How do you solve a problem like inflation? (Part 1)
Historically, this is an easy problem to solve (or relatively at least). But for the UK economy, it is proving a stubborn pain the a*se!
The question’s are: What is different, and what can be done about it?
Firstly, let’s look at the basic tools:
Take disposable income out of the economy, on the basis that if there is less money = less demand = lower prices.
- Raise Interest rates = higher costs of borrowing = lower spending.
- Raise Taxes = less disposable income = lower spending.
- Reduce money supply (issue gov bonds) = takes money out of the system = higher cost.
- Reduce Government spending = less money in the system = lower spending.
To be honest, that’s pretty much it… Make it harder for people to spend!
Let time take the sting out of higher prices and prices stop rising so quickly. Crucially, this doesn’t mean prices fall!
So, why isn’t it working?
It’s the Billion £ question, and the answer is simple despite it being pretty obvious…
The UK economy got drunk on cheap money, and like any addict it kept on drinking until the problem became a big problem.
When the Banking/Financial Crisis of 2008 struck the global economy, a sensible solution was to flood the world with money. The way this was done was to cut interest rates and at the same time increase money supply by approximately 15%…(this was done by the Central Banks, BoE and the Fed for example, buying their own Govt bonds or gilts and effectively giving their respective Governments more money to spend).
Why is printing money a problem? Well, that’s a big question with many moving parts but a simple answer could be this:
- A countries economy has a perceived value, and there are many measures. But let’s say the UK economy is worth £1000. Let’s say that at that point, £1
could buy $2. So if we buy something from America, we know that £1 can buy $2 worth of stuff. - What happens if the UK Government prints another £500? The economy is still worth £1000, but now that 1000 is worth £1500… Magic! Yes? Umm, no… Because for every 1 unit of economic value (which in our example is worth $2) that is now worth £1.5… so £1.5 = $2. Or £1 is now worth $1.33.
- Clearly, printing money needs rapid economic growth, and in this case we did not have it! So 10 years on, instead of starting to take back that Quantitive Easing (as it was called), the economies of the world were still struggling to recover, and so it was mainly just left to roll.
In fact, some economies actually increased their money supply, like the UK for example.
For evidence of this, we can see the weakness of the £ on the FX markets. In July 2007, the Pound was worth 2.03 US$. In July 2018m 1.32 US$. And today, approx 1.25 US$… So the buying power of our dear old £ has reduced internationally over the last 15 years.
It is not tricky to figure out that if the £ is worth less, it costs more £ to buy all the stuff that the UK needs… And over the last 15 years, nothing has really been done about it except keep making the problem worse by keeping interest rates low and keeping money supply too loose.
So, why is inflation difficult to shift?
Because it has been a 7 year problem waiting to happen.
In the next blog, I will pick up a few more of the reasons and problems before hopefully suggesting a solution.
(Patrick Collier is former Head of Global Interest Rate Proprietary and Foreign Exchange Trading for a number of Leading City Banks)