Inflation is an increase in the price of goods and services in an economy. High inflation means, effectively, that people can buy less with their money. This can happen for a number of reasons: a run on a country’s currency that increases prices of imported goods; a large stimulus to the economy when the system is already at or near full capacity; a strongly unionised labour force exercising its bargaining power; a sudden shortage of labour (following Brexit, for example) or international cost-push factors outside an individual country’s direct control. The latter happened at the time of the two oil crises of the 1970s, and it’s happening again now.
Central banks aim to keep inflation low and steady. When it gets too high, there are various measures they can take, including raising interest rates, reducing money supply, raising taxes to contain spending or implementing a prices policy to keep certain prices at least under control. The French, for example, have forced their energy companies to keep electricity price increases to households to no more than 4% this year, which has kept inflation lower in France than in other European countries.
The problem now is that demand-pull inflation, which we experienced when Covid restrictions were lifted and the economy surged, has turned into cost-push inflation, determined not by wage growth but by the war in Ukraine, which has sent energy and food prices soaring. No central bank by itself can do much about this, except through lowering growth and possibly bringing about a recession – or even depression.
Most economists regard the interest rate solely as a policy lever to be used for controlling inflation. Thus, when inflation falls below the central bank’s target, which in most developed countries is set at 2%, interest rates come down and stay down. Low rates encourage individuals, companies and countries to borrow, and to spend, boosting economic growth. This is what happened over the past decade. But when inflation climbs above the target level, as it has done in recent months, rates are hiked, incentivising saving, rather than spending or borrowing. In theory, as demand for goods falls, so do prices, bringing down inflation.
After the global financial crisis of 2008, central bankers conducted an unprecedented experiment with zero and, in some places, negative interest rates. They successfully prevented a repeat of the Great Depression, when a bout of deflation – a sharp decline in the level of consumer prices – destroyed the US banking system. But among the unintended consequences of this monetary experiment have been a surge in global debt, a proliferation of speculative bubbles, weak household savings and much wasteful investment, accompanied by stagnant economic growth.
Now interest rates are rising and people are finding out that they are less wealthy than they believed they were. Companies and governments are having to pay more to service their debts. Emerging markets that borrowed too much have started to default. The German central banker Hjalmar Schacht got it right when he said in 1927: “Don’t give me a low rate. Give me a true rate, and then I shall know how to keep my house in order.”
To go deeperA History of Interest Rates by Sidney Homer and Richard Sylla is a classic account of lending practices over the course of four millennia.
Even before war erupted in Ukraine, western central banks and economic policymakers were caught between a rock and a hard place. Growth seemed likely to slow down, after a post-Covid rebound. But consumer prices were surging on the back of supply chain bottlenecks. The latter created pressure for central banks to raise interest rates, but the former suggested they should wait.
The war in Ukraine has made the policy dilemma far nastier. On the one hand it has sparked sharp increases in energy prices and other commodities, pushing inflation above 8% in America, and 6% in Europe. That increased pressure on central banks to raise rates. At the same time, business and consumer confidence is crumbling in western economies. In short, we face a phenomenon we have not seen for almost 50 years: stagflation, or inflation amid recession, in combination.
Since the financial crisis in 2008, regulators have tried to strengthen the financial system. But many financiers have tried to avoid the new controls by moving funds into less regulated, non-bank corners of finance, such as hedge funds, loan vehicles or the so-called “private” markets, away from public platforms. This has left regulators looking like a plumber in a house where the pipes have been reconfigured, not knowing exactly what will happen to the water pressure until it is turned on.
To go deeper If you want to understand what is really driving the global economic system today, and all the half-hidden financial flows that knit countries together, read Adam Tooze’s Substack.
The Bank of England’s role is to ensure that, over time, prices rise as predictably as possible at a rate that is not too fast and not too slow. Specifically, we are tasked with keeping price growth at 2% a year. We have a committee of rate setters whose job it is to make sure this happens and who are democratically accountable to parliament.
