The Bank of England meets on 19 March to decide on interest rates.
Many commentators now say rates cannot fall because war in the Middle East could push up oil and gas prices and increase inflation.
But that argument misunderstands what is actually causing inflation.
If prices are rising because of a global energy shock, raising interest rates will not reduce those prices. Instead, it will increase mortgage costs, reduce investment and push the UK economy closer to recession.
In this video, I explain why imported inflation from oil and gas prices requires a completely different response from the Bank of England.
Not all inflation is the same, and treating it as if it were is simply bad economics.
This is the audio version:
This is the transcript:
We need to talk about war, oil prices, and interest rates because they are all intimately related at this moment, and that is, of course, a matter of concern to me because I believe that interest rates are too high in this country.
The Bank of England next meets to discuss interest rates on the 19th of March. Many commentators were expecting that interest rates would fall on that day. Now the same people are saying that interest rates cannot fall. Why? Because of the war in the Middle East. They say, in the face of oil and gas prices rising, we must see maintained interest rates or even that interest rates must rise to challenge the inflation that they claim is bound to follow from those increases in oil and gas prices. But there is a serious problem with that argument, and I want to discuss why it's wrong.
People are being told that higher energy prices will mean higher inflation, and I'm not arguing with that. I suspect that that is true. We do already face a risk of an increase in inflation of 0.3% or so a year. It may be worse than that. Household energy prices could increase by £500 a year as a result of what has already happened in the Middle East, and it may get worse. Therefore, it is argued that interest rates must stay high or even rise again, and the Bank of England is already murmuring about the fact that this might be needed to control inflation, but that logic only works in very specific circumstances.
The key question to ask is this: what is causing inflation right now? Is it too much spending in the UK economy, or is it an external price shock? Because those are completely different problems that both give rise to inflation, but which require totally different policy responses.
The reality is that at present we are facing oil and gas prices that are set on global markets increasing as a consequence of war. They're rising because of geopolitical stress. The UK does not control those prices. This is the simple, straightforward statement of fact which has to be taken into account when deciding on interest rate policies.
Inflation in oil and gas prices is imported inflation. Nothing that happens in the UK has given rise to that inflation risk. In that case, we have to decide what interest rates are actually designed to do.
Interest rate increases are designed to reduce domestic demand within the economy. They do that by making borrowing more expensive. They discourage investment, and they reduce consumer spending. The consequence is that interest rate rises are intended to cool an overheating economy.
But we haven't got an overheating economy. What we've actually got is enforced additional non-discretionary spending on oil, gas, and electricity. People simply cannot avoid these costs. They have to heat their homes. They have to fuel their cars. Businesses cannot stop using energy, and energy demand is largely non-optional.
So, higher interest rates do not reduce energy prices. What higher interest rates actually do is increase mortgage payments and push up rents, discourage business investment, and reduce spending in the rest of the economy, while leaving the energy price shock entirely untouched.
Despite this, the Bank of England's defence for increasing interest rates is that they must stop what they call ‘The Second Round Effects'. They claim they worry about workers demanding higher wages, and pay rises chasing higher prices, and a wage-price spiral developing as a result, as a consequence of which inflation becomes embedded. But this assumes workers have significant bargaining power, and that assumption is deeply questionable. In reality, real wages have been weak for years. Trade union power is far lower than in the past, and many workers have little negotiating power at all. They're on contracts which deny them every chance to change their wage rate. Pay, as a result, has rarely kept in line with increasing prices already, so the wage-price spiral argument is totally exaggerated.
The real consequence if the bank raises interest rates because of oil prices is that households will become poorer. Mortgage holders will suffer higher costs. Businesses will impose delays in investment programmes, and that will reduce employment opportunities. Economic activity will slow as a consequence, and we will head for recession and all the while the price of oil will not change.
So what should we be recognising? When inflation is driven high by energy shocks, interest rates are the wrong instrument to use. They treat the symptoms but not the cause of this inflation. They shift the burden of risk onto households, and they risk pushing the economy towards recession. The real point we need to understand is something important: not all inflation is the same. Some inflation comes from overheating economies. In those cases, interest rate rises can, I stress, can work, although taxation would normally do the job better.
But some inflation of the sort we're now getting has come from external shocks, and this was also true, of course, in 2022. Using the same policy for both overheating economies and external shocks is simply bad economics.
So, when the Bank of England meets on the 19th of March, ask yourself, is the inflation being driven by war and global energy prices, which should therefore result in UK mortgage holders and businesses being asked to pay the price, even though they did not create this situation? Or should the Bank of England be leaving interest rates where they are, or even reducing them to compensate for the higher costs that households are already paying as a consequence of increased oil prices, with those reduced interest rate costs then rebalancing the economy in a way that guarantees stability?
That is the question the Bank of England should be asking.
That is not the question it will be asking.
It will only be asking about inflation, and it will only be asking about the question of whether or not to raise rates, because that's what they always do when they see an inflation risk, irrespective of the consequences.
And there's a final point to make. If the Bank of England really cannot work out that this inflation is something that they can't solve, they shouldn't be in their jobs.
That's my opinion. What do you think? There's a poll down below.
Poll
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What do I think? Lots of phone calls from banks to the BoE – oh please raise interest rates (I guess the same @ “catch-up” meetings BoE & the usual suspects).
Spot on.
At its heart this is a “Goodhart’s Law” problem. Inflation is an important indicator of what is happening in the economy – but when you make it a target things go wrong. Sure, raising rates WILL reduce inflation but it will do so by wrecking the economy; the BoE will claim success in hitting their inflation target…. the mess it creates in real lives being “not my problem”.
