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Crisis begins

The apparently good news this week is that the rate of inflation has fallen sharply enough for the politicians to attempt to take credit.  But that one was even too rich for the establishment media to swallow… BBC economics correspondent Andy Verity, for example, asking:

“Can government claim credit for fall in inflation?

“When inflation started to accelerate early in 2022, Rishi Sunak as chancellor attributed the rise to global factors. Now as prime minister, he’s claiming it as a success for government policy that it’s come down.

“However, leading economists are sceptical that the halving of inflation compared to last year has much to do with any government plan – or indeed is something within the government’s power.”

Unfortunately, the article then goes on to promote the neoliberal myth that only the Bank of England can tackle inflation – conveniently forgetting that prior to 1997, government set both fiscal and monetary policy.  In any case, there were things that the government could have done, but chose not to, to help lower the rate of inflation.  The government might, for example, have imposed a public sector pay freeze on employees earning more than the median wage (unpopular, but less damaging than hiking interest rates) it could have increased the VAT on luxury goods and services, and it might have refrained from spending an inflationary £36bn last winter bailing out the energy companies (via £400 credits to every UK household’s energy bills).

This latter policy decision gives the lie to the October inflation data because it is only by counting that £36bn as household spending rather than as a direct bung to the energy companies, that the headline inflation rate dropped at all.  To understand this, we have to dig beneath the headline figure in the ONS release.  If the rate of inflation was genuinely falling, we would expect to find a uniform slowing of price rises across the economy.  Instead, the data shows a significant fall in just one sector of the economy – housing and household services.  And if we drill down further into this, we find that it was just one component of that sector which fell dramatically:

This was one reason why nobody outside Versailles-on-Thames gave much weight to the government pledge to halve inflation – once last winter’s energy spike receded, the fall in the price of electricity and gas would do the government and Bank of England’s jobs for them… at least on paper.  And that is bad news for two reasons.  The first, and most obvious, is that because of the government’s £36bn bailout of the energy companies last winter, what we actually spent on energy was a lot less than the figures – which are based on the energy price cap – imply.  And that means that consumers will spend more on energy this winter than they did last – that is, October’s fall in inflation will be experienced as a rise in prices by Britain’s businesses and households.

There is a bigger concern here, however.  We get a glimpse of this when we strip out the housing sector (which contains that energy price fall) from the data.  Instead of the steep fall suggested by the headline figure, we see a more modest decline.  And, notably, much of the decline is in discretionary sectors:

The temptation would be to congratulate the Bank of England on a job well done… soft landing ahead!  And a cursory examination of the housing cost sector without that drop in energy prices might suggest that the interest rate policy is working:

What appears to be happening is that rising interest rates have forced households to switch their spending away from discretionary sectors to meet their rising housing costs.  The problem with this explanation though, is that the majority of mortgages affected by the Bank of England’s rate rises are still on fixed rate deals taken out when the interest rate was just 0.1 percent.  More than a million of those deals will come to an end in the first half of 2024.  And the devastating conclusion we have to draw from that is that the rising housing costs showing up in the data so far are but the tip of a big ugly iceberg which the economy has yet to crash into.

Put simply, the mortgages which have been rolled-over so far, were taken out prior to the SARS-CoV-2 world tour, and so were at interest rates of two-to-three percent – making the jump to five or six percent easier to manage.  Although, that said, the latest quarterly report from Finance UK shows a continuing increase in the number of households falling behind on their mortgage payments:

“There were 87,930 homeowner mortgages in arrears of 2.5 per cent or more of the outstanding balance in the third quarter of 2023, 7 per cent greater than in the previous quarter.  Within the total, there were 34,110 homeowner mortgages in the lightest arrears band (representing between 2.5 and 5 per cent of the outstanding balance). This was 10 per cent greater than in the previous quarter.”

These are a fraction of the level seen in 2008, and there is no sign yet of the negative equity which economists and politicians rightly fear.  But, given that around a million households are about to see their monthly mortgage payments rise by anything from 50-to-100 percent in a single jump over the next few months, the numbers falling into arrears, along with the housing component of the inflation figure are guaranteed to spike upward through 2024.  And that may just be the beginning of Britain’s woes.

The problem with analysing the UK economy over the past two years has, in large part, been with conventional economics’ misunderstanding of inflation.  This is mostly to do with the abandoning of the distinction between monetary inflation and other causes of price increases (such as the post-2021 supply shocks).  In effect, the economists, central bankers, and politicians leaped to the (wrong) conclusion that we were witnessing a re-run of the early-1970s and reached for the (equally erroneous) cure of higher interest rates.  The (again wrong) belief being that only by causing a recession, increasing unemployment, and thus lowering demand across the economy, could we avoid the dreaded “wage-price spiral.”

