Inflation, interest rates and the poorest

This morning I was interviewed on Premier Radio about today’s interest rate rises. I talked about those whose costs will rise – mortgage holders, renters and those who are already burdened by unavoidable debt accumulated over the lockdowns. I also talked about the rise’s effects on those who are already just keeping their heads above water.

All true and worth saying. However, what I didn’t do was tell the more difficult story about why we are increasing Central Bank interest rates, the uncomfortable assumptions that underpin the policy and the systematic disadvantage it places upon those with the least. Long term, that is the much more important story, so I thought I would begin to tell it here.

Why are interest rates rising to combat inflation?

The theory begins with a deceptively simple premise – inflation happens when the economy has too much money chasing too few goods. If you believe that is the problem, the solution is to increase the amount of goods (increase supply side) or decrease the amount of money.

Raising the interest rate decreases the amount of money available, by making less credit available to businesses and households and by making it more profitable for money to sit in banks rather than be invested elsewhere.

The aim of raising interest rates is to reduce consumer and business spending, reducing the demand for goods and services, and, so the theory goes, reducing inflation.

You may have spotted an issue – 2.5 million people are already destitute, and basic decency says their spending is already too low. 14.6 million already experience poverty, and asking them to consume less is plain cruel. Not to mention the millions who will be pushed towards poverty or destitution by the rising cost of living compounded by interest rate rises.

The response is often a “jam tomorrow” argument – emphasising that tackling inflation will help the poorest in the long run. The argument is not unreasonable, but in the short run children need feeding, houses need warming and growing up in poverty for any sustained period scars health, education, and future wellbeing. For children, ignoring the short run harms the long run [1].

I would also note that whilst there has been no shortage of policies affecting the poorest that hurt now to benefit later, poverty has increased, deepened and its consequences intensified over the past decade.  For some, despite the promises, “jam tomorrow” never comes.

Economists have understandable difficulty predicting what happens “in the long run”

“The only function of economic forecasting is to make astrology look respectable” – John Kenneth Galbraith.

The deceptively simple premise – inflation is caused by too much money chasing too few things – is applied to a staggeringly complicated world. Galbraith’s quotation was not a criticism of forecasters. Economic predictions are extraordinarily difficult, and any usable insight is a success. The criticism is of how the forecasts are used. The false air of certainty allows decision makers and politicians to confidently implement policies without needing to acknowledge the risks. He also noted that the risks of these policies tended to be borne by those without money or political clout – while the rewards were distributed in the other direction.

To know what effect raising interest rates has on inflation you must know two things – what would have happened if you hadn’t increased rates, and what did happen. In any single economy, it is not possible to know both these things – you must estimate one. That means any evaluation of the effect of raising interest rates is only as good as your ability to predict the path of inflation if you hadn’t raised interest rates.

Economists have a hard job and predicting inflation is very hard indeed.

Charles Goodhart, former Bank of England interest rate setter and Professor at LSE, began a recent presentation with the truth we have known for a while but dared not speak: “the world at the moment is in a really a rather extraordinary state because we have no general theory of inflation”.[2]

He explained that there were once two competing theories but evidence over decades has now shown their predictions to be unreliable.  A recent paper by the US Federal Reserve also highlights that there are several theories that underpin the modelling of inflation – and none reliably get it right. It specifically looks at and rejects the increasingly fashionable “expectations prediction” method, where we predict inflation by asking lots of forecasters using their favoured different methods what they think inflation will be in the future. You can guess the state of the field if that is viewed as a potential winner.

My point is not that forecasters are not good at their very difficult job. My point is Galbraith’s – that there is a false certainty which leads to policy choices that are all to willing to disregard the short term because we have confidence in the long term. The short term is where the poorest must live – only those with a cushion can afford to ignore the short term and wait for the long.

Where next in the long term?

In lots of ways the economy is not behaving as pre-2008 textbooks told us it would. The UK printed £900Bn over a decade without stoking inflation – basic economics textbooks still invoke the Weimar Republic and the inevitable and immediate disaster that would follow large scale printing of money. Large levels of sustained immigration happened in the UK with little or no downward effect on wages. [3] The once cast-iron relationship between low unemployment driving low rates of poverty and rising wages has been severed.[4] Economists are working hard to understand and explain this new reality – but if your knowledge is a pre-2008 textbook, you will have a lot to unlearn.

I would argue, as Kate Raworth and growing number of environmental and feminist economists have, that our basic assumptions about the nature of the economy is holding us back from addressing the most important economic challenges we are facing. Traditionally, the economy is viewed as a machine, with money and contracts flowing between different sectors obeying quasi-natural laws, with the key aim of delivering ever increasing consumption. It is in the ever-increasing consumption that human wellbeing is believed to lie.

The economy is better seen as network of relationships, some with contracts and money attached, but most without – where people’s wellbeing not linked to ever increasing consumption but instead the quality of relationships and the ability to meet needs. Importantly, we must include our relationships with the ecosystems we are embedded in.

A mechanical model offers simplicity – too much money and too few good and services leads to inflation. It also offers a comforting but stifling illusion of control – raise interest rates and inflation will fall. However, when this mechanical model hits the real world, with its complexity and its real humans, by design it encourages us to look away from the things we know to be important. Instead, the mechanical view of the economy simply offers it’s best guess at a long term path for more consumption and more capital. Those who have capital and consume lots will probably be pleased – those who don’t less so.

I cannot help but think that a Christian understanding of the economy should be focussed not on ever increasing consumption but nurturing relationships and ensuring that needs are met. In some times and places those aims will look the same but in many others they will not.

What next in the short term?

The US Federal Reserve Paper discussing interest rate policy contains the following sentence, “I leave aside the deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally oppressive, unsustainable, and unjust social order.” If economic logic tells us we must reduce everyone’s consumption, as the Bank of England has today, but not compensate those who are already consuming too little and face destitution it will become increasingly harder to leave that concern behind.

The Bank of England’s job is done, money is being directed out of the economy to hopefully slow inflation. The Government’s job must now begin. The counterpart policy must be one that directs money towards those who are already unable to consume enough and are going to be harmed by the interest rate rise. In the first instance that is families facing poverty and destitution and the most effective way to direct that money is by uprating benefits. I hope our potential Prime Ministers are listening.



[3] A few studies site some impact at the lower end of the wage scale – many don’t. At mid to higher wages the effect of immigration may have been to increase wages by making companies more profitable.

[4] These are statements so unsettling we try to cling onto previous beliefs – that it not true, or an exception or the consequence has merely been delayed.


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