Interest rates are not the answer to inflation - or are they?

Jacob Reynolds tackles the UK's inflation dilemma - with some additional thoughts from Rob Lyons.

The Bank of England has pushed interest rates to 5%, insisting it is the only way to rein in inflation. Continued interest rate rises seem to have done little to tame inflation thus far, and are in danger of causing misery for many of those with variable rate mortgages.

But inflation has to be tamed somehow - and the era of low interest rates was terrible for productivity and the wider economy.

What is to be done?

Below is an exchange between Jacob Reynolds, the Academy of Ideas’ Partnerships Manager, and Rob Lyons, convenor of our Economy Forum.

Interest rate rises are an alibi for a ruling class out of ideas

Jacob Reynolds

We first need a working understanding of what inflation is, and what is causing it. Inflation is the rate at which prices are rising, and there are multiple different ways of assessing it, depending on what you want to include or exclude. In official figures released this week, the UK Consumer Prices Index for May was up 8.7% compared to a year earlier - the same rate as in April, when most analysts had expected the rate to fall.

The essence of inflation is that ‘too much money’ is chasing ‘too few goods’. At a very basic level, then can be dealt with in two ways: first by reducing the amount of demand (ie, money), or second by increasing the amount of stuff.

This second point is key and we will return to it later.

Given this, will interest rate rises dampen inflation?

It seems likely that they should. Rate rises both incentivise saving (meaning less money is spent and so less is ‘chasing stuff’), and also leave mortgage-holders (which are 28% households) with less money to spend elsewhere. Likewise, if landlords put up rents in response to increased borrowing costs, this affects the spending power of the 20% of households who rent. Interest rates also impact those who borrow to spend, as the cost of their debt increases, and have a number of second-order effects on the economy, further depressing demand. So far, so A-Level economics.

But it is not that straightforward. The real effect of interest rate rises depends on which goods and services are subject to inflation.

If the main drivers of inflation are things like fuel, food, energy and basic services, the effect of interest rate rises will be muted. This is because people cannot always easily reduce consumption of these goods - even if the price increases, you still need food and fuel. People may cut discretionary spending first, they might save less, or they may borrow to sustain their habits. Importantly, people might also negotiate pay rises to keep their consumption levels steady (which the Bank of England governor, Andrew Bailey, argues is fuelling inflation even more).

Of course, if you limit people's disposable incomes enough, then they will be forced to reduce spending across the board. But it is unclear if we can or should reach such levels of downward pressure on demand.

Indeed, when the chancellor of the exchequer, Jeremy Hunt, or the Bank of England talk about recessions as the only answer to inflation, this is essentially what they mean: crash the economy, put people out of work, and force people to spend less.

This is, to say the least, an extreme solution.

This raises the key question: Why are the people who run the country forced to flirt with recessions in order to control inflation?

The short answer is that they have completely given up trying to actually improve the basic functioning of the economy. Instead, as with a great many problems in the UK, elites seem to treat inflation as a simple, unalterable fact of economic decline. We are all expected just to grin and bear it as living standards are crushed.

To be fair to the Bank of England, this is baked into its mandate: to control inflation using the money supply and interest rates. The Bank of England is doing precisely what it has been tasked to do, with the tools given to it.

But the fact that Hunt also insists that interest rates are the only medicine - tough, regrettable, but necessary - shows an utter failure of imagination and confirms that politicians believe that they are powerless to take charge of the economy (except to clean up after crises have happened!).

Is there an alternative?

We need to remember also that inflation is not an ‘act of god’ or a consequence of Putin. In fact, our elites in large part created this mess through their pandemic policies which were directly inflationary. Shutting down large sections of the economy whilst pumping money into it is as textbook a recipe for inflation as can be imagined.

Thus, if we were put into this situation through specific policies, we can get ourselves out of it. But how?

This brings us back to where we started. The other approach to controlling inflation: increasing the amount of stuff.

Of course, the UK cannot snap its fingers and immediately create more stuff to balance inflation. But, to take one example, we could easily grant new gas licenses in the North Sea and increase gas supply relatively quickly. Or to take another example, whilst we cannot produce microchips overnight, but we could easily produce more food domestically.

This is the fundamental point: Interest rate rises may dampen the effects of inflation, but they do not address its causes.

The problem is that no one in authority in the UK is trying to seriously address the causes of inflation.

There is, however, something of an exception to this. Some people do believe there is a simple fix for inflation: more immigration to drive down wages. But aside from the cultural and political debates about immigration, it is a highly superficial solution from the perspective of economics. In fact, it once again directly mistakes causes and effects.

Importing cheap labour is the idiot's solution to economic woes. A serious, long-term approach to reducing costs is to increase public and private investment with the aim of producing a more productive economy. A more productive economy produces more stuff for less input - which is directly anti-inflationary.

There is no escaping from the fact that tackling inflation requires us tackling the central problem: Britain's economy is broken, and elites systematically stifle any attempt to fix it. Rather than fixating on interest rates, we need a serious discussion about our economic woes.

Interest rate rises are an alibi for a ruling class out of ideas.

Interest rates and the death of zombie companies

Rob Lyons

I agree with lots of Jacob’s points, but I think he leaves out something important.

This is: what’s the impact of higher rates and inflation on business?

