Events this week have bolstered my view that high inflation won’t disappear on its own.
Yesterday’s half-point rise in interest rates from 4.50% to 5% shows that the Bank of England is realising this.
Even so, I suspect the Bank of England will have to generate a recession to break the back of inflation.
We all know the problem. At 8.7% in May, consumer price inflation is still way too high. It has fallen from 11.1% last October. But it is still more than four times the Bank of England’s 2.0% inflation target.
Moreover, it is higher than inflation in all other Western European countries and is more than twice the 4% rate in the US. This is one league table you don’t want to top.
The cause is the imbalance between demand and supply, particularly with regards to workers.
It’s not that businesses are demanding unprecedented numbers of workers. The number of people with a job now is the same as before the pandemic. Instead, the number of people available to work has declined.
This is mostly because more people are saying they are too sick to work. The result is that businesses are struggling to fill their job vacancies. So in order to retain existing workers and attract new ones, they have raised wages faster.
And in turn, in order to maintain their profits, they have raised their selling prices faster.
In response to having to pay higher prices in the shops, employees have demanded higher wages, and the cycle continues.
This isn’t a wage-price spiral on the same scale as the 1970s, when at one point wages were rising by 35% a year and consumer prices were increasing by 25% a year. But it is clear that faster wage growth is feeding into inflation.
There are two possible solutions. The first and painless option is to increase supply.
This could involve more inward migration, particularly of workers with skills matching the vacant jobs, or by enticing those not working back into work.The Government is trying to pull these levers, but progress will be slow.
It’s no coincidence that a record number of people are saying they are too sick to work when NHS waiting lists are so high. Reducing the NHS backlog may take years.
The second option is to reduce demand. That’s what higher interest rates do. It’s the quicker option and an easier one to control, but it is also more painful.
The Bank of England needs to raise borrowing costs far enough to convince households to spend less and to persuade businesses to employ fewer people. That would reduce the upward pressure on wages and selling prices.
Most forecasters have been hoping that a bit more supply and a bit less demand would do the job.
That’s why they have been expecting the favourable dual outcome of the economy avoiding a recession and inflation eventually falling back to the Bank of England’s 2.0% target.
That sounds too good to be true to me. I doubt the inflation problem will go away without a recession. Without the economic pain, nothing changes.
Unfortunately, this pain won’t be shared equally. Higher interest rates hurt borrowers (particularly those whose fixed-rate mortgage deals are coming to an end) and reward savers.
And the pain will be particularly acute for anyone unlucky enough to lose their job. But the alternative of inflation being consistently well above the 2% target is not painless either.
In fact, I would argue that would be a worse outcome as it would mean that over time an increasing share of everyone’s incomes would be absorbed by higher prices.
The big question is whether the Bank of England has the mettle to deliver this economic pain?
The half-point rise in interest rates from 4.50% to 5.00% yesterday is an encouraging sign
But to get on top of inflation, I suspect the Bank will have to raise interest rates a bit further and keep them high until the economy buckles.