Now, the UK DOES have an inflation problem and has done so for decades but I suspect it is a “Rentier/monopolist problem” rather than anything else.
Much to agree with
Richard
You and I are both old enough to remember the oil crisis of the 1970’s.
The UK Government took a number of actions to reduce oil consumption, amongst other things there were limits on the maximum temperatures buildings could be heated to and cuts in the speed limit – the 60mph default national limit is a relic of that – it was previously 70
So what about the same again? I would suggest that there would be significant benefits to cutting the speed limit dual carriageways to 60 mph and to 50 mph on other roads. Perhaps a ban on the sale of new large engine and /or heavy cars. Possibly throw in a ban or restriction on the sale of some ‘high energy’ consumer products eg Patio Heaters, hot tubs and private swimming pools.
Agreed
…. but we live in a country where the providers of energy (and water) are incentivised to sell us more! Madness.
Take into public ownership and introduce “progressive pricing” – abolish Standing Charge and charge higher prices for usage above certain thresholds.
This highlights the need to extract our own energy from the North Sea. We are always at the mercy of an oil shock otherwise.
PLease don’be be an idiot. There is little left to extract. The evidence is we need to do much more om green energy
Not really true…
Industry groups (e.g., OEUK, Westwood Energy, Wood Mackenzie) argue for higher recoverable potential under supportive policies and enhanced recovery:
• Up to 7-7.5 billion boe could still be produced by 2050 (more than double some government forecasts).
• Some analyses suggest 14 billion barrels in existing fields via better recovery rates, or even higher (15+ billion boe) including unexplored areas.
• However, UK government policy (e.g., no new exploration licenses, focus on net zero) limits new developments, so actual extraction may stay closer to the lower official figures (potentially only decades of production at current rates of ~1 million boe/day or less).
And then it is panic stations when the price of oil. We are the architects of our own problems.
Have you heard of climate chnage?
Now, please go away and stop proving yourself to be a complete fool.
Perhaps more to the point, oil from the North Sea is an always has been sold to us at the global oil price by the companies that produce it. That’s how the system was designed.
Energy from the North Sea is not “our energy”. It’s extracted by the supra-national oil companies and sold at the international going rate. Extraction does nothing at all to ease UK energy prices.
I agree. More north sea wind farms are needed. It is a matter of national security and the owner of golf courses who live outside the UK and aren’t even a citizen should be ignored.
Andrew Bailey only has a hammer so he is always seeing nails.
Bailey, and the rest have no idea of what goes on in the real world. Whatever bonkers economic theory that they follow must be followed regardless of outcomes.
The UK government is too scared to use it powers over the Bank of England to stop an unnecessary rise in the base rate.
“We must not upset the markets”,
Result? Misery for the majority.
Well, here we go. The madness is starting.
From the BBC website this morning
“UK lenders have begun raising mortgage interest rates as the ongoing conflict in the Middle East has raised fears that inflation will rise and curb further Bank of England rate cuts.”
https://www.bbc.co.uk/news/articles/cly1jxdv439o
It really puzzles me that financial institutions fail to differentiate between the different causes of inflation.
Ref John Boxall’s post this morning.
I, too, remember the oil price crisis in the early 70’s. The speed limits imposed were 50mph on motorways and 60mph on other major roads (which seems a bit odd now). I recall travelling down the M1 from Sheffield to London with a single line of cars in the inside lane all travelling at 50mph. It was impressive. I wonder if the UK public would be so compliant now?
The then government also prepared for petrol rationing, the ration books were actually printed but apparently the conservation methods put in place made them unnecessary. Perhaps the current government should think about hauling them out of storage 🙂
The concept of rationing in a time of potential oil shortage seems to be more rational than allowing the oil companies to make the windfall profits which seem to be inevitable (looking at their behaviour in their initial response to the war in Ukraine) . After all, people accept that when water is in short supply we have hosepipe bans…
And, as has been mentioned, perhaps the government should take this opportunity to really emphasise the benefits of renewable energy generation in making us more independent of the adverse effects of geopolitics.
Thanks
As a non-economist I have been making this argument to anyone who will listen for years. It’s patently obvious that domestic interest rates will make absolutely no difference to externally induced inflation drivers and that increasing interest rates in a misguided attempt to influence the inflation will only result in compounding the problem by increasing further the costs borne by both households and businesses. That will also result in higher wage demands which push inflation even higher. Having received my education in what were once called new universities (Heriot Watt and Strathclyde) I often wonder what thought processes these Oxford PPE degrees are designed to deliver. It clearly isn’t logic.
The BoE can’t prevent the energy shock, it can only try to ensure that wage labourers, rather than the rentier class, take the hit.
I saw some major lenders putting up the rates on even their fixed rate mortgages the other day and it made feel me sick to my stomach. It is just so unfair and greedy. I am mortgage free but I feel for those still paying them down – I do not see the link between war and interest rates – it is a knee jerk reaction borrowed from a knee jerk BoE.
This sort of bollocks is meant to tell us that money – even fiat money – is scarce and that the same money used to fight wars or defend ourselves pays for our mortgages. Nothing could be further from the truth.
Autocratic Neo-liberal rentiers never let a good crisis go to waste.
The only way to fight this in my view is to do what Richard Douthwaite said back in the day – that it was about time the different interest rates were applied to money based on their use – risk, social utility, speculation and the like. Money that leads to real social useful assets should not be made as expensive as this.
Current interest rate management is rather like Sauron’s ring – it binds us all to penury.