UK interest rates up!
The wrong answer to the inflation problem...?
Bank of England (BOE) increases interest rates for the first time in 3 years.
On 5th November, the anniversary of Guy Fawkes’ failed attempt to blow up the UK Parliament in 1605 (celebrated each year by fireworks displays…seriously), the BOE has sparked some fireworks of it's own by increasing the Bank Rate from 3.75% to 4%.
Most economists agree this is the correct response to rising inflation. But is it? Read on…
What is the Bank Rate?
This is the interest rate that the BOE uses to pay interest on the money held in reserve by all of the UK’s banks, at the Bank of England. If one of the UK’s banks wants to borrow money from the BOE, it's also the interest that gets charged to them.
Whatever country you live in has a version of the Bank Rate. It's often referred to in the press as the ‘base rate’.
In the US you call it the US Federal Funds Rate. In the EU, it's the Deposit Facility. In India it is simply called the Base Rate.
There are other rates as well, but the Base Rate is the most important.
OK, so what does this have to do with me?
When a Central Bank, like the Bank of England, or the Federal Reserve, changes the Base Rate, they are doing this on purpose to change how the economy is working. That might be good news, or it might be bad, depending on your personal situation.
The Base Rate drives all other interest rates for consumers and businesses alike.
When your bank lends money to you, the interest rate they charge you must exceed the Base Rate, otherwise there is no point lending money. They can just leave the money with the Central Bank instead, and earn more.
This means if Base Rates go higher, interest on loans, overdrafts and credit cards go up.
The difference between the Base Rate and your interest rate must be enough to cover the cost of the loan, losses from defaults, and profit. So the rate you pay is often way higher.
If Base Rates go down, the interest you pay for new borrowing usually follows, but not always. If your bank can maintain the higher margin by not reducing rates on loans, they will. Most businesses will protect profit margins if they can.
Interest on savings usually also follows Base Rate changes, but again, not always. This is because other factors come into play, such as how much in savings and reserves a bank already holds.
However, if you are a saver, not a borrower, then rising Base Rates will usually work in your favor, as savings interest often also increases.
Whatever your situation, changes to Base Rates affect you, your family, your community and the businesses you buy from.
Why do Central Banks increase Base Rates?
Now we’re getting somewhere! Central Banks are tasked by Governments to ‘fight inflation’. Their job is to stop inflation going too high.
Which is a good thing, right? Because we have all been hit by inflation in the last few years.
Until you start to understand how they do this. Why? Because you pay the price.
According to the BOE;
Higher interest rates mean higher payments on many mortgages and loans, meaning people must spend more on them and less on other things. Saving becomes more attractive because the returns are higher and it becomes more expensive to take out a loan. These things all discourage consumers and businesses from spending.
Higher rates deliberately make debt more expensive and reduce spending. But if consumers and businesses have less money and spend less, that means less sales for businesses, and eventually that could mean less pay rises, and fewer jobs.
It’s a big price to pay.
I’m not saying Central Banks are trying to get people sacked, but it’s an inevitable consequence of their monetary policies.
Could it be that increasing interest rates is the wrong answer to the inflation question?
Why is this the wrong answer?
Conventional economics believes high inflation is caused by ‘too much’ money chasing too few goods and services.
Another way of looking at this is too much demand and not enough supply.
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Think about housing. Not enough housing units are being built to safely house everyone in most countries. So, the cost of housing goes up because there are too many people (‘too much’ money) trying to get a home, compared to how many homes are available.
Demand is higher than supply, and this pushes prices up.
Increasing interest rates is an attempt to change this imbalance, by reducing demand.
In other words, even though good quality housing is unaffordable in many places, higher interest rates deliberately makes mortgages more expensive, and housing becomes even more unaffordable as a result.
Increasing rates means more money goes on debt repayment . There is less money in the economy, because debt becomes more expensive. Higher debt repayment costs means you, and everyone else, has less money to spend. So, less money means less people buying things. Not just homes. Electronics, clothes, food, holidays, you name it.
