On Inflation
Because inflation is affected by delays in the economic system, it is cumulative and persistent. To minimise the depth of any recession, policy should aim to address the effects of inflation on living standards and thus demand in the economy fully and as rapidly as possible. Second-order effects (such as currency depreciation and/or interest rate rises) should be minimised by spending to reduce inflationary pressures at source, trading more government (or pseudo-government) borrowing for less inflation. The risk of increased nominal debt because of inflation should not be exaggerated.
This post should really have one of those 19th century-style long titles, such as: “On inflation in the context of unprecedented rises in energy prices, with reference to the Tory leadership election”.
It’s surprising to see Dominic Raab on Channel 4 News this evening (31st August) explaining how “inflation is public enemy number one” and that only his candidate, Rishi Sunak, can be trusted to deal with it, just hours after the Office for National Statistics (ONS) confirmed that “the energy bill rebate being paid to households will not directly lower the UK’s inflation rate”. As I pointed out some months ago, Rishi could have provided support to households by directly lowering energy costs, which would have lowered inflation.
France is adopting the strategy of protecting households from energy price rises, so its inflation rate is much less than the UK’s. Which plan makes more sense? Well, let’s reflect a little on inflation before we make our mind up.
Price inflation without wage inflation reduces demand
If prices increase by more than wages then demand in the economy will inevitably decline, potentially causing a recession. I can’t put it better than Danny Blanchflower and colleagues in a letter in the FT today, 31st August:
“Households that cannot pay for energy, food, rent or mortgages will stop spending on everything else.”
Quite. Rishi’s plan to deal with inflation would appear to be one that would inevitably lead to recession. Maybe Channel 4 should have put this to Raab.
Furthermore, Sunak argues against Truss’s tax cuts on the grounds that they’d increase demand and have the (secondary) effect of increasing inflation. Highly doubtful when inflation is already destroying demand, I suggest. Why Sunak is being touted as “the safe pair of hands” is beyond me.
To prevent the economy going into reverse one step that could be taken (as I’ve already argued) would be to ensure wages, benefits and pensions rise in line with inflation. This wouldn’t solve everything, but would keep the economy moving.
The current government appears to expect workers to accept below-inflation pay-rises, whereas they could be saying that pay-rises should match inflation, but not exceed it significantly because that would risk creating a wage-price spiral.
I presume part of the reason for the policy – if that’s what it is – is that the Tories see trade union militancy as a plus for them, as in the 1978-9 Winter of Discontent. I humbly suggest that it depends who is in government. As I recollect, Heath didn’t come out too well after the Three-Day Week in 1974.
Policy recommendation: Government should ensure pay rises match inflation, especially for the low-paid. Benefits and pensions should also be uprated to account for inflation.
Headline inflation has already happened!
The way inflation statistics work introduces lags. When it is said that CPI is 10.1% that is actually for the year just passed, in fact the year to 31st July 2022. So when inflation is rising any pay increase is eroded over the year until the next increase, such that monthly income may no longer cover monthly outgoings at the end of the period.
Let’s look at an example. The National Living Wage (NLW) increased by 6.6% from April 2022, taking into account the inflation rate in September 2021. In fact this was a more than usually generous real increase in the NLW, because the government is trying to raise it to two-thirds of median wages, against a previous benchmark of 60%.
However, by April 2023 inflation may well be significantly higher than 6.6%, so those on the NLW will actually have experienced several months of lower real income than a year earlier.
Universal Credit and other benefits also increase each April based on inflation the previous September.
There’s no reason apart from custom for these delays. If we wanted to we could uprate benefits and wages on (say) a monthly basis. We have the technology. Prices on Amazon change far more ferquently!
Policy recommendation: The NLW and all benefits should be uprated more frequently when inflation is high. An emergency increase on 1st October 2022 (6 months since the last increase) should be implemented.
Inflation is cumulative
What do I mean by this? I’m making the simple point that inflation in, say, 2023 is on top of inflation in 2022. An inadequate increase in pay in 2022 would mean an above-inflation pay rise is necessary in 2023 to restore living standards. Below inflation pay-rises create a backlog (and erode any savings or create debts).
Squeezing real wages just because inflation is high leads to greater pay pressure in subsequent years.
At some point living standards will recover. Delaying just causes suffering.
Furthermore, one-off payments do not compensate for inflation.
Policy recommendation: Pressure on living standards caused by inflation should be addressed as soon as possible.
Inflation is contagious
Inflation spreads from one part of the economy to others. High energy prices, for example, will cause price rises in many other sectors.
Inflation is persistent
Because of time-lags and because inflation is cumulative, and contagious, inflation is persistent. Even if energy prices were to come down, some inflationary pressures would persist. Wage demands would continue in order to restore living standards, pay rises are in any case retrospective so inflation in 2022 for example, can create cost pressures for employers in 2023 and many price rises will not be reversed.
I repeat: one-off payments cannot compensate for permanent increases in living costs!
Inflation isn’t the same for everyone
Some people and businesses are affected more by price rises in a given commodity, for example, energy.
Policy recommendation: If possible, government should aim to tackle the root cause of inflation. At the present time that is energy prices.
Inflation reduces debts!
It turns out that the UK has about £500bn of index-linked debt. The coupon payments on this debt increase with inflation. But the real value of the debt declines with inflation, so the effect is neutral. Problems only arise if the interest payments are unaffordable. This shouldn’t be a problem for government which can take on more borrowing.
Strangely, student loan interest rates in the UK have been capped at less than the expected inflation rate. Even students paying off nothing on their loan will have less debt in real terms because of inflation! Graduates should be dancing in the streets!
Policy recommendation: Don’t obsess about nominal amounts of outgoings. Adjust everything for inflation.
Inflation affects currencies and interest rates
It always baffles me when higher than expected inflation figures are announced and the value of the currency (sterling, say) rises.
Inflation devalues a currency and it should fall in response to higher than expected inflation. The reason it doesn’t is because currency traders think high inflation will lead to higher interest rates.
This is the area where inflation causes huge problems.
If inflation is caused by an over-heating economy – a tight labour-market, say – then reducing activity by raising interest rates is a logical response.
Another reason to raise interest rates might be to protect the currency in order to avoid importing further inflation. The UK could be forced to raise interest rates simply because other countries, notably the US and EU, are doing so.
It’s striking how rarely cash savers are mentioned these days. With very low real interest rates savings are being rapidly eroded.
But raising interest rates is itself inflationary because it implies increased loan repayments, especially on mortgages.
Policy recommendation: Although there is little political pressure to raise interest rates, government should act to avoid highly negative real rates. Doing this by raising rates risks worsening inflation, reducing demand in the economy and exacerbating recession.
It is curious that there is a potential trade-off between national debt and inflation. Subsidising energy prices by government borrowing (or by guaranteeing borrowing by energy suppliers in order to spread the energy price spike out over a decade or two) would increase the national debt but reduce inflationary pressures. With the UK’s over-priced housing market making its economy highly exposed to an interest rate shock, it would seem essential that government borrowing take on some of the heavy lifting.
I’m conscious that nearly everything I’ve suggested is highly unconventional, but perhaps it’s time to challenge the conventional approach of tackling inflation – or at least that part of it caused by an external supply-side shock – by lowering living-standards and risking deep recession.