David Gauke is a former Justice Secretary, and was an independent candidate in South-West Hertfordshire at the 2019 general election.
There are multiple consequences of higher interest rates. One of which is that various bad ideas gain currency as proposals are put forward that will supposedly avoid the pain that is to come. Here are four examples.
The first bogus argument starts with the premise that our inflationary problems are not caused by excess demand but by inadequate supply – caused by Covid and Brexit disruption and so on. Therefore, the argument goes, the way to address inflation is not to reduce demand but improve supply.
There is, of course, an element of truth to this, in the sense that restricted supply is the source of many of the problems. If we could remove the supply constraints – such as an absence of workers – we would have less of a problem with inflation. Policies that increase the supply of labour – whether that is training, welfare reform, occupational healthcare or immigration – may ultimately help reduce inflation. But these are not measures that are likely to have an immediate impact on inflation.
In other words, even if our problems result from restricted supply and not increased demand, the situation is still that demand is exceeding supply. To address this quickly (and not addressing it quickly will create further problems) we need demand to be reduced.
The second set of bad ideas is to focus on the symptoms not the causes. When prices go up to adjust to a new equilibrium between supply and demand, the businesses putting up prices get the blame and are accused of profiteering. There was much excitement last week when the International Monetary Fund pointed out that corporate profits had grown. “Greedflation” is the fashionable phrase as large businesses – particularly supermarkets – are blamed for putting up prices. As it happens, the IMF was referring to Europe, and the evidence of corporate profits growing in the UK in the same way is not at all convincing.
The argument also misses two bigger points. Businesses making bigger profits (or, for that matter, workers receiving high pay awards) is a consequence of inflationary pressures, not the fundamental cause of them. And market signals are helpful in allocating resources efficiently. For example, where supply constraints force up prices in a particular sector, the incentives created by higher prices will help address the problem.
Governments need to ensure that markets are competitive, but exhorting businesses to ignore supply and demand in setting prices and to act against their interests is not an effective method of controlling inflation. Some advocate going further and imposing price controls. At best, this always proves to be ineffective and results in unintended consequences. At worst, price controls result in disastrous shortages. Politicians and central bankers should not be blaming businesses operating in competitive markets for the prices they charge.
The reality is that demand has to be reduced, and the best tool available to the Bank of England is to increase interest rates. The consequences of higher interest rates, of course, are not evenly spread. For those with large mortgages, at least once off their fixed rate, the news is very bad indeed. If we assume that landlords will pass on higher interest costs to tenants (and this is an assumption that can be questioned), tenants may pay higher rents. But for those who own their home outright, this will not have a direct impact and, if they have savings, will benefit them.
Unsurprisingly, this has led to calls for protection for mortgage holders. Discouraging foreclosures by, for example, enabling mortgage holders to switch to interest only mortgages may be sensible but other ideas make up our third set of foolish ideas.
The Liberal Democrats – reverting to their traditional position of trying to bribe the middle classes with their own money – were quick to see the problem emerging and have advocated taxpayer funded grants to those struggling to pay their mortgage. Some Conservative MPs have called for a return of MIRAS – mortgage interest relief at source – which was part of our tax system until 1999.
These policies might be popular. One can see why beneficiaries would welcome them, but they would still be a mistake. They would blunt the anti-inflationary effectiveness of higher interest, perhaps forcing interest rates up even further which would damage business investment.
There is also a moral hazard issue, as people would take on higher levels of borrowing on the assumption that the State would bail them out if things went wrong. Related to this, these policies would further distort the savings market towards housing rather than more productive investment. And the support would not be progressively targeted – much of the support would end up going to people on medium and even high incomes.
If we wanted to redistribute the pain – and it does have to be said that the pain is going to be heavily concentrated on mortgage holders – we could use fiscal measures to try to take some of the heat in the economy. The Government is seeking to do that by tight control of public sector pay although that comes with the consequence of making the public sector uncompetitive in terms of recruiting and retaining staff. Tax increases are already happening (with the freezing of thresholds). Some argued that the April 2022 increase in national insurance contributions (subsequently dropped) risked weakening demand and threatened a fragile economy. That argument now looks wrong; our post-Covid, post-Brexit economy was overheating.
To protect mortgage holders from even higher interest rates, the Government could engage in a further fiscal tightening of some description. In general, governments should be wary about relying too heavily on fiscal policy to tackle inflation (getting the timing right is immensely difficult) but, at the very least, fiscal policy should not be working against monetary policy. A big fiscal loosening while inflation is high, such as large tax cuts, would make matters worse.
The fourth example of a bad idea becoming more fashionable is that we should abandon an independent central bank and return monetary policy to the Treasury. Yes, the Bank of England was too hesitant in raising rates earlier, but this does not mean that the entire model is discredited.
It is true that Rishi Sunak, as Chancellor, was quicker to worry about inflation when Chancellor than many, but the perception of the markets will continue to be that governments will be more reluctant to administer tough medicine than central bankers. Undermining independent economic institutions comes at a very great cost, as Liz Truss demonstrated. To maintain market confidence, interest rates would have to go higher and stay high for longer if politicians had direct control of monetary policy.
The problem for the Government is once you dismiss all the wishful thinking that exists on inflation, you are still left with a big problem and a painful solution. We should seek to address supply constraints, but this will not quickly address inflation. Inflation is not the fault of greedy big businesses, and it cannot be regulated away. We cannot protect everyone from the pain inflicted by effective anti-inflationary measures, even if we could go some way to redistribute it by pursuing very unpopular policies. Changing the institutional arrangements for the Bank of England will almost certainly make matters worse.
Squeezing inflation out of the system is going to hurt – and there is no plausible way to avoid that. This is the essence of the Prime Minister’s message to the nation. He is speaking the truth, even if the country is unlikely to be grateful to hear it.