That means there will be less money swirling around the economy. This reduces demand. So prices go up less quickly, and inflation should then come down.
So you pay the price!
In order to combat inflation, your credit card bill gets more expensive. Your mortgage gets dearer when you take a new mortgage out. A new loan is more expensive. Companies find that refinancing debt gets more expensive.
Less spending means companies make less money. Some make a lot less money and start to lay people off. You could be one of them!
Raising interest rates is a deliberate attempt to stop you and others spending money.
Higher debt costs and job losses are effectively the collateral damage of this approach.
Why is raising rates ineffective?
One view is that inflation is caused not just by higher prices in your country, it is also caused by higher prices globally.
As per the BOE;
conflict in the Middle East has disrupted the transportation and supply of energy, raising its price and pushing up households’ motor fuel costs and utility bills
Changing interest rates will affect economic activity in your country. So any inflation caused domestically will be targeted by higher interest rates. I would argue it is still the wrong approach but at least it would eventually work, albeit at a cost to jobs and housing.
But your Central Bank has no effect on inflation caused elsewhere in the global economy.
That problem is outside your country’s jurisdiction, and your Central Bank can’t do anything about it. Because your Central Bank only sets rates for your jurisdiction. Even in the EU, the European Central Bank sets rates for the Eurozone, which covers more than one country, but it still doesn’t affect commodity prices elsewhere.
If global oil prices go up due to geopolitical events, then they go up regardless! The BOE increasing interest rates has negligible or no effect on global oil prices. UK consumers using less petrol, because they have less money, because of higher rates, does not affect the global oil price!
So this means the BOE, and other Central Banks, are trying to control things they simply cannot control.
The cost of commodities, which is name for the basic building blocks of life; oil, gas, wheat, corn etc. are set by global markets, not national ones. Supply side shocks, as they are known, happen regularly in commodity markets. And anyway, increasing rates AFTER the price increase cannot work because the price increase has already happened.
Back to the UK, petrol is up over 20% over the last 12 months. Increasing the Bank Rate by 0.25% cannot affect that increase as it has already taken place and is subject to global geo-political pressures which the BOE has no influence over anyway.
(To be fair, this is more arguable when it comes to the Fed due to the US Dollar status as a global currency, but that’s another story!).
The real question is why your economy cannot offset higher prices elsewhere with lower prices domestically.
Is there another way?
Yes there is! Instead of reducing demand, why not increase supply?
If inflation means there is ‘too much’ money chasing too few goods, then why not increase the supply of goods?
More goods and services means more supply, and therefore less inflation. More housing, more public transport, more farming, more products, etc.
Yes, this is more long term, because it requires investment to get it started, but you have to start somewhere. We need less short termism and more long term thinking. Otherwise we will just keep going round in this never ending inflation doom loop.
In the very short term, it would be more effective, and fairer, to adjust taxes.
For example, housing costs jumping up? Then tax landlords on the increased rent and landowners on the increased value of land. Tax increases with a special time limited tax. This penalises the excess profit caused by inflation, and pulls prices back as landowners seek to avoid being heavily taxed.
So, you target the specific areas of increased prices, not the whole economy, with expiry dates on these taxes set up front.
Alternatively, if a product is already heavily taxed, and there is high inflation for that product, temporarily reducing the tax rate would directly reduce the rate of inflation.
Tax on petrol, diesel, or gas, for example, is very high in many countries. Reducing the tax take would have a real impact for many people, and would directly reduce the rate of inflation. Norway did it!
Conclusion
It might not be perfect, but taken together, fixing the supply of products and services has got to be better than hammering everything in view with higher interest rates, which just leads eventually to economic recession and job losses.
Thanks for reading! The ideas here are based on a combination of Modern Monetary Theory and Land Value Taxation. Any views?
