Inflation embedded?

In our post of February 2021 it was pointed out that most economic commentators had apparently failed to recognise that the primary, if unspoken, purpose of so-called Quantitative Easing (QE) was to facilitate the artificial holding down of interest rates by allowing the monetary authorities to bid up the market price of financial assets to a very high level regardless of what it would be in the absence of such distortion. As a result the official Bank of England base rate has, from about 2010 until very recently, stood at 2 per cent or less – equal to the lowest rate ever recorded since the Bank was founded in 1694.

As noted in numerous earlier posts, this ultra-loose monetary policy has remained in force for most of the last decade, during most of which time the rate of inflation has stayed consistently quite low – even though such low interest rates would normally be expected to result in higher inflation. This anomaly has been explained as due to the deliberate channelling of the excess liquidity generated by QE into financial assets or markets, which did indeed rise considerably in value during the period, rather than higher prices of goods and services – although it is not clear whether or how this might have resulted from official policy.

Against this background the recent sharp rise in the inflation rate seems like a reversion to normal, though it leaves

unexplained the previous deviation from the norm. If it is really the case that it stemmed from an unusually strong vogue for investment in financial assets other than those yielding the very low fixed interest rates then prevailing – as well as equities – that would suggest investor sentiment is now turning bearish and that significant stock market falls are to be anticipated.

At the time of writing (August 2023) the British authorities, led by the supposedly independent Bank of England, seem committed to a policy combining higher interest rates – now raised to 5.25 per cent – with public sector pay restraint (see below) They are evidently alarmed, however, as well as mystified to find that prices are continuing to rise in spite of tighter monetary policy. Yet it is perhaps not hard to see that it could be the cumulative effect of excessive monetary expansion in recent years, particularly since the start of the Covid pandemic.

At that time, faced with the imminent prospect of a widespread collapse of economic activity, the government declared itself prepared to do “whatever it takes” to avert such an eventuality. Yet seemingly virtually noone reckoned on the impact that the massive public borrowing required to support this policy would have on the overall fiscal balance and thus on the rate of inflation.

It is not known whether any attempt was made at that time, by either the Treasury or the Bank of England, to estimate what the likely impact of such fiscal profligacy might be. In fact official data show that UK public debt rose by £112 billion in 2022 – to £2.516 trillion. At this level it is equal to around 100 per cent of Gross Domestic Product – more than double the ratio recorded in 2009.

What policy actions can be envisaged to remedy this evident disaster? The most obvious one would appear to be a reversal of QE (or “Quantitative Tightening”). However, since this would entail selling back to the market the debt built up by the central bank in the process of QE this would require raising interest rates to levels high enough to be attractive to market investors. The predictable problem now is that a) there is no telling how high these rates might need to rise before they might fall again and b) they would apply also to the stock of existing public sector debt, which is already seen to be at an unsustainable level.

Faced with this impasse the British authorities are attempting to put the burden of curbing inflation on those least responsible for creating it. This is reflected in the government’s steadfast refusal to entertain claims for public sector pay increases that compensate for past rises in inflation – precisely on the grounds that they would be inflationary. Unsurprisingly this has provoked a wave of highly disruptive industrial action in public transport, education and other public services.

It is hard to see a possible dénouement to this manifest crisis. The only conceivable ones that could be viable would involve massive increases in direct taxation, mainly on wealthy individuals and the corporate sector, which would be anathema to the ruling Conservative party, committed as it is to lowering taxes rather than increasing them, while the Labour party – as the presumptive alternative government – is clearly anxious to avoid provoking the overwhelmingly right-wing tabloid press by proposing any radical tax increases – particularly ahead of the imminent general election which they are desperate to win.

Although the above description relates to Britain, which perhaps represents a “worst-case” scenario among developed economies, it must be stressed that most, if not all, others are likely to confront similar difficulties in the near future. Ultimately this may prove to be a cause of significant civil unrest, particularly in countries other than Britain (given the latter’s tradition of rather slow reaction to social repression), which may in turn compel fundamental systemic change, given the lack of policy options compatible with the continued functioning of the “free” market.

It is, as always, impossible to foresee how the situation will unfold in response to such conflicting forces, other than to make the rather trite observation that “the status quo is not an option”. It needs to be clear, however, that any emerging alternative to the existing order will of necessity have to tend towards abandoning the idea that economic growth and prioritising of the profit motive should continue to be central to any viable model of economic organisation. In the light of past experience and bearing in mind the continuing power and inflexibility of the ruling vested interests it is impossible to be optimistic.