The relationship between raising interest rates and cutting inflation is a relatively simple one. Raising interest rates diminishes consumer demand by restricting the amount of money in consumers’ pockets.
Hike interest rates, mortgages get more expensive, people buy less on the back of credit. The recipe (and so-called remedy) was confirmed this week as the Bank of England signed off on an open-ended extension to historically high interest rates. Yet – as Andrew Bailey conceded – the bank cannot tell us how much more of this particular medicine we will need.
The reason is simple. As the Bank’s chief economist Huw Pill conceded, the solution to inflation is not under its control. The principal drivers of price rises today are geopolitical, the situation in the Middle East picking up where the war in Ukraine left off.
It could be then, that, absent change or consensus at the Monetary Policy Committee, interest rates stay at comparatively high levels for the foreseeable future. This is where I fear underappreciated economic danger – and serious danger at that.
By historic standards, rates of 5.25 per cent are by no means high. As the UK’s economy boomed in the 1980s, the rate never dropped below 8 per cent. Yet, a crucial difference exists between now and then. It is a difference that makes the bank’s current interest rate experiment dangerous. In my view, it is capable of triggering a crash of 2008 proportions.
The difference is our economy’s chronic indebtedness. At least since the financial crash, we have fuelled what economic growth we have had with cheap credit (alongside cheap imported labour, investment and goods).
As a result, our nation’s businesses and households are grotesquely indebted.
Household debt has almost trebled since the 1980s. Meanwhile, British businesses are in debt to the tune of £1.4 trillion. Measured another way, their gross debt-to-earnings ratio is over 300 per cent. Before the millennium, it sat closer to 200 per cent.
Subtle changes in this rate can tell a powerful story about the state of the economy. But these are not little changes. The foundation of our economy has shifted in a generation. Our businesses are debt-laden like never before. Accordingly, they are particularly vulnerable to interest rises.
Firms across the country have outstanding loans that enabled critical investments at negligible interest. As loans on fixed rates expire, and begin to track the base rate they will join other variable rate loans and make highly leveraged businesses unviable.
All this has a very real impact. According to insolvency specialist Begbies Traynor, nearly 50,000 UK businesses are in “critical” financial distress. The number of firms in this position was up 26 per cent in the fourth quarter of 2023. The third quarter was itself a 25 per cent rise from the second.
The Bank of England, however, tells a different, Panglossian story. In its Financial Stability Report, published in December, the Bank has simply replaced the graph that featured UK companies’ gross debt-to-earnings ratio with a kinder measure. While it acknowledges the risk that highly leveraged businesses pose to the economy, it affords itself a relatively clean bill of health.
Andrew Bailey might be right. Interest rates might – with relatively minor damage – tame inflation and allow the economy to reset on a sounder footing. But he might be wrong.
Imagine, briefly, that the situation in the Middle East grows worse, with more interruption to shipping. That the war in Ukraine rumbles along into yet another winter of interrupted gas supplies. That Donald Trump – as the polls suggest – is re-elected and that he uses his first year in office to finally turn off the taps of cheap dumped Chinese goods that have decimated American manufacturing.
These factors would see inflation stay persistently high. Andrew Bailey has made clear that if it does, interest rates will stay where they are. And more and more businesses structured around the cheap credit of the 2010s will spend more and more servicing their debts. Households who bought houses on huge mortgages will face more and more of a squeeze. Throw into this the undeniable instability caused by our crazy system of fractional reserve banking and it is not hard to see the potential for real economic carnage right around the corner.
At some point, removing gloomy graphs from reports isn’t going to cover the cracks in our economy. All economics might be educated guesswork based on some shaky assumptions but at some point, the public deserves to see the plan B. The Bank needs to come clean: what happens if inflation stays high? What price is too high to maintain its current interest rate strategy? And what happens if this all ends in tears?
Phillip Ullmann is an investor and businessman who for 20 years ran one of the UK’s largest employment agencies