Those of us who had warned at the start of 2020, that locking down the economy was bound to create a supply shock which would result in higher prices, might have been vindicated in our view that the price increases would be self-limiting, had it not been for the reckless behaviour of government during the lockdowns.  While the common sense assumption is that a loss of supply of something essential like microchips or fossil fuels must be inflationary, the opposite is true – at least, so long as governments do not create additional currency at the same time.  That is, if the price of fuel rises but household incomes and business sales stay flat, then discretionary spending must fall as businesses and households adjust to the higher cost of fuel.  In time – perhaps two or three years – the ensuing decline in the discretionary sectors of the economy will lead to a fall in demand for fuel, which will result in the price falling back.

The complicating factor in 2020 and 2021 is that then Chancellor Rishi Sunak went on a spending spree, pumping new currency into favoured Tory-linked businesses, paying workers to stay at home watching Netflix, and placating voters by buying them dinner via the “eat out and spread the virus about” scheme.  Along with the later spending such as the bung to the energy companies, this amounted to an inflationary influx of currency into an economy which lacked the spare productive capacity to absorb it.  To add to the problem, governments around the world were using similar policies with little thought about their inflationary consequences, so that the problem is global.

The difficulty from the autumn of 2021, was that prices were being impacted by two very different forces.  Most obviously – and in line with the official narrative – we were being hit with a massive inflationary spending boom, as the pent-up savings during lockdown could finally be spent.  This was classic monetary inflation – government had borrowed into existence far too much new currency for the productive base to absorb.  And so, prices were bound to rise.

At the same time though, we were being hit by a deflationary supply shock caused by shortages of key resources such as fossil fuels and key minerals, along with broken supply chains creating bottlenecks in the global transport system which persist to this day.  These were precisely the kind of price increases referred to in the old saying that “the cure for high prices is high prices.”  And, crucially, the central bankers were correct to see them as “temporary” – albeit that temporary meant several years rather than a couple of months.  Deflation was fighting inflation… but in the short-term, inflation won… next it is deflation’s turn.

Which brings us to the latest retail sales data.  Following last month’s decline in sales values, there was a slight increase (1.1%) solely due to an increase in fuel prices, without which, sales were flat:

This appears to be confirmation that the additional currency created during lockdown has now made its way out of the economy, together with the short-term credit which allowed people to continue purchasing despite inflation eating into the volume of goods and services they could consume.  That is, for two years we have been spending more to buy less, but only in the last couple of months we have switched to both buying less and spending less.  This seems to be borne out by the sharp decline in the M2 money supply from it’s post-lockdown peak a year ago:

What is concerning about this, is that it is further evidence that the Bank of England’s interest rate rises have yet to have their full impact on the UK economy.  That is, much of the fall in the stock and flow of currency through the economy is merely the government-created lockdown currency returning to the neoliberal circle of hell from whence it was spawned, with interest rate rises having an impact only on short-term credit, such as credit cards and car leasing (both of which have slowed since last year).  In short, the monetary inflation component of the post-lockdown period is – barring more reckless government spending – at an end.

Enter the Bank of England’s interest rate rises.  Perhaps the most telling aspect of the establishment media narrative is the belief and expectation that once inflation has fallen below three percent, interest rates will fall.  But why should they?  In a healthy economy, having interest rates slightly higher than inflation would be the norm.  And prior to the 2008 crash, an interest rate of 5.25% would have been considered entirely normal.  But there’s the rub… these are anything but normal times.  Which is why bond markets across the western states have been inverted since 2022, as financial institutions bet the house on central banks lowering interest rates sooner and faster than they claim they are going to.

What are the financial institutions seeing that the central bankers can’t?  Most likely, the negative consequences of raising interest rates into an economy in the throes of a deflationary supply-side crisis.  For we mere mortals, most of this is experienced as ever higher prices of essentials – which are only made worse by higher interest rates which force mortgage payments and rents to increase.  And as we have seen, the real shock to housing costs is only beginning.  More important than this though, is the impact on businesses.  Following the 2008 crash, there was a massive increase in the number of so-called “zombie businesses” – which can, just about, service their debts but have no means of repaying them.  Until now, banks have preferred to roll-over the debts rather than enter into costly legal recovery processes.  But with interest rates rising and bank lending standards tightening, hundreds of thousands of businesses may face bankruptcy as consumer spending continues to fall.  This, in turn, might trigger a similar round of bank failures to those seen in 2008.

The risk is that interest rates are now so high that instead of the preferred “soft landing,” the economy crashes through the floor, forcing the Bank of England to hack rates down to zero and implement yet another round of quantitative easing…  which might not be enough to save the economy this time around.

As you made it to the end…

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