In the last blog, we looked at how burgeoning money supply and a failure to deal with the embedded problems over time created an inflationary time bomb.

Basically, a weakened pound on the foreign exchanges led to imported inflation.

Why does raising interest rates not really work?

This a real problem. One of the main traditional weapons for bringing down inflation – raising interest rates – is not working today.

Why is that?

In simple terms, the UK economy differs from our European friends because the UK has always had a strong home/property ownership model, where in Europe most people actually rent.

The UK population is heavily influenced by house prices, and rising house prices makes the UK population feel better. Except those who are trying to buy a house, for example!

Many people believe that buy to let is a great thing and has been around for ages, but actually 25 years ago it was uncommon. People bought a house and lived in it. Councils rented out houses, not BTL investors.

Over the last 25 years, fuelled by low interest rates and interest-only BTL mortgages, we have seen an incredible rise in house prices. And guess what – this puts money into the economy and is inflationary.

What is interesting is that this house inflation has not actually filtered into the economy in the past. However, it is now, and in a big way!

As house prices rise, so in turn does the size of the mortgage…

That’s pretty obvious. With low interest rates, all is affordable and so is the growth of the BTL investor.

But, rising interest rates actually bring that subdued inflation roaring back into the economy…

As interest rates rise, so do the mortgage payments, and those percentage increases are on large amounts of money.

For example, in 2021 it was perfectly possible to borrow on a BTL interest-only mortgage at 1.5%, and equally for a residential owner again at 1.25%.

Rents were set in line with the mortgage rate, with a small positive cashflow movement.

For example, a £200,000 mortgage interest only would cost £250 PCM (add insurance, ground rent, service charges and a small profit), and the rent would be around £600 PCM.

Today, a 5-year fixed interest only mortgage would be 6%, so the mortgage cost alone is £1000 PCM (add the insurances, etc) and the rent has to be £1400 PCM… So a 133% increase.

It’s not hard to see that this is unsustainable as such BTL investors sell the flats and so there are fewer places to rent and as such rents rise further…

Embedded inflation plus a massive social housing problem and falling house prices… all of which creates a spiral that isn’t good on any level.

Mortgages suffer from the same issue, so a £200,000 mortgage in 2021 would have been around £750, and would now be £1300!

So renters suffer, BTL investors suffer, home owners suffer… all to differing degrees, of course, but the outcome can only be higher wage demands… Inflation.

So in the UK, raising interest rates, particularly at the speed of recent rises is fuelling wage inflation which is actually the worst of economic inflationary pressures, simply because rising wages creates the very worst of inflation and fuels it for the future..

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)