Inflation is the increase in the price of goods and services in an economy. High inflation essentially means that people can buy less with their money. This can happen for a number of reasons: a run on a country’s currency that raises the prices of imported goods; a big stimulus to the economy when the system is already at full or near full capacity; a heavily unionized workforce exercising its bargaining power; a sudden labor shortage (after Brexit, for example) or international cost drivers outside of direct control of an individual country. The latter happened during the two oil crises of the 1970s, and it is happening again now. Central banks aim to keep inflation low and stable. When it is too high, they can take various measures, such as raising interest rates, reducing the money supply, raising taxes to curb spending, or implementing a price policy to keep at least some prices under control. The French, for example, have forced their energy companies to keep household electricity price increases 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 took off, has turned into cost-push inflation, determined not by wage growth but by the war in Ukraine, which has driven prices of energy and food rising. No central bank alone can do much about this, except to reduce growth and possibly cause a recession – or even a recession. To Go Deeper For a great historical perspective on inflation, read The Great Inflation and Its Aftermath: The Past and Future of American Affluence by Robert J Samuelson (Random House).
2. Why do interest rates matter?
Edward ChancellorEconomic historian and author of The Price of Time: The Real Story of Interest (Allen Lane) Most economists view the interest rate solely as a policy lever to be used to control inflation. So when inflation falls below the central bank’s target, which in most developed countries is set at 2%, interest rates fall and remain low. Low interest rates encourage individuals, companies and countries to borrow and spend, boosting economic growth. This has happened in the last decade. But when inflation rises above the target level, as it has in recent months, interest rates rise, providing an incentive to save, rather than spend or borrow. In theory, as demand for goods falls, so do prices, reducing 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 period of deflation – a sharp drop in the level of consumer prices – destroyed the US banking system. But among the unintended consequences of this monetary experiment was an increase in global debt, the proliferation of speculative bubbles, weak household savings and a lot of wasteful investment, accompanied by stagnant economic growth. Now interest rates are rising and people are discovering they are less wealthy than they thought they were. Companies and governments have to pay more to service their debts. Emerging markets that borrowed too much have started to default. German central banker Hjalmar Schacht got it right when he said in 1927: “Don’t give me a low interest rate. Give me a real percentage and then I’ll learn how to keep my house in order.” Going Deeper Sidney Homer and Richard Sylla’s History of Interest Rates is a classic account of lending practices over four millennia. Illustrated by Steven Gregor.
3. What is the role of the war in Ukraine?
Gillian TettUS Editor-in-Chief at the Financial Times and author of Anthro-Vision: How Anthropology Can Explain Business and Life (Cornerstone) Even before the war in Ukraine broke out, Western central banks and economic policymakers were between a rock and a hard place. Growth looked likely to slow, following a post-Covid recovery. But consumer prices were rising because of supply chain bottlenecks. The latter put pressure on central banks to raise interest rates, but the former suggested waiting. We are facing a phenomenon not seen for almost 50 years: stagnation or inflation in the midst of a recession, combined with The war in Ukraine has made the political dilemma much more unpleasant. On the one hand, it caused sharp increases in energy and other commodity prices, pushing inflation above 8% in America and 6% in Europe. This increased pressure on central banks to raise interest rates. At the same time, business and consumer confidence is collapsing in Western economies. In short, we are facing a phenomenon we have not seen for almost 50 years: stagnation or inflation in the midst of a recession, combined. Since the financial crisis in 2008, regulators have tried to shore up the financial system. But many financiers have tried to avoid the new controls by moving capital to less regulated, non-bank financing corners such as hedge funds, loan vehicles or so-called “private” markets, away from public platforms. This has made regulators look like plumbers 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 really drives the global financial system today, and all the semi-hidden financial flows that connect countries, read Adam Tooze’s Substack.
4. What can the Bank of England do to help?
Rupal Patel and Jack MeaningEconomists at the Bank of England and authors of Can’t We Just Print More Money? Economics in Ten Simple Questions (Cornerstone) 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 have a duty to keep price growth at 2% per year. We have a commission of rate regulators whose job it is to ensure that this happens and who are democratically accountable to parliament. In times when prices are rising too fast, meaning the money in people’s pockets is losing value too fast, the Bank’s role is to slow this process down and reduce inflation. To do this, it can raise interest rates and slow or reverse the rate of money creation (known as quantitative tightening). After all, this works to reduce the money people spend and then reduce price increases. The trick is to do this enough to get price growth (inflation) back to where we want it, but not so far that there is a risk of prices rising too slowly or falling. This is the tightrope on which the Bank’s rate-setters walk. The decision to cool the economy in this way is not without consequences. It can affect 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 in the long run, particularly for some of the most vulnerable in society. This is why the clearly defined, independent role of the Bank of England is so important. To go deeper The Economics in Ten podcast has some great episodes on the cost of living, but also central banks and famous economists from history. To understand the economic processes behind the cost of living crisis (and many other economics), check out Ha-Joon Chang’s book Economics: The User’s Guide.
5. What could / should the government do?
Mariana Mazzucato Professor at University College London and author of Mission Economy: A Moonshot Guide to Changing Capitalism (Allen Lane) The UK economy is plagued by lagging productivity, stagnant wages and low economic growth, which are now being exacerbated by the cost of living crisis. Energy prices and corporate profits, not wages, are driving current inflationary pressures: UK corporate profits have risen by 34% since the start of the Covid-19 pandemic, 90% of these increases coming from the top 25 multinationals. The government brought the ratio of private debt to disposable income back to what it was in the 2008 crisis To tackle both current inflation and longer-term problems, we need to restructure the UK’s over-financialized economy. By simply adding more loans to the system – Help to Buy, for example – the government has brought the ratio of private debt to disposable income back to where it was at the start of the financial crisis in 2008. The current business model is all about short-term profits, which means that many companies do not invest their profits back into the system, but export them through practices such as share buybacks, which boost stock prices and stock options for executives. To tackle inflation, the UK government has implemented an energy profits levy, a windfall tax of 25% on the profits of UK energy companies for the next 12 months. This is a step in the right direction, but it needs to go further. Government loans, grants and bailouts should only be made on the condition that profits are reinvested and that they encourage a green transition. Going Deeper Katharina Pistor’s Capital Code shows that so many of the dysfunctions of modern capitalism are rooted in corporate law and how intellectual property rights are governed. The Ezra Klein Show podcast navigates the world of economics and politics through a decisive, entertaining lens.
6. Will the crisis eventually reduce house prices?
Josh Ryan-Collins Associate Professor of Economics and Finance at UCL and author of Why Can’t You Afford a Home? (Political Press) The latest figures show that UK house prices are rising…