At times when prices are going up too fast, meaning that the money in people’s pockets is losing its value too quickly, the Bank’s role is to slow that process and bring inflation back down. To do this it can increase interest rates and slow, or reverse, the rate of money creation (known as quantitative tightening). Ultimately this acts to reduce how much people spend and, subsequently, cools price rises. The trick is to do this just enough to bring price growth (inflation) back down to where we want it, but not so far that it risks prices growing too slowly or falling. That is the narrow tightrope that the Bank’s rate setters are navigating.
The decision to cool the economy in this way is not without consequence. It can impact economic growth and people’s jobs. However, the alternative, a world in which price rises accelerate and become undesirably high on a permanent basis, is much worse over the longer run, particularly for some of the most vulnerable in society. That is why the Bank of England’s clearly defined, independent role is so important.
To go deeper The podcast Economics in Ten has some great episodes on the cost of living, but also central banking and famous economists from history. To understand the economic processes behind the cost of living crisis (and lots of other economics), check out Ha-Joon Chang’s book Economics: The User’s Guide.
The UK economy is plagued by lagging productivity, stagnant wages and low economic growth, all of which are now compounded by the cost of living crisis. It is energy prices and corporate profits, not wages, that are driving the current inflationary pressures: corporate profits in the UK have increased by 34% since the onset of the Covid-19 pandemic, 90% of those increases made by the top 25 multinationals.
To address both the current inflation and the longer-term problems, we need to restructure the UK’s overly financialised economy. By simply adding more loans to the system – for example help to buy – the government has made the ratio of private debt to disposable income rebound to what it was at the beginning of the 2008 financial crisis. The current business model is wedded to short-term profits, which has meant that many companies are not investing their profits back into the system but extracting them through practices such as share buybacks, which boost share prices and stock options for executives.
To tackle inflation, the UK government has implemented an energy profits levy, a 25% windfall tax on the profits of UK energy firms for the next 12 months. This is a step in the right direction, but it must go further. Government loans, grants and bailouts should be made only on the condition that profits are reinvested, and that they foster a green transition.
To go deeperThe Code of Capital by Katharina Pistor shows that so many of the dysfunctionalities of modern day capitalism have their roots in corporate law and how intellectual property rights are governed. The Ezra Klein Show podcast navigates the world of economics and politics through an incisive, entertaining lens.
6. Will the crisis eventually bring down house prices?
The latest figures show UK house prices rising at the fastest rate for 18 years. However, this could well be a temporary phenomenon. Many middle- and higher-income households still have significant savings built up from the Covid-19 period, and buyers may be rushing to lock in still-attractive mortgage interest rates before expected rate rises by the Bank of England.
Within a few months, these factors could have played out and falls in disposable income – driven especially by the increase in price caps on energy bills, due in October – will be substantially reducing first-time buyers’ ability to save for a deposit. This, coupled with higher rates, will reduce the appetite for taking on big mortgages for both prospective and existing homeowners seeking to trade up. Rising rates should, in theory, make property less attractive as a financial asset; although housing can also be viewed as a good hedge against inflation.
However, a gradual fall in property prices looks more likely than a bust at this point. Employment is at historic highs and the labour market remains very tight. Wages look more likely to increase than fall, in the medium-term at least. Besides, if the housing market does start to look shaky, you can bet (your house) on the government intervening to prop up demand.
To go deeperWhose Housing Crisis? Assets and Homes in a Changing Economy by Nick Gallent (Policy Press, 2019) clearly and correctly identifies the key challenge for housing affordability in the UK: the irresolvable paradox of treating housing both as a financial asset and a place to live.
7. How can we increase productivity? Do we all need to work harder?
The UK fares poorly on productivity compared with some similar economies. At its broadest, productivity is how effectively an organisation (a business or government agency) or a country turns the resources it has into useful outputs. It has nothing to do with how hardworking or lazy people are; it grows when workers have better equipment and software to work with. Productivity has varied greatly between eras, growing fastest in the mid-20th century but flatlining since the 2008 financial crisis – the slowdown being most pronounced in some of the UK’s best-performing industries, such as pharmaceuticals, finance and software.
