Raising interest rates isn’t an option
With inflation rising again, some are calling for interest rates to rise. They are wrong. Increasing interest rates would not only be a pointless measure but it kill off any chance of an economic recovery.
CPI, the Consumer Prices Index is the government’s preferred measure of inflation. It has risen to 4.5% in April from 4% in March. Quite a jump. RPI, or Retail Price Inflation has fallen slightly from 5.3% in March to 5.2% in April.
To me, RPI is the measure we should use. It reflects the cost of mortgage repayments that to many is a significant part of your monthly expenditure.
Why are some calling for inflation to be tackled and for interest rates to rise? This is largely because their understanding of economics is flawed. In the 1980’s when we moved to a monetarist economic policy, interest rates were the weapon of choice to combat inflation.
Indeed when inflation is caused by excessive demand or by wage-push inflation, so it is the right tool to use. It’s about controlling the money supply. If an increase in money supply is driving prices up, so interest rates can be used to slow excessive growth.
However we are in a very different economic situation now. Inflation is coming through structural tax changes and rising commodity prices. Pushing up interest rates would suck more money out of the economy, push up the costs of doing business, raise our currency strength making it more expensive to export goods and services and provide further inflation within the system. In addition to that it would raise the cost of capital and therefore push up target returns for business before achieving profit.
I know all of that sounds a bit nebulous and if you have cash in the bank earning next to no interest it’s very frustrating. Indeed for those with significant sums in cash, this is a difficult time. Cash is no longer king. For longer-term investments you need to diversify. Keeping all your investments in cash even in a volatile market isn’t good. For the first time in a generation, a diversified investment policy of some cash, some property, some stocks and shares, some bonds and even some commodities is the way forward.
Back to interest rates. It’s really important in my view to understand what’s going on in our economy. The inflation we have is actually reducing our national and structural debt. In addition, low interest rates mean the cost of the debt to our economy is minimised. Whilst currency rates are at the $1.62 and Euro 1.14, that’s about right… for now. For those with cash, it’s a difficult time. For those with debt and those seeking to expand a business by using debt it’s actually quite a good environment. Except for one thing. The banks are not lending properly. Until debt becomes more widely available and the costs really come down, then an increase in the Bank of England’s interest rate would not be the right policy to pursue. When and only when inflation is being driven by excessive consumer demand or indeed through wage inflation, that’s the time to act. Now is not that time.
Let’s just hope that those in the media calling for that rate rise go and take a lesson in economics rather than decreasing the chances of a solid economic recovery for UK PLC.