...a blog by Richard Flowers

Saturday, February 19, 2011

Day 3702: An Interest in Inflation


Featured on Liberal Democrat Voice

This week, we learned that the headline rate of inflation is 4% (with the rate including mortgage costs an even higher 5.1%) and we were warned that higher interest rates are on the way, pinching our purses even tighter.

For lots of people, particularly those on public sector pay freezes, this is VERY BAD NEWS. Inflation turns a pay FREEZE into a pay CUT: you get the same money, but it doesn't go as far. In fact, inflation does this even if you do have a pay rise.

So why risk the EXTRA pain of higher mortgage repayments now?

Well, for starters, interest rates are like exoplanets – you really want to find them in the GOLDILOCKS ZONE.

(No, that's NOT like Dr Woo's "Medusa Cascade"; it means not too hot and not too cold but just right.)

It's fairly obvious what the problems are if your interest rates are too HOT or rather too high: anyone with any borrowing – which is most businesses, on top of everyone one who bought a house using a mortgage – they get squished flat under the cost of repayments.

If all your money is going in interest repayments then you have no extra cash to put into savings or to employ new workers.

So, HIGH interest rates are HARMFUL to prospects for GROWTH.

BUT, there are problems if your interest rates are too LOW as well.

Although it is much cheaper for businesses to borrow, it's much harder to find anyone to borrow FROM, because almost no one wants to lend money when the rate they'll get back is so low.

Think about this as a SAVER: people who have money in the bank are seeing it LOSE value at the moment because the interest rate is LESS than the inflation rate.

If I had £100 today, I could buy £100 worth of sticky buns with it. But put it in the bank and in a year I might have £100 and 50p, but to buy the same number of sticky buns would cost me £104!

Or to put it another way: I could buy sticky buns today for £96.63; in a year's time those buns will cost £96.63 PLUS £96.63 x 4% inflation, which is £96.63 PLUS £3.87 or £100.50, which is what I get from putting my imaginary £100 in a bank.

So what we call the "REAL" value of putting £100 in the bank is that it LOSES £3.37 (or 3.37%) in value!

(Of course real savers can get better interest than the ½% base rate, but it makes the point.)

So for starters, very low interest rates discourage saving, which is a bad thing anyway. But more than that, they mean banks have no reason lend money out, even if there were any savers putting it in, which perpetuates the CREDIT CRUNCH.

So, LOW interest rates are actually HARMFUL to prospects for GROWTH too.

SAVERS want to make a PROFIT on their savings, so they need higher interest rates to encourage them to put their money into banks.

BANKS – and this is going to be unpopular – need to make a profit too. So THEY need higher interest rates both to tempt in savers AND to make money when they loan it out to businesses.

BUSINESSES need more lending, so that they can buy new machines or factories to grow their businesses and take on more workers who in turn will then have money to save.

Okay, but I'm sure you can spot the problem at once. You don't need to be a genius to work out that you DO need to be a genius to know WHERE the Goldilocks Zone IS.

A rise in interest rates will inevitably (and in fact AUTOMATICALLY) cause a rise in that measure of inflation that includes the cost of mortgages. (It's called the "RPI" if you want the technical language.)

Put up interest rates and you MIGHT stimulate growth – but you WILL stimulate inflation, which cuts into people's budgets and makes it harder for them to save or invest… which might REDUCE growth.

Worse still, an increase in the interest cost that businesses have to pay might stop them from expanding or, worst of all, mean they can't cover their other costs and put them out of business altogether!

(And you very well KNOW that just as SOON as interest rates start to go up Hard Labour will be putting on their sad puppy faces and saying how AWFUL it is that Coalition policies are making things WORSE for "hard pressed" families with mortgages and business with borrowings.

Which is a bit like someone who's just driven a TRUCK through the front of your HOUSE saying how AWFUL it is that the builders are going to have to knock down your garden wall to get it back out again.)

Sticky, isn't it. And not in a bun way.

So, you might very well ask, if low interest rates are so BAD, how come the Bank of England let them get this low in the first place?

Well, the Bank lowered interest rates during the recession in order to protect EXISTING BORROWERS. By reducing the amount that people and businesses had to spend on interest, the Bank gave them more to spend on other things, reducing the effect of higher prices and protecting jobs.

As I explained above, low interest rates DON'T help savers and they DON'T help NEW borrowers (because there's nothing for them to borrow). So it's hard to invest in new projects. But in a recession, the economy is shrinking and defending what you have is prioritised over starting new stuff.

You DO have to start investing in new stuff EVENTUALLY. (Real investment, I mean: people starting or growing businesses; not Hard Labour's idea of more public spending.) But WHEN you start investing is a whole 'nother sticky bun!

Anyway, when dead low interest rates didn't look like working, the Bank went one step further and started printing money, so-called Quantum of Easing, which meant that there was more actual money washing about in the economy.

The low interest rates contained the problem of the huge debts that Hard Labour had run up; printing money allowed them to go on spending like there was no tomorrow. And as it happened, for Mr Frown's government there WAS no tomorrow.

One way of looking at this is to say that the extra money soaked up the effects of inflation, allowing the economy to keep going through the downturn.

But the flip side is to suggest that the extra money actually CAUSED the inflation because it meant that prices COULD rise, stuff could cost MORE, even though there was LESS economic activity because of the recession.

Monetarists will tell you that if there is more money about and the same amount of stuff to buy, then the price of the stuff will go up to match the available money. If you believe that – and I'm not entirely sure that I do – then RAISING interest rates will REDUCE the amount of money in the economy and so reduce inflation.

What I do believe is that by printing money we have undermined the value of the POUND. Printing new pound notes does NOT magically create new VALUE out of nowhere. It takes the EXISTING value and just spreads it out a bit more thinly.

So, low interest rates means there is little return for FOREIGN investors to put their money into Great Britain, and printing money means that they think (correctly) that our pounds are now worth LESS than they used to be. So our pounds can buy less of their goods.

In other words, the pound goes DOWN and imports become MORE EXPENSIVE, which is INFLATION.

Raising the interest rates – and, possibly even more importantly, starting to reverse the Quantitative Easing – will strengthen the pound and ease the inflationary pressures of higher import costs.

I only say EASE, not ELIMINATE, because there are GENUINE reasons beyond the weakness of the currency that mean imports are getting more expensive. And will KEEP ON getting more expensive.

In fact, looking back I see that I already wrote a diary about this… back in 2007!

Yes, it is a bit SCARY to think that the economic crisis has been going on for MORE THAN THREE YEARS!

And those forces have not gone away. The pressures on food and energy resources will continue to grow as China and India and Brazil and all the others continue to expand their economies and populations.

In spite of this, it has been clear for quite a while – from signs like the weak pound and the rising inflation rate – that interest rates are definitely too LOW at the moment. A carefully planned and MODERATE increase (or rather a gentle series of cautious increases) might provide some comfort to savers and maybe, just maybe, do better than Project Merlin in convincing the banks to start lending again.


Anonymous said...

Of course, weakening the pound makes it easier for Britain to pay back its debt, and also increases exports.

If the government wants to do both of those things then they're doing the right thing...

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