Interest Rates and Mini-Budgets

Martina Seale

On May 4^th the Bank of England (BoE) decided to raise the Bank interest rate by 0.25% to 1%.  The stated purpose of the increase is to help fight inflation.

The logic that the BoE is following is really quite simple.  Inflation is caused by demand for products being greater that the supply of those products.  Reducing demand will reduce inflation.  Consumption and investment are the two main private sector sources of demand.  Consumption financed by borrowing will now be more expensive and so will be reduced.  Similarly investment on new and existing projects will become more expensive thus reducing profitability and so previously planned projects may be shelved or completely abandoned.

A problem with this logic is that, in the current context, the difference between supply and demand is not caused by an increase in demand.  Rather it is caused mainly by a drop in supply.  The Covid pandemic has interfered with the production and distribution of the goods which people wish to buy.  That initial Covid disruption is now being dramatically amplified by the war in Ukraine.  

What needs to be fixed is the production and distribution of these goods.  There is no reason to believe that an increase in interest rates will help that process.  If anything it will hinder it by increasing the cost of completing projects that might improve the supply of goods.

Energy  and food prices have increased noticeably in recent months.  Year on year inflation in the UK is reported to be at 9%.  Consumers are still spending as much but that spending is buying less goods and services.  The providers of those goods and services that are no longer being bought will ultimately become unemployed.  So, the inflation has built into it an automatic drop in demand which will in due course create unemployment.  By increasing the rate of interest, the BoE, is reinforcing that drop in demand and pushing the economy in the direction of recession and higher unemployment.

Inflation leads to a drop in the real wages of workers because they can buy less goods and services with their existing wages.  How workers react to such a drop in their standard of living has great political implications.  In the 1970s and 1980s British workers demanded compensatory wage increases and they were politically strong enough to get these increases.  However,  employers refused to accept the consequent drop in profits and instead increased prices.  This lead to a wage-price spiral inflation.

Although the 0.25% increase in the interest rate announced by the BoE on 4^th May was presented in economic terms, in fact it was very much a political intervention.  The BoE is sending a message to working people that they must accept the drop in their standard of living implied by the current inflation, that any attempt to defend their standard of living will result in increased unemployment.  

It is somewhat amusing that the 0.25% increase in the interest rate which is designed to take demand out of the economy is being substantially negated by Sunak’s attempt to soften the effect of the increase in energy prices on living costs.  Sunak is injecting some £20 billion of extra demand back into the economy.  One continues to wonder why Johnson retains Sunak as Chancellor.   This may seem a strange statement since Sunak’s budget was a definite step in the direction of easing the cost of living crisis. 

The problem with Sunak is that he had stated categorically only a few weeks ago that the government would not introduce a windfall tax.  Doing a U turn makes the government look both ridiculous and incompetent.

Sunak’s budget pretends that the money to finance the various payments he proposes to make come from the windfall tax.  It doesn’t.  The UK government is a currency creating government so it can create whatever amount of money it thinks makes sense.  During the pandemic, Sunak created £400 billion of new money to pay those on Furlough.  So why have a windfall tax?  Taxation takes away spending power from people.  The purpose of taxation is mostly to free up resources that can be directly purchased by the government or, more normally, by the people to whom the government gives money.  

Sunak presented his spending into the economy in  a way that suggested that it was being financed by the windfall tax.  But he then introduced an uplift on capital investments which somewhat gives the game away.   If you spend £100 in investment you will get a tax allowance of £190.  If this investment allowance is taken up by the oil companies then Sunak will get very little extra tax revenue.  Which of course completely undermines the idea that it is the windfall tax that is financing the cost of living payments.

It is doubtful that Labour will pick up on this nonsense since Rachel Reeves, like Sunak, believes that the money that the government spends into the economy comes from taxation.