Labour’s Inflationary Challenge: The Monetary Background

In the second instalment of a blog series on inflation, James Bartholomeusz suggests the impact of the Cost of Living crisis on monetary policy. 

Had you told a Daily Mail reader in advance of the 2019 general election that, within a year, the government would be paying people to eat out at restaurants, they probably would have thought the Corbynite dystopia had arrived. Middle England’s hard-earned taxes going to subsidise dinners for the metropolitan liberal elite? In fact, it was Rishi Sunak - Thatcherite and Brexiteer - who dreamt up this policy as a bailout for the hospitality sector after the first national Covid-19 lockdown.

We will likely look back on Eat Out to Help Out as the last decadent flourish before times got really tough. That isn’t even because total public debt (after 10 years of austerity) is now more than 100% of gross domestic product - which is another way of saying you would need the aggregate output of two British economies to pay back what the government now owes its creditors. The real reason is that the consumer price index (CPI) is now running at 7%, its highest rate since 1992. Inflation is back on the policy agenda for the first time in decades.

The Bank of England - formally independent of government since 1998 - is primarily responsible for maintaining UK monetary stability. During ‘normal’ times it has a fairly straightforward mechanism for doing so, by shifting the base rate which acts as a reference point for other interest rates on debt across the whole economy. If the economy is growing with risk of excessive price inflation, the Bank can raise interest rates to discourage borrowing and therefore spending. Conversely, if the economy is stagnant or shrinking, interest rates can be lowered to encourage more borrowing and spending and provide an economic stimulus. The Bank’s mandate is to target around 2% CPI inflation, a level thought to create the optimal conditions for sustainable growth.

The problem is that, since the 2008 financial crash, this mechanism has essentially broken. With successive Tory governments cutting spending and raising taxes to balance the budget, even maintaining rock-bottom interest rates was not enough to restart economic activity. Instead, like other central banks around the world, Threadneedle Street was driven to experiment with more radical policy tools. Through several rounds of ‘quantitative easing’, the Bank attempted to boost spending power by buying up privately held debt, effectively exchanging financial-market assets for newly ‘printed’ digital cash. During the first phase of the pandemic, this approach extended to directly absorbing the corporate debt of businesses struggling under lockdown. (One wonders what the original theorists of central bank independence would say, given that such institutional reforms were meant to reduce rather than increase state intervention.)

These trends are now sharply reversing. On top of the supply and demand distortions of Brexit and the pandemic, the war in Ukraine has sucked in two major exporters of essential goods, one of which is now encircled by Western sanctions. With supply constraints driving up inflation, and with much worse predicted for later in the year, the Bank has raised interest rates three times in the last six months. This round of monetary tightening will very likely continue: the squeeze on energy supplies will drag on, pushing inflation yet higher than the current 5% above the optimal CPI rate. Monetary policymakers will have to work ever harder to press down towards the 2% target.

After an extended period of flatlining prices, this is set to be a deeply unpleasant experience for households, businesses and public bodies alike. Net growth in the British economy has been virtually non-existent for a decade, but neither has the cost of living dramatically changed. Now the water is swiftly rising, but we find ourselves chained to the seabed. A great many people on low and middle incomes are facing the disastrous combination of extortionate energy bills, more expensive staple goods and higher interest payments on loans and mortgages. Indeed, it’s possible that even tighter monetary policy won’t be able to contain inflation, given that the primary driver of price increases isn’t a booming economy (if only!) but geopolitical instability beyond the control of any single government or central bank.

We can now start to see how the fiscal and monetary jigsaw pieces fit together. Inflation is a mixed blessing for the public finances. On the one hand, with the majority of gilts repayable at a fixed nominal value, a weaker pound helps erode away the debt burden on the government (If a debt I owe was worth £100 in real terms yesterday but only £90 today, I can be very thankful indeed). On the other hand, rising interest rates will increase the cost of future borrowing, as gilt prices shift with competition from alternative investments that are now more attractive. Coupled with falling tax revenues from lower growth and higher automatic payments (for example, because more households now qualify for universal credit) the fiscal situation can easily deteriorate if left unchecked.

There are a wide range of policy interventions available to mitigate the looming cost of living crisis. Unfortunately, and quite apart from the impact on public indebtedness, some of these interventions themselves pose an inflationary risk. Piling further demand on already scarce goods - for example, by buying and stockpiling fuel for future use - could actually make matters worse by driving prices yet higher. For this reason, Labour needs to think carefully and creatively about how it responds to the new economic landscape.

James Bartholomeusz is a Young Fabian and works in campaigns and policy at a global union federation. He writes here in a personal capacity.

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