Inflation is likely to rise again, but governments are reaching for the wrong solution.
When policymakers see inflation, they instinctively raise interest rates and try to slow the economy. But that only works if inflation is caused by excessive demand.
Right now it is not.
The inflation risk facing the UK comes from supply shocks driven by war, energy disruption and broken supply chains. Higher interest rates cannot produce more oil, reopen trade routes or repair supply chains.
What they can do is damage the rest of the economy.
In this short video, I explain why governments repeatedly make this mistake and what their real job should be during a crisis: protecting people, preventing profiteering and stabilising the economy while the shock passes.
This is the transcript:
In the face of crises, governments keep making mistakes, and that's profoundly annoying.
At the moment, we face a risk of inflation, and when inflation rises, governments nearly always reach for the same solutions. They raise interest rates. They say the economy must slow down. They say spending must be reduced, but that only makes sense if inflation is being caused by too much demand, and that is not the case at present at all.
Right now, the risks we're facing within the economy are coming from supply shocks. They're the result of war, energy disruptions and broken supply chains.
Raising interest rates does nothing to fix any of those things. High interest rates do not produce more oil. They do not reopen trade routes, and they do not repair supply chains.
What they do instead is damage the rest of the economy. Businesses will delay investment. Households will cut their spending. Mortgage costs will rise. And a temporary shock will turn into a recession if the government increases interest rates.
We have seen this mistake time and time again in the past. Instead of stabilising the economy, policymakers panic.
But the real job of a government during a crisis is different; their job is to protect people, to prevent profiteering, and to keep the economy stable while the shock passes.
If governments use the wrong tools, they do not solve the crisis. They make it worse, and that is what we're heading for.
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They have just one tool, so they hammer away with interest rates on any projecting cost spike on the assumption that it is a nail that can be driven home, when they might more profitably give it a twist with a screwdriver, or file it down, or saw it off.
If only there were other economic tools in the box.
Unimaginable that we might try fiscal policy (e.g. windfall taxes). Public spending (e.g. subsidies). Regulatory rules (e.g. rationing).
Agreed
I suppose that if the BoE raises rates in the short term in response to energy price increases, logic would indicate it will increase rates again later in the year when predicted food price increases start to happen, also as a result of external factors like fertiliser cost increases. So I guess it could be a pretty miserable year.
But our main focus must continue to be that this war is wrong, unlawful and a shocking crime against humanity. Responsibility is shared between the US, Israeli and Iranian regimes, and countries like ours who have failed to call it out.
When it is an external price shock raising interest rates will increase production costs further and likely worsen inflation in the short term.
Then, when the external pressure recedes, dampened demand may cause inflation to undershoot the target.
All it does is amplify the volatility, when the target should be to moderate it.
I suspect the (unspoken) idea is to deter the wage labouring class from bargaining for inflation-matching wages, and protect the asset-owning class. The economic damage is a price worth paying.
I fear that you are right
Completely agreed with you @Richard Interest rates and inflation controls are largely irrelevant in the current global context — from a microeconomic perspective. When we look at the world on a broader scale, through the lens of the global economy — with war, massive debts, systemic disruption, and rising unemployment — a mass debt write-off may be necessary to clear the books of governments. Yes, inflation will inevitably rise as a result, but artificially constraining the economy with interest rate policies now has little logic or benefit, as any effect will vanish once those debts are written off. Continuing to rely solely on interest rate hikes erodes public confidence in the economy and worsens unemployment, which further destabilizes society.
Historical precedents:
• Ancient Near Eastern debt jubilees — rulers cancelled debts to stabilize society.
• Post-World War II Germany — the London Debt Agreement of 1953 wrote off large portions of Germany’s post-war debt, enabling rapid economic recovery despite short-term inflation.
Restoring normality:
• Reinstating the world back to normal would solve inflation, but that is not in the hands of ordinary people.
• There should be strict policies against countries at war that disturb the normality of life.
• Interest rates are not a tool to control inflation — they are one-sided measures that do nothing to address the real causes.
Microeconomic dimensions of inflation:
• Inflation is also driven by practical supply-and-demand factors. For example, if egg and milk prices rise in supermarkets, the solution is to support local farmers to increase supply, rather than increasing taxes, which would raise their costs and push prices higher.
• How central banks handle interest rates also affects GDP growth. For instance, the European Central Bank (ECB) maintains lower interest rates than the UK, yet the Eurozone achieves higher GDP growth, showing that GDP growth is a critical factor in economic stability and inflation control.
Conclusion:
Interest rates alone cannot solve inflation, especially when the causes are systemic — wars, disrupted supply chains, massive debts, and rising unemployment. Continued reliance on interest rate policies erodes public confidence in the economy. So in summary a sustainable approach is needed that is policies . I am not sure why policy makers not realising it .
You are somewhat misrepresenting what I said and I do not agree that we are in a position where Jubilee’s are necessary to write off government debt. In fact, this would be economically disastrous government so-called debt has a positive role in the savings structure of most societies.
Important points. Could I ask you:
Would it be better to focus on the GDP deflator (average price of goods produced in the UK) rather than CPI, which includes prices of imports like oil?
What would you say to the argument that higher inflation bakes expectations into the economy and influences future producer pricing plans and wage claims?
I quite often use the GDP deflator when looking at long-term issues. All such measures do, however, have their own flaws
What would you say to the argument that higher inflation bakes expectations into the economy and is self-perpetuating because it influences future producer pricing plans and wage claims?