In the UK, everyone prays at the “temple of inflation,” but few understand what inflation actually is. The number that people often associate with the ‘rate of inflation’, typically the Consumer Price Index (CPI) or CPIH, derives not from something intrinsic to the economy but it is in fact a flawed fabricated metric. To create it, the Office for National Statistics (ONS) chooses numerous items to place in an imaginary basket of goods, then tracks how their prices change over a year. These changes are then weighted according to how much people typically spend on each item. And they feed into a final number we know as inflation. At first glance, this might seem logical, but it’s fundamentally flawed. While it is flawed, that it isn’t insidious, what is insidious is how how the Bank of England uses this flawed measurement to conduct inflation targeting.
Central banks worldwide strive to maintain inflation at 2% to stave off deflation. Deflation is seen as a haunting prospect which could lower consumer spending. The idea goes something like this; Deflation is falling prices of goods and services, meaning that the price of something this year would be lower next year. Therefore, deflation could discourage spending, because people would save more and spend less. This in large part because their money will be worth more in the future than now. Obviously this is absurd, people wont avoid buying a TV or cooker this year because next year it could be £8 cheaper, but that is the theory. So the Central Banks aim to ensure that money continually loses its purchasing power, which they do by maintaining a 2% inflation rate. This rates means that the basket of foods in the CPI increases in cost by 2% each year. Two percent is chosen as a buffer to prevent deflation and encourage spending rather than saving.
In the 2009–2021 period The Bank of England, struggled to hit their 2% inflation target. Hence they held interest rates at record lows. The idea being that lower interest rates raises inflation because more people to take out more loans, thereby creating more money. It’s important to note here that every time a loan is issued, money is essentially created out of nothing. If more money is created there is more in circulation. Then theoretically, you need more money to purchase the same quantity of goods, thus inflation has happened.
However, during that period money creation, when coupled with Quantitative Easing, primarily inflated the prices of high value assets, including housing, cars, and high-value goods. Meanwhile, the prices of general items like TVs, bread, milk, and washing machines remained relatively stable. In fact, we have seen a decline in the relative costs of numerous items. For instance, new computers, once priced at £1000 during my childhood, are now available for just a few hundred pounds. I recall buying a 14-inch TV for £75 from Argos when I was about 9 or 10 years old. Now, one can purchase significantly better TVs for less than £100.
Such price reductions can be attributed to advancements in various fields. Semiconductors, logistics, improved modelling software, and more reliable manufacturing processes have all contributed to decreasing production costs. The efficiencies gained in appliances, such as refrigerators, have also lowered consumers’ costs by reducing the operational expenses of shops. Even factors such as the use of larger, more efficient tractors have come into play, allowing a single farmer to accomplish more work in less time, consequently reducing labour costs on farms.
Interestingly, when inflation did occur, in the 2009 to 2021 period, it was often due to government intervention rather than market factors. For instance, while gas prices remained stable, energy costs increased due to poorly planned green policies that inadvertently drove up the price of energy.
Consequently, the economy was in a prolonged period of natural deflation when the BOE was trying to stimulate inflation, but they only really succeeded in inflating the cost of assets. The measure of inflation they were trying to push up through inflation targeting; therefore, has a fundamental flaw. It does not account for technological advancements that lead to efficiency and cost savings. Which should result in lower production costs for almost everything and therefore lower costs to the consumer and result in deflation. They created an asset bubble because inflation targeting is like using an asteroid to hammer in a nail. Wrong tool, wrong job.
After 2021, and the BOE inflating asset prices, we had Covid and demand for everything dropped, factories shut down and stock in warehouses depleted. When Covid ended and people returned to work, and buying things, there was a high demand for goods and services, the demand was there but the supply wasn’t, that nudged inflation up as people were willing to pay more for the goods that they wanted. Then, when the Ukraine conflict occurred, the country was primed for a significant leap in inflation. This wasn’t due to anything inherent in the economy, but rather because the cost of gas and fuel skyrocketed. The prices of goods and services surged because gas and fuel costs influence everything in the economy.
Increases in gas and fuel prices affect all sectors, not just home energy costs. Fertiliser for farmers is produced through the Haber process, which requires natural gas and substantial amounts of energy. Farmers drive tractors that use diesel, the price of which has surged. Lorries, which also use diesel, have experienced a rise in costs to move goods from warehouses to shops. The cost of commuting to work, which requires diesel or petrol, has jumped. The construction industry, which now cannot use duty-free red diesel, has seen costs increase. Every retail shop in the UK uses electricity; a manager at Mountain Warehouse informed me that their company-wide energy costs increased by £6 million due to a leap in gas prices. This occurred before the real shock of price increases. Consequently, every product you buy in a store has its price indirectly influenced by the price of gas. This includes restaurants, fish and chip shops, and swimming pools, all of which are factored into the problematic inflation measurement. The inflation measure, CPI, isn’t measuring the price rise of many distinct goods; instead, it gauges the price rise of gas and fuel over a year-long period. This is where we encounter the problem with raising interest rates today.
CPI inflation is still high because it measures prices over a year, and the market hasn’t adjusted to the lower energy costs. This is problematic as the UK price cap (which relates to average energy costs for an average household) was around £2000 until October last year. It then jumped to £2500 when the Government’s price guarantee kicked in at £2500. So, we are still seeing the effect of this increase in the CPI figure even though the cost of energy has fallen and will drop further on July 1st. The Bank of England is now setting the base rate, and therefore mortgage rates, on a figure of inflation which has not taken into account the decrease in wholesale prices of gas and energy. Which is a deflationary pressure and will occur in 9 days.
We can already see food costs dropping in supermarkets, but costs will fall across all sectors over the next few months. Expenses for heating, restaurants, swimming pools, fertiliser, and electricity for every business across the country will decrease, and therefore inflation will fall, leading potentially to deflation. The Bank of England will argue that falling inflation is due to the raising of interest rates and that they did a ‘good job’, but this isn’t the case. It is entirely due to the fall in gas prices, which is a consequence of European storage being full and therefore Europe demanding less gas, with supply increasing from other parts of the world to replace Russia’s supply. Ironically, the Bank of England raising interest rates will increase inflation because it elevates the cost of housing in the CPIH measurement.
In theory, we should see a period of deflation following the energy cost falls, but the BOE will do everything in its power to stop that. Just as it dropped the ball with its butter fingers on inflation, it will drop that ball too. It will probably rapidly drop interest rates and carry out more QE to stabilise the economy. But it will be a disaster, like the train-wreck they are currently ploughing through the country.
*The theory behind raising interest rates to reduce inflation is primarily based on limiting money creation via loans. People take out fewer loans, so less money is created, and more is destroyed. This, in theory, reduces the money in circulation, and if there is less money to go around, the cost of goods falls because its relative value goes up. But it’s all smoke and mirrors.