Productivity trends are driven by waves of technological innovation but also by national context: does pure research get converted into commercial revenues? Is there adequate national infrastructure, or training for technical skills? Can startups thrive? Can investors rely on stable government policies? The answer to such questions in the UK is often no, hence the disappointing comparison with other rich economies.
This matters, because productivity is the measure of whether living standards are improving. It gives the economy extra output with no need for additional labour, material or capital. Bringing inflation down will be harder here than in countries that are more productive, because we will have to do more to squeeze growth in order to rein in inflation.
To go deeper For all you ever wanted to know about productivity, try the Productivity Puzzles podcast – the first episode is about why productivity matters.
8. Would the British people be better off if we had stayed in the EU?
If you measure “better off” in terms of pounds, shillings and pence there is no question that everyone is the poorer for Brexit. There is no branch of economic activity that has not been damaged to some extent by the new intense trade frictions with our largest market. British exports of goods and services to the EU are now subject to scrutiny of their content, standards and probity that did not exist as EU members. Many imports have been similarly damaged. Investment by British and foreign companies has decreased as a result.
Consequently, everyone’s wages and salaries are lower than they would otherwise have been – a loss made more acute by the higher inflation rate. Only pensioners reliant on the state pension and inflation-proofed private pensions are no worse off – one reason, many pollsters think, that so many older people are Brexit supporters. The trade and investment losses will continue for many years, and the economic scarring will be permanent.
But for true Leavers, “ better off” should be defined more broadly. Britain has won the precious gift of “sovereignty” and control of its borders, ending the untrammelled free movement of EU citizens into the UK. However, Britain needs a larger workforce to support its current level of output, so immigrants are arriving from the rest of the world. Unless you believe the psychic benefit of “sovereignty” trumps poverty, Brexit has made Britain poorer.
There are 14.5 million people in poverty in Britain, including 4.3 million children. Two-thirds of those children are in a household where someone is in work. If you are in work, even if your company is booming, you have little say over whether you will benefit from its profits. If your landlord increases your rent or threatens eviction, or if your mortgage company fails to pass on interest rate cuts, you are largely powerless.
The prices of the basic goods you need to live on are set by a small group of multinational companies that between them carve up the market and set the prices to profiteer. So it’s a statement of the obvious that poverty is caused by the combination of low incomes and high living costs faced by many British people. But what brought this about?
Since the late 1970s, neoliberalism has dominated government policymaking in Britain. This is a school of economic thought that sees markets as the optimum means to organise an economy. Its adherents believe that if you cut taxes for the rich and corporations, wealth will automatically “trickle down” from the top. But we’ve seen over the course of the past decades that this is not the case. The profits of big business and executive pay have soared, while the proceeds of that wealth have not been shared, because trade union rights have been undermined, producing low wage, insecure employment.
10. Could there be any environmental benefits to an economic slowdown?
Chaitanya Kumar Head of environment and green transition at the New Economics Foundation
Slowdowns or recessions are brought on by a drop in output in an economy, which more often than not tends to result in a drop in carbon pollution. However, such benefits are small and short lived, and they can go on to trigger a counterproductive rise in pollution.
Take the Covid-induced global recession as an example. In 2020, global emissions fell by 6.4%. Scientists have told us that to have the faintest chance of limiting global heating to 1.5C, we would need to cut carbon emissions by 7.6% per year for the next decade. And since 2020, consumption has rebounded and emissions have jumped to their highest recorded levels.
But perhaps the biggest danger in the long term is the tendency of policymakers to cut public spending in recessions. This has generally meant savage cuts to the green investments that we desperately need. In the UK, the 2008 financial crash triggered austerity and the slashing of what David Cameron infamously referred to as “green crap”. More recently the government has ignored calls for public investment in dealing with the growing food poverty crisis, choosing instead to abandon its much-trumpeted commitment to raising environmental standards in farming and reducing meat consumption.
Ultimately, no nation has fully decoupled economic growth from carbon emissions, and this is the challenge we urgently need to solve. Recessions are undoubtedly opportunities to accelerate new economic thinking. But we shouldn’t comfort ourselves that they are a way to protect the environment.
To go deeperThis Changes Everything by Naomi Klein shows why we cannot tackle climate change without fixing our broken economies first.