970s led to the discrediting of postwar Keynesianism, the Bank of England’s recourse to monetary tightening in response to higher consumer inflation today has revealed the limits of ultra-loose monetary policy. And this is now starting to impact more acutely on everyday economic life.

Above all, the current inflation spike has exposed the Bank of England’s independence as an illusion. After all, the Bank of England was effectively told to fuel government spending from 2020 onwards. Behind the mask of the bank’s independence, it is politicians who are making the decisions that affect us all. They need to be held to account for these decisions, especially when they have failed time and again to come up with a meaningful plan for growth.

We need our political leaders to develop a laser focus on fixing Britain’s productivity slowdown. We need leaders who are willing to create the conditions for a wave of transformative business investments. Above all, we need them to take responsibility for the economy once again.

Phil Mullan’s Beyond Confrontation: Globalists, Nationalists and Their Discontents is published by Emerald Publishing. Order it from Emerald or Amazon (UK).