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Slamming on the brakes

Image: Ed Webster

Taking a lead from the Federal Reserve Bank, the Bank of England has raised interest rates for the first time in a decade.  The move comes on the back of headline unemployment figures that are lower than the official definition of full-employment, together with an official inflation rate of 3 percent.

Conventional economic wisdom – i.e. the wisdom that caused the 2008 crash – holds that the best way to squeeze inflation out of an economy is to raise the cost of borrowing money.  This, economists assume, will cause firms to cease investing and consumers to cease buying.  The ensuing drop in the velocity of money will cause the inflation rate to fall.

Certainly, raising interest rates is likely to cause the inflation rate to fall… but not for the reason economists believe.  Interest rates do not simply affect the price of money; they determine its very existence.  This is because almost all of the money in circulation (aside from the notes and coins) is created out of thin air every time a bank makes a loan.  In order to maintain economic growth, the rate of debt (i.e. the creation of new money) must grow first.  Raising interest rates will either slow or reverse the creation of new money by deterring firms and households from taking on new debt; while simultaneously motivating them to pay off existing debt (i.e. destroy money).  When the rate of debt falls, the economy crashes.

Behind the official figures on employment and inflation used by the Bank of England are extremely worrying trends that may yet cause the interest rate decision to backfire spectacularly.  First, and most obviously, the headline figures are misleading.  They are made up by government agencies in a way that makes them look most flattering.  The definition of “employment” does not simply mean people that have a job, but also:

“… self-employed people, unpaid family workers and people on government-supported training and employment programmes.”

Moreover, those considered to have a job include the many millions of part-time and zero-hours workers who would dearly love to work more hours were they available.  This, in part, explains why despite the headline employment figures, wages are lower in real terms than they were in 2008.

How, then, is inflation increasing?

The Bank of England assumption is that “consumer confidence” has resulted in people using credit to spend.  There is, however, a far more worrying trend that may more properly reflect the experience of ordinary British people – we’ve been dipping into our savings.  As Chris Giles in the Financial Times reported at the end of June:

“UK households have responded to a tight squeeze on incomes from rising inflation, taxes and falling wages by saving less than at any time in at least 50 years.

“According to new figures from the Office for National Statistics, 1.7 per cent of income was left unspent in the first quarter of 2017, the lowest savings ratio since comparable records began in 1963.”

In fact, the ONS figures in June have since been revised upward.  Nevertheless, the revision only leaves us where we were in March, when the media was also reporting the savings ratio as a record low.

The added complication is that a large part of the inflation we have experienced since June 2016 is the result of the dramatic fall in the Pound following the EU referendum.  The result, according to Larry Elliott in the Guardian is that:

“The only recent parallel for such a prolonged squeeze occurred four decades ago, when a combination of a sterling crisis, pay restraint and public spending cuts agreed with the IMF resulted in real household income falling by around 6% between the fourth quarter of 1976 and the second quarter of 1977.”

It should come as no surprise then that economists were divided about the wisdom of hiking interest rates in the face of the underlying data.  Economic policy, after all, is often compared to lifting a brick with an elastic band – you pull and pull and nothing happens until, at a critical moment, the brick flies up and hits you square in the face.  Raising the rate by a quarter of one percent may not appear to do anything if British households and firms absorb the hit by drawing on the remainder of their savings and accessing whatever lines of credit are still available.  But further rises next year aimed at returning the rate to around 2 percent could provide the trigger for the next crash.

One reason for thinking so is that one of the key elements in the decline in productivity – the cost of energy – is beginning to rebound.  The oversupply of oil and gas that caused prices to fall dramatically in the second half of 2014 is being depleted faster than expected.  The result is that oil prices have risen outside of the “Goldilocks zone” of $40-$60 per barrel (below which oil companies go bust and above which economies crash into recession), as David Sheppard and Anjli Raval in the Financial Times report:

“An oil price recovery has been under way since June as crude demand finally starts to outpace supply, with Brent rallying by almost 40 per cent to $61 a barrel, as the global oil glut that had built up over the previous three years starts to draw down.”

Although slightly earlier than anticipated, this is in line with forecasts made by oil industry analyst Art Berman:

“Oil prices will be lower for longer—that is the conventional wisdom…

“That mantra made sense in 2015 and in the first half of 2016 as global inventories soared and supply outstripped demand. But data clearly shows that things have changed. The OPEC-NOPEC production cuts and increased demand for oil and refined products have resulted in a profound reduction of inventories. If those patterns continue, higher oil prices are likely in the first half of 2018.”

Oil, of course, is one of those “externalities” that economists like to pretend do not matter (about as sensible as a meteorologist pretending that clouds do not matter).  Nevertheless, in the real world ten out of the last eleven recessions were preceded by an increase in the price of oil.

When the price of oil fell in 2014, politicians regarded it as a net benefit; not just because of the fall in the cost of fuel, but because all of the goods made from or transported using oil would also fall in price.  To households, it would be similar to a tax cut; they would have more money to spend or save.   The situation proved more complicated – many firms (including the big energy companies) chose to keep the savings for themselves rather than pass them on.  And where consumers benefited, they as often used the saving to pay off existing debt rather than buy more goods and services.  But while the cut in oil prices was not as beneficial as expected, the increase is going to be a real problem.

In the wake of the EU referendum result, most retailers were able to absorb much of the inflation caused by the fall in the Pound.  Their ability to continue to do so came to an end earlier this year, with the result that households have been obliged to switch their spending toward food and essentials, while cutting their discretionary spending.  It is doubtful that retailers have the spare capacity to absorb oil price rises today, nor will households be able to manage the ensuing price increases.

While oil price rises will cause inflation in the short term, their impact on consumer spending will be the same as the impact of rising interest rates and increased taxes – households will be forced to cut back even further on discretionary (and not so discretionary) spending in order to pay for essentials:

“The greater danger is that a collapse in discretionary spending will infect our critical infrastructure.  The communications network, for example, depends upon all of the frivolous cat videos and drunken tweets being posted to social media to remain profitable.  The banking industry depends on new borrowing for consumer spending.  The transport network depends on sufficient non-essential travel.  The energy grid depends on marginal consumption.  As with shampoo, this risk is not that people will stop using these things entirely.  It is simply that, as with shampoo, if enough of us choose to make relatively small shifts in our patterns of consumption, the entire infrastructure can be rendered unprofitable.”

Far from being inflationary, rising oil prices, along with the fall in the value of the Pound, are ultimately deflationary – by limiting household spending, they will force unprofitable companies and industries into bankruptcy; rendering their workers unemployed, further undermining our disintegrating social contract.  Interest rate rises merely add to the deflationary clouds gathering on the economic horizon.  Only time will tell whether this one will be a step too far.

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