It is important to ask this question because the era of low interest rates has allowed many barely-profitable businesses to limp on, tying up people and capital that could be better invested elsewhere. This problem - the problem of ‘zombie companies’ as people like Battle of Ideas festival regular Phil Mullan call it - is one of the most serious facing the UK economy. In essence, there are a great many companies whose time is up, but can delay the inevitable by taking on and rolling over debt - so long as they can borrow at low interest rates. But their presence ties up capital and takes market share from more productive and profitable enterprises.

This ‘deadweight’ on the economy is suddenly challenged by the rise in interest rates. Over the long term, we need interest rates to come up - the era of low rates was an anomaly and has had many perverse effects including the rise of the zombies. What we need is a fundamental restructuring of the economy - clearing away the old and the inefficient to make way for the new. The capital tied up in zombie companies needs to be invested in the industry of the future. Higher rates predicate the end of the zombies. So, maybe we should welcome them.

But, as Jacob notes, interest rates are never simple. If what the economy needs is investment then high interest rates make this more difficult. If you’re a company and want to invest in some new machines, it was much easier to pay off the debt on borrowing at a low rate than today’s higher rates.

Yet at the same time, the rise in wages - a feature of inflation and perhaps a feature of consumer responses to higher interest rates - directly incentivises companies to invest to make production more efficient. I recognise that some investment might not feel like progress - try getting anything done with your energy company’s new ‘AI Chatbot’. But in broad terms, higher wages force companies to focus more effort into time-and-labour saving technology.

Another complicating factor is that the era of low rates and loose monetary policy massively skewed investment decisions across the economy. When rates were low, and banks were printing lots of money (‘quantitative easing’), this had the effect of massively inflating asset prices. From meme stocks to huge house price rises, the value of lots of assets outstripped any rational valuation. In this climate, ordinary businesses barely got a look-in. Why invest in a plastics company’s new factory which promises decent if meagre returns when you could double your money sticking it in shares of a small number of tech giants or such trendy froth as WeWork or lab-grown meat? Yet, we know that the performance of small and medium size firms is often decisive for the overall health of the economy. In other words, low rates perhaps starved bread-and-butter firms of investments.

However, if investment is one of the key things we need, we can’t just fixate on interest rates and inflation. We need to think seriously about the massive, structural barriers to investment. Jacob mentions excessive regulation as one of these when talking about the continued potential of North Sea Oil - and this is right. But huge issues such as the structural shortage of housing also hurt the economy. For example, housing shortages hit companies bottom line when they have to attract people to work in London or the South East where houses/rents are expensive. Similarly, high housing costs hit disposable incomes in these areas, too - and did so well before interest rates began to rise. To tackle the barriers to economic productivity, we need to address the housing shortage.

Another long-term factor is infrastructure. We need better roads, transport links, internet connections. Instead, the government botches it at every opportunity - just take a look at the ever-ballooning cost and shrinking ambition of HS2, with another £360million added to the cost this week.

We should also mention energy - the economy would be wildly different if we had the plentiful, reliable energy that could be provided by a few dozen nuclear reactors. In other words - and this is where I really agree with Jacob - the government is ignoring fundamental parts of economic policy and pretending all it can do is fiddle with interest rates or make minor changes to taxes.

So, I agree with Jacob that there is a lot of bad faith going on, but think the impact of interest rate rises is more mixed than he suggests.

It matters why they move interest rates

Jacob Reynolds

Thanks for the great reply, Rob. But I couldn’t resist picking up one of your points.

I agree with your points about the zombie companies - everyone should read Phil Mullan’s Creative Destruction: How to start an economic renaissance. But I think we need to be careful what we wish for.

The Bank of England are not raising rates because they recognise the failures of the past 20 years of British economic policy. Far from it. In fact, as mentioned earlier, Andrew Bailey seems to think the problems come from greedy workers demanding excessive pay rises. There is zero recognition of the role that central banks and governments have played in creating our economic problems.

The ‘great experiment’ since the Financial Crisis - low interest rates and endless money printing - was only accelerated in the response to the pandemic. This experiment directly contributed to the inflation we see today. There is a collective amnesia from the people who run society about the effects of their actions. They resemble less competent technocrats than a pet that’s done something unspeakable to your carpet: when confronted with the evidence they give you a look as if to say Who? Me?

I think this is important for two reasons. First, if they are raising interest rates as a blinkered attempt to control inflation (rather than attempting to reverse decades of abnormal policy) then there is nothing to stop them reverting to low rates when the next (inevitable?) recession hits. This just brings us back where we started. Second, rebalancing the economy away from the zombie companies is not something that can just happen as a result of higher rates. There needs to be a serious plan for the transition - what to do with workers who lose jobs, how to make sensible use of old capital, how to ensure that money gets allocated to the new industries, etc. At the moment, the only ‘transition’ on the lips of policymakers (except those involving schoolchildren and cats) is the green transition. This would just replace one series of inefficiencies with another.

To sum up, then, the problems of an era of low rates, low investment, and low productivity will not be solved overnight by a reversion to higher rates. We need a serious debate about how we got into this mess and how to get out - one that in a truly democratic spirit involves everyone across society.

With that sentiment at least - I am sure you’ll agree.