The Bank of England today raised interest rates by half a percent, in a move that exemplifies a panicked central bank. Interest rates are a blunt instrument and adjusting them abruptly and significantly hardly inspires confidence in the institution responsible. This surprise decision will have no substantial impact on inflation, but it will undoubtedly damage market and economic sentiment and repairing the resulting effects will take a long time.
In a somewhat comical response, the pound did not strengthen, which is one of the main reasons for raising interest rates—to bolster the local currency and reduce import prices. Instead it went into a trauma of randomness.
In a nutshell, the U.K. is currently facing both political and economic turmoil. It is plagued by inflation and the accompanying instabilities, mainly because it lacks the ability to navigate the challenging post-Covid economic and political landscape.
The country finds itself trapped in a self-inflicted vicious circle of inflation, a consequence of economic mismanagement. Inflation can only be created by increasing the money supply, and only governments have the authority to do so. However, governments typically avoid taking responsibility for inflation and instead shift the blame onto others.
It is important to acknowledge that inflation can serve as a useful tool, acting as a short-term economic pain reliever to mask underlying long-term economic issues that require time to resolve. The U.K. is currently in such a period, where inflation arises when systemic problems are too severe to be fixed with a quick, drastic measure, necessitating a prolonged readjustment. This situation is often observed during and after wars when financial systems and infrastructure are severely disrupted, and wealth destruction occurs. In such circumstances, governments resort to debasing the currency, typically by printing more money, to have funds available for their purposes via the printing press. Inflation is a flat tax since government revenue does not rely on unpopular tax collections and can be executed instantly. Inflation is a stealthy and chronic process rather than a brutal and acute one, which contributes to its popularity as a policy tool.
The real trouble begins when governments become dependent on this method and find it easier to continue relying on inflation rather than endure the cold turkey of doing without it. It took the U.K. more than a generation to overcome its addiction to inflation after World War II and some countries remain perpetually hooked on the drug of printed money, as is evident in many developing economies.
The U.K. is dicing with this outcome.
Contrary to popular belief, high interest rates do not cure inflation. Over the years, we have witnessed low interest rates not leading to inflation, as well as numerous countries with persistently high interest rates experiencing runaway inflation. Inflation is primarily controlled by adjusting the money supply, either by loosening or tightening it. If money supply growth is halted, interest rates will naturally adjust themselves. However, even with high interest rates comparable to those in African nations, inflation will persist if money supply exceeds the balanced needs of an economy.
When the U.K. distributes new money to address its “cost of living” problem, it inadvertently fuels further inflation. Similarly, when it provides funds to cap fuel costs or runs significant deficits, it contributes to more inflation. Raising interest rates will have minimal impact if the government continues to distribute and utilize newly created money.
Moreover, if interest rates are increased to the point where businesses and consumers are severely affected, with the hope of curbing demand and thus suppressing prices, there is a certainty of declining tax revenue, perpetuating the need for money printing, unless politically impossible cuts to expenditure are inflicted. This scenario reflects the economic death spiral often witnessed in poorly managed nations. Regrettably, the UK is flirting with this dangerous outcome.
After Brexit, the UK finds itself in a precarious position. It has been unable to implement an ambitious swashbuckling agenda that would transform it into an agile and deregulated nation, free from EU constraints. Instead, it finds itself caught in the worst of both worlds—outside the EU without the advantages of membership in the world’s largest economic market, leading to a gradual erosion of sectors such as financial services, while unwilling to throw off the chains of bureaucracy and stifling regulation.
If the current strategy is to cripple businesses and consumers to combat inflation, this suffocating situation will only worsen. Meanwhile shifting interest rates in significant increments is not the path to achieving the economic stability required for price stability.
