A more dramatic economy headlines follow yet another, with explosive (and probably incorrect) language such as “inflation predicted to explode to 21%!”. So it goes on… and on.

So, what is happening? And more importantly, what will happen?

The basic problem for policy makers is that unlike previous economic cycles, this one is artificial. Which is to say that there has not been a boom bust, or a spike in inflation caused by domestic (and therefore controllable) events… but a perfect storm of international global events that have come together to literally screw us all!

Let’s ignore the rest of the world for a minute and just look at the little old UK…

1. We have a great job market, pretty much full employment. This is good for the economy! GDP should rise. There is money sloshing around the economy, and the cost of the welfare state (which is a big economic drag) should come down, and so government borrowing falls.

2. We have a strong housing market. This is a good thing, because people feel wealthier when the price of housing rises. So, they spend money in the economy. I know it’s hard on the kids, but in economic terms that is different from a social problem.

However, these two big economic drivers are torpedoed by a couple of minor issues:

1. We have just had a huge economic global shock – COVID. But, in fairness, that was ok. Why? Because, the money supply globally increased. All the countries printed money to pay for it, and would continue to do so. If all was going well, the Government debt would be bought by the printing of money, and so the Public Sector Borrowing would fall. Usually, this is very inflationary and bad because the value of the currency would fall. However, in this case everyone did the same thing by about 15%. So, if everyone does it, nothing changes!

2. So, why is this a problem? AHHH, well… we had a spending bubble! Pent up frustration at being locked down with the same disposable income (in the main, not everywhere) meant that it became a bit of a boom. The problem was there was no supply of anything. Be it building materials, or pilots, or fuel. So, a lack of demand led to prices rising. And just as it was settling back…

3. A war! Economically, this is very bad news! We have a demand for raw materials, we have a demand for energy, and we have a demand for money. Added to that, we have uncertainty… So this is basically inflationary! Also, the USD becomes very strong on the foreign exchange markets, and energy is priced in USD, so the demand for USD goes higher still and the cost to the UK in £ just goes out of control.

So the UK, and Europe, have a big problem. The cost of living spike is imported…

It is 80% caused by the UDS$ strength. In December 2021, the exchange rate hit 1.40. Today, it hit 1.12. What that means, is the £1 bought $1.40 and now only $1.12, a fall of 20% from the highs. So, if there was no spike in the cost of energy (caused by the War) the basic cost would be 20% higher anyway – and that feeds into everything!

Normally, to combat a falling currency, the Bank of England would raise interest rates (making our currency attractive). But, this will not work… And I think it’s pretty obvious that it isn’t working.

Monetary Policy fails in this scenario, because everyone is in the same boat!

The BOE cannot raise Interest Rates enough to counteract the fundamental movement. So, what happens?

● Costs will continue to rise. Only government intervention can slow the pace, which in fairness, they are now realising and trying to do.
● Mortgages/rents are a huge part of the economy. Raising interest rates has the effect of increasing taxes… it takes money out of the economy. However, it also creates inflation, which is the exact opposite of what they are trying to do!
● Increasing interest rates also increases the Government borrowing as well as hitting GDP, which has the effect of weakening the £ on the FX markets.
● Increasing taxes reduces growth… and this has the effect of hurting GDP. Again, the exact opposite of what they are trying to do!
● As the cost of living increases (mortgages, etc), people (understandably) want higher wages. A 7-10% increase becomes the norm. This leads to rising wholesale prices, and an inflationary spiral!

So, raising interest rates is a folly. It is inflationary, it is bad news, and importantly won’t work.

What we need is growth. We need to improve the GDP, make the UK a place to invest, and that will improve the FX rate and bring down inflation.

The problem…?

We already have a load of Government Debt. We haven’t unravelled the COVID debt yet – no one has! We have started on the rising interest path, so we are already in the wage demand cycle, and we were too slow and too mediocre at facing up to the reality of the cost of energy.

So, whilst the current Government strategy is flawed (and far too late), in reality it is possibly the only path that might work. And that’s a scary thought!

But, what will happen is that the news headlines will have to stop talking about how bad it is, because people get bored and really don’t want to read that. In about 9 months, they will start talking about how it is getting better… and public confidence will grasp the nettle and things will be better. The interest rate curve will be better, and mortgage rates will start to fall back, and so we will start to turn that way…

So what works? Time works. Hunker down, keep hold of that cash, and have faith in the ability of the human spirit to get bored!