Sharply raising central bank interest rates might prove catastrophic, rather than just inappropriate, as a solution to the current inflationary environment. That was the message lurking in the speech of one of the Bank of England’s monetary policymakers, Silvana Tenreyro, last week. It’s hard to disagree. While inflation is hurting the poor disproportionately because of their low incomes, rate hikes are a “cure” that is worse than the disease.
The Bank regards growing unemployment as a necessary trade-off to prevent the acceleration of inflation. Its central projection for rising interest rates suggests almost 2.5 million people would be jobless in 2025 – with the worst-case scenarios seeing 3 million out of work. This would lead to widespread misery. Nobody wants to be jobless. Karl Marx’s reserve army of the unemployed is full of conscripts, not volunteers. Many are already deserting its ranks, preferring to leave the labour force entirely rather than be jobless.
Both higher unemployment and higher inflation lower wellbeing. The economist David Blanchflower showed in 2014 that unemployment makes people much more unhappy than inflation. Every one percentage point increase in the unemployment rate, he suggested, lowered wellbeing by more than five times as much as a one percentage point increase in the inflation rate. More recent work suggests people suffer “between nine and 13” times the daily anguish from unemployment than they do from inflation.
Given the UK economy has only just emerged from Covid, orchestrating a deep recession is chilling. The Bank is operating under a flawed logic: that the more it increases rates, the more unemployment is pushed up and the quicker inflation is reduced. But this relationship between unemployment and inflation does not exist.
It is striking that the current low unemployment rates are now considered “unsustainable” even though similar unemployment rates were fine pre-pandemic. For a decade after the 2008 global financial crisis, inflation remained largely unresponsive to the fall from 9% to 4% in the UK’s unemployment rate. Real pay was stagnant. Such a drop in joblessness should have produced rapid wage growth. This did not happen because of what the economist Michał Kalecki described as an economy’s “degree of monopoly”. This allows companies to limit the ability of workers, consumers and regulators to influence the markup of selling prices over costs and to defend the share of wages in output. Since 2008, UK average markups increased from 20% to 35%.
Prof Blanchflower correctly forecast that in the US price rises would begin to slow. The Federal Reserve was caught unawares by last week’s lower-than-expected inflation readings. The economist thinks Britain will probably follow the same path. The biggest driver of UK inflation in October will be the higher energy price cap. But to see this month’s inflation keep rising at the same rate as September’s would require prices to jump by about 10 times their historical average. That seems unlikely. Disinflation is the more probable outcome.
After the initial blast of higher energy costs and Covid disruptions fade, there are few ways for the inflationary shock to propagate. One mechanism would be firms marking up sustained cost changes. With no intervention to fix prices or a competition watchdog with teeth, Britain is a treasure island for firms to gouge profits using price rises. If that is happening, then the Bank’s interest rate hikes threaten to push the economy into recession and harm millions of people – with little impact on the overall inflation rate.
