Curbing inflation will not solve the cost of living crisis

Andrew Bailey, governor of the Bank of England - Hollie Adams/Bloomberg
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One of the first casualties of war is the truth. This holds not only for real shooting wars but also for such things as “the war against inflation”, currently underway.

Yet the people who are suffering during this particular war need to hear the unvarnished truth.

According to the Chancellor and umpteen Conservative spokespeople, we must stick with the policy of driving down inflation because inflation is the greatest threat to living standards.

The implication seems to be that once inflation is down to the 2pc target, then living standards can start to rise again.

This is complete bunkum. The rate of inflation is the rate at which consumer prices are rising. When inflation is down to the target, prices will still be rising, just at a slower rate than before.

This means that any fixed money amount, whether it be a bank deposit or a salary, will be falling in real value.

Of course, wages and salaries generally rise over time. But the underlying assumption seems to be that as price inflation is brought down, the rate of increase of wages and salaries remains the same.

Yet the very thing that shouts out loud and clear that we have an underlying inflation problem is the currently elevated rate of increase of wages and salaries.

With productivity growth so pitiful, the rate of increase of wages and salaries has to be no more than about 3pc to get inflation sustainably at 2pc, compared with the current 6pc plus.

In other words, it needs to fall back considerably.

As price inflation falls, there is no guarantee that people will become better off on average. That will only happen once price inflation has fallen below the rate of increase of earnings.

When, and to what extent, that happens isn’t really about inflation as such. In the short term, there is scope for this to happen simply as the result of falls in the international price of energy and commodities.

But over time the scope for it to happen – and therefore for living standards to rise – is determined principally by the rate of increase of productivity.

So why is it important to get inflation down?

Inflation is a wasteful process that distorts relativities and it tends to be associated with higher interest rates and bond yields, which inhibit investment.

Inflation also redistributes income and wealth in an unfair way and leads to instability which undermines confidence. So reducing it is the right thing to do.

But don’t deceive yourself into thinking that returning inflation to 2pc will itself solve the cost of living crisis.

People often complain that using higher interest rates to suppress inflation is a blunt weapon. They are right. But it is about the only weapon we have, apart from operating a tighter fiscal policy.

Compared to the stance adopted under the brief Truss/Kwarteng regime, we are operating a tighter fiscal policy. But it would be unpalatable to have fiscal policy even tighter, would it not?

Believe it or not, even if the Truss/Kwarteng policy settings would have been better for the economy in the long run, interest rates would now need to be even higher had the plans been persevered with.

People also complain that higher interest rates will impose pain on those with mortgages. Again they are right. But this is a vital part of how the policy is supposed to work. The labour market is currently very tight. It needs to be made looser, i.e. unemployment must rise. That means someone’s spending needs to be curtailed.

Doing this through higher interest rates hits unequally across society. Those people with savings are actually made better off by this policy as interest rates on their savings increase, albeit usually not by as much as mortgage rates rise.

Consequently, banks, and therefore their shareholders, are also made somewhat better off by this policy. But we can usually assume that neither savers nor banks and their shareholders will increase their spending to the extent that hard-hit mortgage borrowers will reduce theirs.

You could justify this imbalance by reference to the fact that for years borrowers have benefited from ultra-low interest rates while savers have been clobbered by having to accept rates on their deposits not much above zero.

Last week was a bad one for the Bank of England.

Not only did the rate of increase of average earnings pick up, but the Governor, Andrew Bailey, gave an unimpressive performance when appearing before the House of Lords Economic Affairs Committee.

He said that there were lessons to be learned from the Bank’s failure to contain inflation, without being clear about precisely what these were.

One of the Bank’s errors has been to place too much store by the forecasts spewed out by its forecasting model. Frankly, it would have done better to have consulted the late Mystic Meg or Old Moore’s Almanac.

Relatedly, it needs to have top class people on the Monetary Policy Committee (MPC), of clear and independent mind and diverse opinions.

Last week the Treasury Committee of the House of Commons interviewed the latest appointee to the MPC, the American economist, Megan Greene.

She gave a lacklustre performance that left us unclear where she stood on the major issues of monetary policy.

And so to this week. The MPC pronounces again on Thursday. It is widely expected that it will increase rates by 0.25pc. Personally, I would increase them by 0.5pc to 5pc.

Of course, this would inflict pain. But that is exactly what the policy needs to do. If it isn’t hurting then it isn’t working.

Isn’t there a danger of overkill? There is, and when an individual or institution has made repeated errors in one direction, there is a particular risk that they will make errors in the opposite direction.

Yet, bearing in mind the MPC’s recent record, I am more worried about the danger of underkill.

Roger Bootle is senior independent adviser to Capital Economics

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